I read a fascinating article over the weekend that I though applied incredibly well to investing and the financial markets. The subject of the article was the paradox of skill, and its implications are rather profound.
Many endeavors in life are a combination of both skill and luck. Think sports for example. In baseball, a few inches can make the difference between a foul ball and a home run. A minor fluctuation in the wind as the ball flies through the air can be the difference between winning and losing a game.
The same could be said about golf, a sport which I highly enjoy. No one would argue that a better skilled player has a much higher likelihood of landing next to the pin, but is the difference between the player who holes out the shot and the one who lands an inch from the cup a matter of skill, or luck?
In business, the same applies. Business involves high levels of randomness which can be controlled to some extent, but not completely. For example, a company can focus on its own products and operations, but it is largely unaware of what its competition is doing. When unknowns exist, there is always an element of luck present.
Poker is another fantastic example. Those who don’t understand poker consider it gambling, yet those who have mastered the game earn reliable profits and consistently find themselves at the final table.
Circling back to investing, there are probably a few folks out there who would be appalled to hear that investing contains an element of luck. Of course there are those on the other side who believe investing is entirely a function of luck, with financial markets being nothing more than large casinos run by the likes of Goldman Sachs et al.
The truth, whether we want to admit it to ourselves or not, is that successful investing sits at the intersection of both skill and luck. A novice investor can make a terrible judgment call, yet be smiled upon by the fates as some unpredictable event occurs, sending the price skyward. At the same time, a skilled investor with every fundamental, technical, behavioral and macroeconomic factor in his favor, can lose his shirt as the proverbial winds blow against him.
Here’s where it gets interesting. Most people - myself included, until yesterday - make the assumption that the more skilled an individual is at their discipline, the less of a role luck plays in the outcome. Sounds intuitive right?
This is where the paradox of skill comes into play. In short, this theory suggests the exact opposite … that the more skilled a practitioner is, the more the results become a function of luck.
Utilizing poker as an example may be the easiest way to understand this, and the discussion applies almost perfectly to investing.
Warren Buffet once said, “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”
In poker, just like with investing, a skilled practitioner will outplay an unskilled practitioner the vast majority of the time. But what happens when both, or all of the players at a table are very skilled players?
Poker, just like many decisions in life, including investing, comes down to utilizing expected value. I’ve talked about this before, but expected value is one of the most fundamental concepts in probability, and can be applied to just about any decision that involves an element of randomness.
The expected value of a decision is simply the probability of an expected outcome multiplied by the value of that outcome. For example, if you were at the fair, and there was a game that allowed you to pay $1 for a 20% chance at $10, would you play? I would, I’d keep playing until they kicked me out. That’s because the expected value of the game is $2, and I only had to pay $1 to play. Sure, sometimes I’m going to pay my $1 and lose, receiving nothing in return, but over the long-run, I will make money.
Skilled poker players nearly always have expected value in their favor. When they commit chips to a pot, the expected value of their potential payoff is almost always higher than the amount of money they had to commit.
When all players in a poker game are skillful, there become fewer opportunities for each player to find wagers where the expected value is significantly greater than what must be committed to the pot. All players exercise great care in not letting the “odds” stack too far against them, and so the results become more evenly distributed, and thus more a function of luck.
Unfortunately, and to the probable dismay of many, investing is no different. Becoming a skilled investor is a prerequisite for being successful, but as the pool of global investors becomes more talented, luck plays an ever increasing role. This is because the ability of one or a group of investors to outsmart their counterparts diminishes, causing the results to be heavily determined by chance.
There are a few takeaways from all of this. First, an unskilled investor will consistently, over time, lose money to their skilled investor counterparts. So it’s of paramount importance to hone your skill set, or the cards will be stacked against your consistently growing your wealth over time.
Second, we must be very discerning and unbiased when we judge ourselves based on the performance of the investments we make. We all know the poker player who is elated with himself after catching a card on the river to win the hand, despite making a series of poor (expected value) decisions to remain in the hand. When some of our investments do well, we must be able to identify whether our underlying thesis was correct, or whether the fates smiled upon us, giving us a win that we otherwise shouldn’t have enjoyed.
Along the same lines, when we make a solid investment decision based on factors that are in our favor, and yet the investment moves against us, we must have the resilience to know that the decision we made was correct, and that it was simply the luck element that didn’t pan out. Returning to the example above where the player catches his winning card on the river, the opposing player, who played the hand correctly and had expected value in his favor, must not waver in his confidence or decision making. He made the right decisions all the way through, but luck was not with him in that instance.
I realize I’ve talked a lot about poker, a game where the probabilities are bounded (there are only so many possible outcomes). Investing is different in that the potential outcomes are nearly unlimited, there are many more variables at play, and there are many more players in the game. But at its heart, the paradox of skill still applies, as does the concept of expected value.
One of the more famous investing books is called A Random Walk Down Wall Street. Part of the reason for the belief in efficient markets and the randomness of stock market returns has to do with the paradox of skill … there are so many skilled practitioners that few are able to maintain a significant edge upon the others. I am not a believer of the efficient markets hypothesis for a number of reasons, as research shows that certain anomalies do exist (which we can exploit), but that’s for a different story.
The preceding content was an excerpt from Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
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