- Technical Market Commentary -

July 28, 2010 (FinancialWire) (Investrend Forums Syndicate) (Via “The Hard Trade”) (By Yaron Sadan) (Go to http://www.financialwire.net/?s=cmmtry for all recent commentaries) — Legg Mason’s Michael Maubossin discusses the differences and contributions of skill and luck to different activities, from sports to investing. He provides us with some incredibly useful insight, first and foremost in defining and identifying both skill and luck. There are a lot of useful frameworks in the article, but I'll try to highlight some areas that I thought were particularly insightful:

On luck vs. skill:

“There’s a simple and elegant test of whether there is skill in an activity: ask whether you can lose on purpose. If you can’t lose on purpose, or if it’s really hard, luck likely dominates that activity. If it’s easy to lose on purpose, skill is more important.”

Applying this to stock investing is an interesting thought process: could you deliberately choose consistently  losing positions? How would you come up with a repeatable process?

More on luck vs. skill (all emphasis is mine):

“The two main ways to assess skill and luck are through an analysis of persistence of performance (with streaks being a particularly useful subset of this approach) and its alter ego, reversion to the mean. The research shows evidence for persistence of performance in sports, business, and investing, although the evidence is strongest in sports. Studies of business and investing point to skill in both domains, although the percentage of companies or investors with skill is small.

“Reversion to the mean is also clear in each realm. The central insight is that the more the outcomes of an activity rely on luck (or randomness), the more powerful reversion to the mean will be. As important, it is clear that many decision makers do not behave as if they understand reversion to the mean, and predictably make decisions that are, as a consequence, harmful to their long-term outcomes. This is particularly pronounced in the investment industry.

“The two-urn model is a useful mental model because it allows for differential skills and accommodates luck. Even Paul Samuelson, the Nobel-prize winning economist and efficient
markets advocate, allowed for the possibility of investment skill. He wrote, ‘It is not ordained in heaven, or by the second law of thermodynamics, that a small group of intelligent and informed investors cannot systematically achieve higher mean portfolio gains with lower average variabilities. People differ in their heights, pulchritude, and acidity. Why not their P.Q. or performance quotient?’”

An examination of transitivity also provides insights into where outcomes are most predictable. A lack of transitivity marks large swaths of sports, business, and investing. Since it is not always straightforward to pin low transitivity on skill or luck, the main lesson is to recognize that matchups and strategies can matter a great deal.

(Transitivity: Transitivity is a key concept in assessing the outcomes of one-on-one interactions. An activity has transitive properties when competitor A beats competitor B, competitor B beats competitor C, and competitor A beats competitor C. Activities dominated by skill tend to be transitive.)

Mauboussin goes on to discuss skill in investing and defining a good investment process (emphasis mine):

“The first part requires you to find situations where you have an analytical edge and to allocate the appropriate amount of capital when you do have an edge. The financial community dedicates substantial resources into trying to gain an edge but less time on sizing positions so as to maximize long-term wealth.

“At the core of an analytical edge is an ability to systematically distinguish between fundamentals and expectations. Fundamentals are a well thought out distribution of outcomes, and expectations are what is priced into an asset. A powerful metaphor is the racetrack. The fundamentals are how fast a given horse will run and the expectations are the odds on the tote board. As any serious handicapper knows, you make money only by finding a mispricing between the performance of the horse and the odds. There are no “good” or “bad” horses, just correctly or incorrectly priced ones.”

Mauboussin goes on to say:

“Finding gaps between fundamentals and expectations is only part of the analytical task. The second challenge is to properly build portfolios to take advantage of the opportunities. There are two common mistakes in sizing positions within a portfolio. One is a failure to adjust position sizes for the attractiveness of the opportunity. In theory, the positions in more attractive risk-adjusted opportunities should be more prominent in the portfolio than less attractive opportunities. In some activities, mathematical formulas can help work out precisely how much you should bet given your perceived edge. While this is difficult in practice for most money managers, the main idea remains: the best ideas deserve the most capital. The weighting in many portfolios fails to distinguish sufficiently between the quality of the ideas.

“The other mistake, at the opposite end of the spectrum, is overbetting. In the past, funds that have seen their edge dwindle have boosted returns through leverage. This led to position sizes that were too large for the opportunity and ultimately disastrous in cases when the trade didn’t perform as expected. . . The analytical part of a good process requires both disciplined unearthing of edge and intelligent position sizing aimed at maximizing long-term risk-adjusted returns.

