Role of Luck and Skill in Investing

A big difference between amateur and professional in any field is that, if amateur wins he would
attribute his success completely to his skill but on the other side, if any professionals’ wins, they
could clearly distinguish between what amount of skill and what amount of luck played the role in
their success. In investment field, Luck and skill both play a crucial role in investors success. Investors
should be very wise to know what mix of luck and skill played in their investment outcomes.

Decoding Skill and Luck

We can improve our skill, through regular practise but we cannot improve our luck. Luck is an
uncontrollable factor so, we may think that, improving our skill will result in good outcome but the
reality is that, improving our skill alone will not result in good outcomes. In this post we will
understand the main characteristics of luck and skill and why we are very poor in differentiating
between these two factors (biases) and in last we will also understand why improving skill alone will
not result in good results.

Understanding Luck and Skill

First, we must understand what does skill and luck signifies and how do they interact with each
other.

Skill

If we have to find how much the skill contributed in the outcomes, we have to ask only one
question, can we fail deliberately?

Let us under through a simple example, an artist is painting a scenery in the drawing competition
and he wins first place. Now would you attribute the outcome (winning first place) to skill or luck?

Now it’s the time to ask the question, can he(artist) fail deliberately?

The answer is “yes” because, if he wished he could have screwed up his own drawing and he would
not have won the game. He has the control over the outcome(result). This indicates that Skill played
an important role in his success and luck didn’t played a crucial role and the artist(winner) was more
skilful than others, who attended the competition.

This above example gives us a thought that, increasing our skill through practise will lead to definite
success. The answer is “no”, increasing our skill along will not guarantee success.

Why increasing skill alone will not guarantee success?

In order to know the answer, we must understand a concept called ‘paradox of skill’.

Paradox of Skill

In the recent times in the financial field, it has become very difficult to find good investments and
the reason may be that, there are not many skilful investors to find attractive investments but the
reason is exact opposite of what we think, it is because of, there is too many skilful investors.

Paradox of skill states that, if the level of skill rises among everyone, then luck plays a crucial role in
determining the success.

Investors make money only when other side loses it. Investors have become more skilful than they
one or two decades ago. So, these skills cancel out each other, leaving the room for luck to play its
 Role of Luck and Skill in Investing

game, in determining success. In other words, we can say that, if everyone increases their skill at the
same rate, they cancel out each other and luck plays the role.

So how to overcome this?

Paradox of skill clearly shows that increasing our skill alone doesn’t increase our results and luck
plays a critical role. Even though we cannot directly control our luck we can minimize its role in our
outcomes. One of the ways is by choosing your game wisely.

Choosing our game wisely

This strategy indicates that we much play our game only against weak opponents to reduce the role
of luck.For example, it will be very difficult for us to defeat chess grandmasters in chess. But there is
a way to defeat them, to play against them but not in chess.

Analysing our edge(skill) and taking full advantage of our edge against the weak players, plays a
crucial role in outcomes.

Now it’s the time to turn our face towards luck

Luck

We now understand that luck plays a important role in success equation. The way to find if any luck
elements played a role in our success is simple. Just ask the question, if we can fail deliberately?

If the answer is “no”, then luck as played an important role in our process. For example, you buy a
lottery ticket with a number 9874 and it seems that ticket number 9874 has won Rs 1 crores, to find
the reason for his success (skill or luck), we must ask just one question, can he fail deliberately?

The answer is “no” because he has no control over the outcome (winning ticket number 9874),
since the winning ticket number was selected by respective, authorised person. Even if we assume
that he wanted to fail deliberately, he cannot guarantee that he will fail because he had no control
of the outcome. So, we can say that it was because of his luck, he won.

Since we can now differentiate between skill and luck, it’s the time to ask the question, does
investing falls in skill side or in luck side of the game.

Is investing, a game of skill or game of luck?

The correct mix of skill and luck in investment decision is very much difficult to precisely calculate
but if we ask the question, can we deliberatively fail in any investments?

This is a tricky question, the answer to the question is not binary. Let us analyse with two situations

A) If we say that, investment is purely based on skill, then we are making a serious mistake
because in investments we are buying future uncertainties and these uncertainties leads to
outcomes that we may never of thought of happening. We don’t have control on outcomes.
B) If we say that investment is based on purely luck. This could be understood by a simple
example, consider we are ready to buy a company with poor fundamental and poor
governance, and make money out of them because we think that we may get lucky.
But this is not the case we may get, lucky few times but not all the times and the expected
value for this approach would be negative.
 Role of Luck and Skill in Investing

So, where does investments lies – closer to skill side or closer to luck side?

Investments lies closer to skill in some situation and closure to luck in some other situations.

So, what are those situations?

A) When you play against the weak opponents, skill plays an important role and role of luck is
relatively small.

For example, in investment field, if you think that you are good in bond markets and
completely understand future payoffs and risk associated with it, one must bet our money in
risk buying and selling bond and not in day trading and investment. The trick is to find an
edge, and make full use of our edge against our weak opponents. So, in this case, the
outcome (investment success) lies more closer towards skill than to luck.

By chosing our game wisely, we may reduce the luck factor in the outcome. There are
millions of ways to make money in markets and you don’t need to know all the million ways.
Our job is to find one of the ways, were we can get some edge over your opponents.

You don’t need to be smarter than everybody, you only have to be smarter than your
opponents, that is enough. So, chose your game wisely.

Emotions and biases in evaluating skill and luck

We have seen a simple way in evaluating skill and luck. But humans being a emotional creature are
swayed away by the biases in evaluating this process. So, we must be very careful that these biases
don’t come in between during our evaluation.

Most common bias

A) Outcome bias
B) Narrative fallacy

Outcome bias

There may be a situation, when we make bad investments but we get good result and we make good
investments and get bad result. In these situations, we may interrupt the situation differently, since
in we got good result (outcome) we tend to believe that we made a good decision in investments
but in realty we made a bad decision and got lucky. This leads us to overestimate over selves and
take more risk. If we get bad result, we think that our decisions were bad and underestimate
ourselves but in reality, we just got unlucky.

Outcome bias can be overcome by considering the process involved in making decisions and not the
outcomes.

Narrative Fallacy

We humans tend to think everything in cause and effect structure and we seek pattern and
connection in everything. This leads us to seek patterns in an environment, even when there is no
pattern and connection. This leads to investors in incorrectly analysing the data and take poor
investments decisions. If we get good results, we would make our own story to suggest that this
outcome was correct and if we get bad results, we would also make our own interruptions to
suggest that the outcome was correct.
 Role of Luck and Skill in Investing

To summarize

The bottom-line is, decision making in investment process is a mix of both skill and luck and one has
to chose his game wisely in order to increase his luck and win more games. One must focus on
improving his decision-making process when luck plays a crucial role. One should not become prey
to biases and handle those biases properly to take good investment decisions.