In the world of investing, the role of skill vs luck is often the topic of much debate. Often, the correlation between the two is not direct. Does it only come down to luck, or does skill play a part in successful investing? In this article, we will try to understand what matters more in investing — skill or luck.
It is not a secret that it is impossible to predict market movements. The stock market can fluctuate due to myriad reasons leading to losses or gains that are not always foreseeable. Due to this fact, people often associate luck as a factor related to stock market investments. How a fund or stock has performed in the past can give us a little understanding of how that fund or stock may perform in the future. Michael Mauboussin, the author of the book The Success Equation, discussed a case study where he compared the returns from funds over three years. He found that people and institutions would favour funds that had previously performed as per their expectations, i.e., generated good returns. However, one needs to keep in mind that the funds’ past performance doesn’t give a complete guarantee of future success. So, we can say that, yes, skill can take you far in investing, but how a fund or a stock eventually performs remains inherently unpredictable. Future gains are often significantly influenced by luck rather than skill.
Since much of successful investing comes down to luck, it can be tough to measure actual skill in investing. How does one determine if an investor or investment manager has just had a few strokes of luck or has investment skills? Even though luck plays a role, the probability of success increases when one has skills in investing.
So, there are a few factors that you may look out for:
If the investor or investment manager has consistently outperformed their equals for some decades, there is no denying their skills in investing. Luck may sustain for a few months or years but not decades. Take the example of Wall Street legend Warren Buffet. He is a fantastic investor who has outperformed his peers for decades. He may have had losses, but his investments were a success more often than not.
Analyse the investment manager's original investment statement versus the ultimate result. Market movements are always uncertain. The key is to find a manager that sticks to a well-defined process that is battle-tested, and also knows to change plans to fulfil the primary goal, i.e., generate better revenues and achieve success.
It can be hard to distinguish between luck, expertise, and skill when the investor has a small investment data set because of a small sample size. It is easier to judge if luck or skill plays a more prominent role if the investor's investment data set has an extensive diversified portfolio.
Ultimately, success in investing comes down to both skill and luck. When judging investors or investment managers, look at the factors mentioned to understand how their skill has helped their success.
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