The Counterintuitive Truths
In my investing career, there are perhaps couple of truths that felt counterintuitive to the extent that my first instinct was to fight it. Not only didn’t it feel right, what complicated it further is accepting these truths felt deeply uncomfortable.
The first was the paradox of skill. As Mauboussin put it: “Greater skill doesn’t decrease the dependence on luck, it increases it.”
As counterintuitive as it may sound, the explanation is rather pretty straightforward. As much as we may want to pretend otherwise, investment outcomes are clearly a mix of skill and luck. What matters for relative performance i.e. beating a benchmark/index is your skill differential versus the competition rather than your absolute level of skill. As any field matures, absolute skill rises across the board, but skill variance compresses. When the skill distribution narrows, the spread between the best player and the median player shrinks with it. But luck's variance by definition doesn't compress at the same rate. So luck's share of the explained variance in outcomes goes up unabated.
I have noticed when people hear about paradox of skill, one tendency is to infer that since your investing outperformance (or underperformance) is increasingly becoming more dependent on luck, your skill doesn’t matter. The way I interpret it, however, is you need to be increasingly more skilled for luck to have a decent shot at helping you. It’s particularly easy to explain this via a sport as I have done in the past with Cricket. It should be intuitive that if you are not honing your skill as an athlete while growing up, it’s impossible to imagine that you would find yourself suddenly in the NBA or NFL when you’re in your 20s. So, you need a lot of skill and hard work to get to the desired stage you want to compete for. But once you are in that league, luck may have a disproportionate role in your outcome while competing against other similarly skilled athletes. This is, of course, not to deny the existence of the likes of Michael Jordan or Sachin Tendulkar in their respective sports, rather highlighting the cold, harsh reality of the vast majority of less than legendary players playing the same sport. Buffett is, of course, the Jordan/Tendulkar of investing. It also perhaps explains why any time someone was labelled as the “next Buffett” has the unfortunate habit of falling terribly short of Buffett’s track record.
I often joke with my friends that if you are actively managing your or other people’s money and you have a tendency to feel luck has typically been not on your side in life, you may want to look for a different line of work as I suspect people short on luck in investing will have a harder job than Sisyphus rolling a boulder uphill. A lot of it may mostly come down to your general attitudes towards life rather than your specific circumstances. Charlie Munger had a failed first marriage, lost a young child, and his left eye due to a botched cataract surgery in his 30s and yet, he didn’t wallow in his own woes. While perhaps not as dramatic, I suspect very few people are short of stories in their lives that could make a compelling case that luck hasn’t been as generous as it could have been. It is, of course, the stories we like to focus on that end up dominating our general attitude in life. Most of us also likely have plenty of stories that we could tell ourselves to notice more intently how lady luck has enriched our lives. In fact, sometimes I wonder that if I were an allocator, the question that I really wanted to answer is how deeply a particular investor appreciates the role of luck. Anyone who is too enamored how their skills are driving the last three/five years result may be much more prone to have warped understanding of investing and the world in general. Skills are largely table stakes in professional investing and frankly speaking, I suspect impossible to differentiate unless you are literally talking to a young Buffett (and as mentioned earlier, let’s not forget the error bar in identifying the young Buffett).
The problem with paradox of skill is it routinely counters to our own experience in the world which is why it is very counterintuitive. All professional investors know a lot of investors (both professional AND non-professional) who are clearly worse at this job than they are. This leads to my second counterintuitive truth. Again, from another Mauboussin paper (I also wrote a thread on this paper in the past):
“…a diverse crowd will always predict more accurately than the average individual. So the crowd predicts better than the people in it. Not sometimes. Always.
…the collective is often better than even the best of the individuals. So a diverse collective always beats the average individual, and frequently beats everyone. And the individuals who do beat the collective generally change, suggesting they are more of a statistical vestige than super-smart people.
The collective “frequently beats everyone”! That’s one of the most counterintuitive truths I have encountered (read the paper or the thread linked above if you need some convincing). Understanding the diversity level of the crowd may be just as important as listening to the individuals within the crowd. One challenge with appreciating the diversity level is we tend to hear mostly one side of the story at any point of time: the winning side! The recent stock price tends to be a comforting refuge for your opinions and the people who have a markedly different opinion than the market tend to keep their opinions to themselves when the stock price has very little inclination to oblige to such opinions.
The survivorship bias of good stories from the winning side makes us particularly susceptible in imagining a preponderance of success while fundamentally underestimating much greater diversity of outcomes. I do want to note that you cannot just “solve” for diversity merely by looking at prices. Indeed, remember “the collective is often better than even the best of the individuals.” So, there is no easy way out there.
Munger emphasized about the requirement of equanimity if you want to invest for the long term. I seem to appreciate such requirement with every passing year. Ultimately, these counterintuitive truths are very antagonistic to how much of the investing world operates: you must come up with how your skills are differentiated from others and show the past 3-5 years of track record of outperformance as an evidence of such differentiation. What I lean towards much more is that somewhat low turnover and long-term focused investors may need much, much longer time than typically appreciated to realize whether they’re truly a timeless good investor. It is possible that you may be a good investor in a particular era due to your differentiated skillset but as the rest of peers catch up and completely nullify your advantage, you will be forced to rely more on luck to outperform the market. Like Munger, Mauboussin also came to similar conclusion of equanimity. To go back to Mauboussin’s paper on Paradox of Skill:
Once you’ve embraced the paradox of skill, you’ll see that it’s appropriate to have an attitude of equanimity toward luck. If you’ve done everything you can to put yourself in a position to succeed, you should accept whatever results appear. Some days you’ll be lucky, and the results will exceed your expectations. Some days the results will be disappointing because of bad luck. The best plan will be to pick yourself up, dust yourself off, and get ready to do it again tomorrow.
Given the outsized role of luck and this potentially more than decadal feedback loop, I have often felt that people who should actively manage their money are the ones who would like to do so not necessarily to beat the market, rather who want to do so DESPITE the glaring possibility that they will fall short of all their peers who are indolently, and mindlessly throwing their savings to the “collective wisdom” instruments! Of course, in reality, active investing ends up attracting people who tend to be much more money obsessed than the general population, and it is through the pile of their dead bodies (including potentially our very own) rather than vicarious learnings, we may finally appreciate the difficulty level of the “sport” we chose to engage with.
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