Is it better to be skilled or lucky?
Skill vs Luck
In the investment industry, not all returns are created equal. As a result, it’s essential to recognize this to make informed decisions.
There are different types of returns, ranging from structural alpha generated by high-frequency trading strategies to passive trackers that seek to replicate the market performance. At the extreme of the spectrum exist illiquid long-term bets made by venture capital and private equity funds. Each type of return requires a different investment strategy and has particular tradeoffs.
The fewer bets you make and the longer you wait to realize the profit and loss, the less certain you can be about your edge or general ability to outperform the market. Additionally, strategies that make thousands to millions of small bets frequently, like high-frequency trading, can become statistically tested to determine whether or not they’re truly profitable.
In contrast, VC and PE investments involve making only a few bets and waiting for years, if not decades, to realize the returns.
Depiction of Rip Van Winkle by Thomas Nast (c. 1875). Housed at Yale University Library.
Thomas Nast – Beinecke Rare Book & Manuscript Library, Yale University Library
In these cases, it becomes hard to distinguish between skill and luck. Furthermore, it’s crucial to recognize that returns may not become realized for a long time, if at all.
However, given the compelling role storytelling and marketing play in the asset management industry, fund managers and allocators often fall into what I call the “coin-flipper’s paradox.” They believe that their success is purely due to skill when it may be completely due to luck. In the short run, there may be exuberance in capital allocation. However, over the long run, allocations tend to reach a more fair distribution. As a result, to succeed, fund managers need to follow the rule of 3P: Performance, Performance, Performance. Thus, this means delivering results, recognizing the role of luck, and striving to eradicate it by having a provable edge and statistically significant sources of consistent alpha. If you don’t know what your edge is, you have none.
In conclusion, it’s essential to understand the different types of returns and the role of luck in investment performance. Fund managers should choose investment strategies carefully and be patient enough to wait for returns to materialize. Moreover, to avoid the coin-flipper’s paradox, managers should evaluate whether there is a true skill that they demonstrated over the long term, and not just in a single trade or investment. Lastly, to do this, managers should have a provable edge and sources of consistent alpha that can be statistically tested to ensure long-term success.
Leicester City’s The Walkers Stadium
“You can say whatever you want, but numbers don’t lie.”
(Leicester City winning the Premier League, 2016 with 5000-1 odds)
Written by Nikita Fadeev, PM @ Fasanara Capital
Is it better to be skilled or lucky?
