Epistemology on the Beach: Questions About Skill

How much skill is possible in the markets? I think the answer is often far less than we like to assume, yet that answer should impact everything you do. At the extreme, if the future isn’t predictable to any degree then any perceived skill becomes merely a comforting fiction. The older I get the more I conclude that we all succumb to that fiction to a significant degree. I think some level of skill is possible, but not an impressive level, and certainly not market-beating skill over the long-term.

For example, one fiction may be that successful investors pick a style of investing that suits their personality. This seems quite reasonable because any strategy can only work if you stick with it, and it isn’t hard to find examples that support the idea. However, it may succeed only because it reinforces a lucky match between personality, style, and market conditions. Those with the right personality for the times survive and are remembered as the investing greats of that era and the rest fade into oblivion.

Mauboussin and others have said the ability to lose on purpose is one way to distinguish skill from luck. That’s an appealing idea since it’s easy to imagine taking the opposite position on all your best trades and conclude your success is largely the result of skill. But could you really go against your natural inclination, take the opposite side of the trade, and then manage the position to realize the expected loss? If your behavior isn’t held constant why are you allowed to assume everything else would  be? Human preferences aren’t static so it’s never as certain as it appears.

Mauboussin further argues that results in the markets end up depending mostly on luck because of the preponderance of skilled participants. I appreciate a compliment as much as anyone, but a simpler explanation is that the skill market participants feel they possess is an illusion. Regardless the cause, the numbers give strong evidence for market performance being far more luck than skill. Over any significant length of time the number of market beating investors is so small it’s entirely consistent with them being nothing but examples of survivor bias, regardless how compelling their rationales and manifestos may be. According to this bracing summary, less than 1/4 of 1% of mutual fund managers beat the market over 10 years (and hedge fund managers fare no better despite, or maybe due to, far greater latitude in investing decisions). Further cheery news can be found here, which also makes a good case that the dumbest money is also the smartest  Worse yet, over an investing lifetime the odds are likely even more unfavorable [1].

In thinking about the future, I view this universe as just one trial out of an almost infinite number of rounds. Learning a particular set of skills and taking certain actions can lead to particular outcomes in ways that, in hindsight, can seem almost preordained. However, that’s just one trial. Since markets move based on the changing preferences of the current participants, executing identical steps in similar situations in another trial may lead to very different outcomes, and we have no idea what the distribution of outcomes looks like on that meta level. Starting again from time 0, and ending right here, reading this, has a probability of approximately equal to zero.

Question #1: Trading is always a matter of odds and small edges. No matter how long your trading career, it’s only a very small sample from a vastly larger unknown population. Your results could be entirely from sampling error. In how many universes do you think your attempted losses to prove your skill would actually be realized?

Question #2: A number of experiments have caught humans unconsciously making up reasons for rapid, instinctive behavior after the fact. In some cases the subjects remain unaware of this reversed causality even when their explanation is preposterous. To borrow from Taleb’s title, how do you know you aren’t being fooled by randomness and then inventing skill as the explanation for your success?

Question #3a, b, and c: There’s no disputing it feels like market success requires skill, but some gamblers have an equally intense feeling they’re on a hot streak. Would the skill to beat the market feel different from the skill to under-perform in a sustainable way? Even over a number of years, both could result in similar strings of winners and losers, with similar returns. How do you know which you have? Many have been very wrong about that answer and in fact had neither skill (see here for an amusing rundown). How do you know you aren’t one of them, waiting to be discovered?

Question #4a, and b: Imagine you are transported 500 years into the future and forced at anti-matter gunpoint to get into the market, without really understanding what’s being traded, what’s going on in the world, or if any other market participants are human. What approach would you use? How is this scenario significantly different from the situation faced every day in the markets?

Think about it for a while. Do you feel shaken and humbled yet? I often feel as though I’m flogging a dead horse when I write about money. It’s all been said before, many times, from many perspectives. I keep doing it because maybe this peculiar version, at this equally peculiar time, will click with someone. If not, and you’re still feeling smug about your skill, ask a significant other for assistance in increasing your humility. They’ll probably jump at the opportunity.


[1] For another example see Warren Buffett: More myth than legend  Great success, whether from skill or luck, quickly leads to managing an enormous pile of cash, and it’s hard to beat the market when you are the market.