Imagine a contest where 1,024 contestants each flip a coin ten times – anyone who flips tails is eliminated. After ten rounds there would be one contestant remaining, who landed on head ten times. Nobody would call him a genius: he could be simply lucky. But put them in a tailored suit, hand them a Wall Street Journal and a Bloomberg terminal, and the market will build legends around them.
The Illusion of Skill
Daniel Kahneman spent years of thought on this. In Thinking, Fast and Slow, he describes analysing the results of twenty-five financial advisers over eight years. The results of his study contradicted the general consensus of success in the market. There was essentially no correlation between one year’s performance and the next. This displays the idea that luck may play a greater role in performance than skill does. The adviser who won one year were not consistently the ones who won the next. Despite this, they still collected large bonuses for what is close to a statistical lottery.
Kahneman called this the ‘illusion of skill’. Clients and professionals held a confident assertion in a talent that data was unable to find. The belief in this talent persisted because the causation seems clear: a successful year was a result of good judgment, and a bad one was a lack of good judgment. Human brains are hard-wired to seek causation even in something where there isn’t, and that’s why a stigma of skill has gathered around traders. Even the most knowledgeable advisers are outperformed by less well-known names annually, not necessarily because they are better advisers but because they chose the correct stocks amidst market volatility.
We Only Hear from the Winners
Nassim Taleb built an entire book, Fooled by Randomness, around one simple idea. Every year, thousands of traders start out, the lucky ones survive and give interviews and write memoirs. Nobody looks at the ones who blew up.
This is called survivorship bias, and it subtly corrupts the way we learn about market. Many of the experts we examine have already been filtered by luck before they reach the front page of the Financial Times. Studying the winners in the markets is as useful to a trader as a lottery player interviewing jackpot recipients to discover the secret of picking numbers. Their routines, stock choices and strategies seem meaningful because we already know how the story ended.
When the Numbers Come In
Extensive academic research support this suspicion. Eugene Fama and Kennet French, in a 2010 study separating luck and skill in mutual fund returns found that – after costs- very few managers showed enough skill to outperform their fees. Furthermore, the distribution of these results looked a lot like what chance alone would produce.
Individual investors don’t have it better. Study after study finds that the most active traders tend to earn less than people who buy and hold positions. Every trade has costs, and confidence in one’s own ability pushes people to trade more often, even at the wrong times. Higher effort, higher conviction and higher activity can actually produce worse results.
Why Markets Teach the Wrong Lesson
Fama’s market hypothesis states that market prices already absorb available information. Therefore, beating the market requires either new information or luck. Burton Malkiel popularised the idea in A Random Walk Down Wall Street with a famously irreverent claim: that a blindfolded monkey throwing darts randomly at the financial pages could select a portfolio performing as well as one chosen by experts. This simple illustration helps to illuminate the significant effect of chance in the investment performance. Yet, investors attribute their performance to their own skill rather than luck, allowing random success to be mistaken as evidence of skill.
The deeper issue is that a market doesn’t reliably reward good decisions or bad ones. A smart move can loose money and a reckless bet can pay off, so traders cannot distinguish from their results whether they were skilful or lucky.
The Paradox of Skill
The market strategist Michael Mauboussin described the “paradox of skill”: as the average competitor improves, the skill difference between competitors shrink. Nowadays, the market is filled with PhDs, algorithms and rapid information – nearly all high-level traders are skilled. Therefore, the gap between first and hundredth place is increasingly a result of luck.
Skill elevates the floor without necessarily separating the winners from the pack.
The Fair Counterargument
Skill isn’t irrelevant. There are many investors and firms that have released records that are very difficult to explain by chance, even while considering how many people are playing. For example, Warren Buffett’s investment portfolio has shown strong long-term returns over the past decade, despite fluctuations in individual years. Certain people evidently have an edge, whether from data, speed, structure or composure.
The problem comes in identification. An impressive record can’t distinguish which side of the line a trader is on, because both the skilled and fortunate can produce impressive records.
What This All Really Means
We ought to judge traders by process rather than outcomes. A good process is a consistent, evidence based approach to making investment decisions, in which risks are assessed, relevant information is analysed, and decisions follow a clear strategy rather than emotion or speculation. For most, a low-cost index fund is a good default, because it makes no claim to talent it can’t prove. Ultimately, good investing is not about predicting every movement of the market, but about making consistent and rational decisions while understanding the limitations of one’s own knowledge. Therefore, whether a strategy can justify the risks taken and the ability to produce sustainable results over time are more representative measures of skill than performance alone.
The next time you see a winning streak, remember the 1,024 coin-flippers. Someone always ends up flipping ten heads.
Bibliography
Barber, B.M. and Odean, T. (2000). ‘Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors’. The Journal of Finance, 55(2), pp. 773–806. Available at: https://doi.org/10.1111/0022-1082.00226.
Fama, E.F. and French, K.R. (2010). ‘Luck versus Skill in the Cross-Section of Mutual Fund Returns’. The Journal of Finance, 65(5), pp. 1915–1947. Available at: https://doi.org/10.1111/j.1540-6261.2010.01598.x.
Kahneman, D. (2011). Thinking, Fast and Slow. London: Allen Lane.
Malkiel, B.G. (2023). A Random Walk Down Wall Street: The Best Investment Guide That Money Can Buy. 13th edn. New York: W.W. Norton & Company.
Mauboussin, M.J. (2012). The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing. Boston: Harvard Business Review Press.
Taleb, N.N. (2005). Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets. 2nd edn. New York: Random House.