“The second part of skill is psychological, or behavioral. Not everyone has a temperament that is well suited to investing, and skillful investors approach markets with equanimity. One such skilled investor is Seth Klarman, founder and president of the highly-successful Baupost Group, who shared a wonderful line: “Value investing is at its core the marriage of a contrarian streak and a calculator.” A large source of mispricing is when the collective becomes uniformly bullish or bearish, opening large gaps between expectations (price) and fundamentals (value). The first part of Klarman’s line emphasizes the importance of the willingness to go against the crowd. Academic research confirms what most people know: it is easier and more comfortable to be part of the crowd than it is to be alone. Skillful investors heed Ben Graham’s advice: “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it—even though others may hesitate or differ.” However, Klarman correctly observed that it is not enough to be a contrarian because sometimes the consensus is right. The goal is to be a contrarian when it allows you to gain an edge, and the calculator helps you ensure a margin of safety.

“Exposure to diverse inputs is crucial to developing sound contrarian views. As an idea takes hold in the investment community, it tends to crowd out alternative points of view. Skillful investors constantly seek input from a variety of sources, primarily through reading. Phil Tetlock, a psychologist who has done groundbreaking work on the decision making of experts, writes that “good judges tend to be . . . eclectic thinkers who are tolerant of counterarguments.” This part of the process also acknowledges, and takes steps to mitigate, the biases that emanate from common heuristics. These biases include overconfidence, anchoring, the confirmation trap, and the curse of knowledge, to name just a few. Overcoming these behavioral pitfalls is not easy, especially at emotional extremes. Techniques that are helpful include expressing views in probabilistic terms, constantly considering base rates, and maintaining a decision-making journal.

“The last component of this part is maintaining what I call a “Mr. Market” mindset. To express a proper attitude toward markets, Ben Graham created the idea of Mr. Market, a “very obliging” fellow who offers to sell his shares to you or to buy yours. Mr. Market shows up every day, but is sometimes very optimistic and, fearful that you will snatch his shares at a low price, posts a very high price. On other occasions he is distraught, and seeks to dump his shares at a bargainbasement price.

“Graham’s main lesson is that Mr. Market is there to serve you, not to educate you. You cannot let the prices entrance you. Graham writes, “Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal.” This is easy to say but requires a lot of skill to do.

“The third part of the process of skill addresses organizational and institutional constraints. The core issue is how to manage agency costs. Costs arise because the agent (the money manager) may have interests that are different than the principal (the investor). For example, mutual fund managers who are paid fees based on assets under management may seek to prioritize asset growth over delivering excess returns. Actions to serve this priority may include heavily marketing products that have been recently successful, launching new products in hot areas, and managing portfolios to look similar to their benchmarks. Charley Ellis made this point when he distinguished between the profession and business of investing. The profession is about managing portfolios so as to maximize long-term returns, while the business is about generating earnings as an investment firm. Naturally, a vibrant business is essential to support the profession. But a focus on the business at the expense of the profession is a problem. Stated differently, you want the investment professionals focused intently on finding opportunities with edge and building sensible portfolios.”

Lastly, Mauboussin ends with:

“In 1984, Warren Buffett gave a speech at Columbia Business School called “The Superinvestors of Graham-and-Doddsville.” …Common to all of the investors was that they searched “for discrepancies between the value of the business and the price of small pieces of that business.” These investors had a common patriarch, Ben Graham, but went about succeeding in different ways. Still, Buffett suggested he anticipated their success based on “their framework for investment decision making.” While some luck along the way didn’t hurt, their results were all about skill.” (For the full article, go to http://contenta.mkt1710.com/lp/26966/115068/Untangling%20Skill%20and%20Luck.pdf)

I think the end of the research piece didn't live up to the beginning, as Mauboussin fails to make process-oriented and research driven statements in the last paragraphs, implying instead that the Oracle of Omaha and the disciples of Graham are skilled investors while all others are not. Instead, I wish he had recognized that within each discipline there were both lucky and skilled investors. Putting that aside, Mauboussin gave a nice summary of the challenges of investment management as a profession and business, the behavioral biases within all of us, and the need to focus on process for any investment strategy.

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