Skill vs. Probability.

Lucky, or good? This question gets asked a lot, but few realize how important it is.

Having just finished Michael Mauboussin’s book, Think Twice, I couldn’t help but reconsider this question across a range of areas.

It turns out to be crucial in sports, business, politics, investing, and even parenting!

The basic issue is that the outcomes we see are one part skill, and one part probability, (i.e. luck). Where we get wrapped around the axle is when we assume that bad luck means bad skill, or, more frequently, that good luck means good skill.

Sports seems like the most obvious example. People assume hot and cold streaks are due to controllable skill, when they’re much more likely due to good and bad luck. A 60% free throw basketball shooter has a 7.8% chance of making 5 in a row; a 40% shooter has a 1% chance of 5 in a row. But, that doesn’t mean that on any given night the 40% shooter won’t shoot better than the 60% shooter. Sorry, that’s just probability.

A better example is the Sports Illustrated jinx. Teams or athletes tend to do worse after they appear on the cover of Sports Illustrated. Luck or skill? They were probably on the cover because they had skill and a streak of good luck. The did worse afterward because they had skill and a streak of bad luck. Fans will probably claim otherwise, but it’s more likely a change in luck than skill.

The same phenomenon occurs in business. Companies and managers that appear on the front of Business Week, Forbes and Fortune tend to under-perform afterward (both their stock and underlying performance metrics). Were they on the cover because they were terribly skillful, or because they had skill and were a bit luckier than average? This doesn’t bode well for Apple, Google or Hewlett Packard that have graced a lot of magazine covers recently.

You can see the same thing in a business’s underlying performance. If a company is shooting the lights on in sales and profits, it’s part luck and part skill. A company with terrible performance may be terrible, but it’s also likely to be partly bad luck. The statistics show that performance tends to regress to the mean over time–the good get worse and the bad get better.

Politics and entertainment are also good examples. Was Bush purely to blame for 9/11 and hurricane Katrina, or was he unlucky? Likely, he was both unlucky and unskillful, but he’s frequently blamed as if it were all bad skill. Same for Obama. Was he unlucky or unskillful to have the housing market meltdown and a giant oil spill in the Gulf of Mexico on his watch? People aren’t very objective in judging politicians and the degree to which luck plays a part, especially when they go into situations with political prejudices.

I’ve found luck and skill even play a part in parenting. If you’re saying “DUH!?” right now, I agree with you. When my almost 3 year old daughter is sick or teething (which I consider luck, not skill on my part), things go worse. This means tantrums galore! When she isn’t sick or teething, things go a lot better. She occasionally even listens to me! My skill is the same (or at least relatively stable), but my results are different because luck plays a part.

No where is this more obvious in my life than with investing. Luck plays a major part in investing because the outcomes are due to so many complex factors. Predicting economic outcomes, weather patterns, competitive dynamics, etc. makes investing a terribly difficult area to separate skill from luck. And yet, both good and bad luck are there along with skill.

That’s why its so important to look at a managers long term record. If he or she does well over the long run but hasn’t done well recently, bad luck is probably playing a part and good luck will eventually come back. On the flip side, a good record doesn’t necessarily mean skill and good luck, it could just be good luck. This burns investors more than anything else in the investing world, and it counts when looking at investing managers as much as specific investments (Apple, anyone?).

Skill or statistics? Lucky or good. You be the judge. But, don’t fool yourself that both good and bad luck aren’t playing a roll. They most certainly are.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Fat lady singing?; Paris.

With the recent market pull-back of over 10%, it’s a good time to ask if the bull market that began in March 2009 is over.

First off, I don’t know, and neither does anyone else. I, like so many others, am speculating on what may happen, not forecasting what will happen. Forecasting short term market direction is foolish. Or, as Warren Buffett put it, “The fact that people will be full of greed, fear and folly is predictable. The sequence is not predictable.”

Given those caveats, I don’t think this market pull-back is the end of this bull market. I have several reasons for this opinion.

1) The governments of the world are still flooding the system with money at zero percent interest rates. It’s unlikely markets will tank with so much easy money available.

2) The governments of the world are still back-stopping every economic problem. Market crashes rarely happen when everyone has just experienced one, or when governments are working so hard to prevent them. Eventually, governments will run out of ammunition, but they haven’t, yet.

3) Lots of economic numbers look good. Granted, commodities like copper and oil have pulled back, but manufacturing data looks strong and railroad shipments are staging a real recovery. These figures may turn down, but for now they are signaling a real recovery.

4) Retail investors were just starting to join the party. I’ve commented before that the general public tends to be a contrarian indicator–do the opposite of what they are doing. Retail investors were just starting to pull money from bond funds and put them into equity funds. I believe they will end up much more fully invested before things really roll over.

I must admit, I was prepared for the downturn. I had bought volatility for both my clients and myself and have mostly cashed out (I invested in a security that goes up when the market goes down). Now, I’m getting reinvested in the same blue chip companies I’ve been recommending for quite some time.

Markets may continue to head down for a bit, and it’s nice to have some hedges against that, but I don’t think the fat lady is singing (yet). It’s a good time to invest in quality companies at cheaper prices.

In the long run, governments will run out of ammunition. When that happens, markets will probably head down by more than 10%. In my opinion, that’s still a couple of years away, but I could be wrong and it could be starting now. Either way, I’m prepared.

On a separate note, my wife and I just got back from a week in Paris, and we had a blast. The food there was simply unbelievable. In fact, my wife and I had the best meal of our lives at a little restaurant called chez l’ Ami Jean (Rue Cler area). Outstanding!

I also found the people of Paris to be incredibly friendly and helpful. It was almost impossible to look at a map and try to figure out where you were without someone stopping to offer help. We tried our French on them, and they were happy to oblige while still being able to speak English when necessary (their English was always better than our French).

Paris is the world’s leading vacation destination, so my recommendation is hardly unique, but I’d highly recommend it to anyone thinking about world travel.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

“The Fault, Dear Brutus…”

I read a stunning Morningstar article the other day. Ken Heebner’s CGM Focus Fund returned an outstanding 17.84% annualized return over the last 10 years. While the market as a whole went down, CGM Focus would have multiplied your money by 5.2 times. Wow!

That’s assuming, of course, that you bought the fund and held on during all the ups and downs of both the market and the CGM Focus Fund. The return that Heebner’s actual investors received (as calculated my Morningstar)? Negative 16.82% annualized!

You might look at those numbers incredulously and wonder how on earth the fund could provide 17.84% returns while investors lost 16.82% annualized.

It relates to the title of this blog. As Shakespeare put it in Julius Caesar, “The fault, dear Brutus, is not in our stars, But in ourselves.” The reason investors get lousy returns is not due to fate, but because they shoot themselves in the foot.

How can a fund go up 17.84% annualized, but investors get -16.82% returns? Investors chase volatile performance. They buy after a fund had done well, only to find it top and roll over. After it tanks, they give up and sell, only to find it race back up again. Rinse and repeat.

Research clearly shows investors are their own worst enemy. Instead of formulating a plan and sticking to it through bumpy markets, they try to game the system. That’s why Dalbar studies have consistently shown investors get 1/4 of the return of the mutual funds they invest in–they chase performance!

It’s not just individual investors who do this, professionals chase performance, too. Jeremy Grantham of GMO talks about how he lost 60%–60%!!!–of his clients during the late 1990’s and early 2000. His clients were abandoning him because he “didn’t get” the dot-com boom. Grantham’s disciplined investment approach, of course, turned out to be right, and he provided brilliant returns for those clients who stuck around.

This lesson is counter-intuitive to most people, but vitally important to investment success. Markets move in fits and starts. Trying to time the market is a fool’s errand. The people who succeed over the long run stick to a disciplined and proven approach. Judging investment records by short term performance, even 3 to 5 years, isn’t enough. If a disciplined approach doesn’t look like it’s working, stay the course or–even better–put more money to work in it. Focus on the long term, even when it’s extremely hard to do, or hire someone who can do that for you.

Or, as Warren Buffett puts it, “be greedy when others are fearful and fearful when others are greedy.”

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.