"It's better to be lucky than good."
- Lefty Gomez, National Baseball Hall of Fame pitcher for the New York Yankees
The longer I live, the more impressed I am by the big truths that are hidden in plain sight. Who doesn't love the simple bit of brilliance that was made real when someone created a rear hatch on a SUV that opens with a touch to the bumper? Or how about the genius that created the cup holder in the grocery store shopping cart? I tip my cap to the people that could SEE what the truth was.....and that brings me to today's topic....the paradox of skill.
While I touched on this topic a few weeks ago, have you ever really thought about what drives success? From the day we could understand language, our parents have taught us to work hard and to master what we do. When I was a kid, I was playing baseball in the summer, football in the fall, basketball in the winter, and soccer in the spring. We just don't see that kind of variety anymore. Instead, parents have their kids specialize in a specific sport that their children play all year. While that is actually a bad thing to do, we know why it's done. It's because we believe that more skill - with a little bit of luck, too - leads to better results.
Skill + Luck = Result
Do you ever hear or read things that are sort of true, but not completely true? Does it drive you nuts? It certainly drives me crazy.
My wife sometimes says I'm on "the spectrum," but that's another story.
Anyway, I often see things expressed poorly and the formula above is what I mean. It's partially true, but not completely true. Now, you're probably thinking, "What the heck is he talking about? Is he saying that more skill DOES NOT equal better results?
Yes. I. Am.
I say that because we often confuse ABSOLUTE skill with RELATIVE skill. Last month, I wrote about my concern regarding WHY people place such a high value on college educations. In part, I was saying that too many college advocates believe that the improvement in absolute skill is the driver of financial success.
That is not only wrong, but it is so wrong that it borders on being a lie.
College educations were incredibly valuable in the 50's and 60's when very few people had them. For those that did go to college, they improved their ABSOLUTE level of skill and knowledge and that is and was important. But it is not nearly as important as the money they were paid because of their RELATIVELY larger level of skill and knowledge as compared to people that didn't go to college.
It was Einstein who said, "Relativity is the name of the game!"
No he didn't, but you get my point.
Because a huge percentage of high school graduates are going to college today, our society's level of ABSOLUTE skill is increasing. At the same time, the variation in the RELATIVE skill of its members is decreasing because so many people are now highly educated. As a result, we see college graduates working at coffee shops.
Given the practical view I just shared, have a fresh look at the revised formula and THINK about the implication.
(relative) Skill + (relative) Luck = (relative) Result
In any environment where the RELATIVE skill of the competitors is decreasing, even if the ABSOLUTE skill of the competitors is increasing, the results will increasingly be based on LUCK.
For instance, say that the formula was 95% relative difference in skills + 5% relative difference in luck = 100% difference in result. If our relative difference in skill is getting smaller over time - or as math geeks might say, "As relative difference in skill approaches zero" - our relative results will increasingly be based on luck.
Weird, isn't it? But it's 100% true.
Consider the Game of Baseball
Let me show you a real life example.
If you know anything about baseball, you know that baseball people love their numbers. They know that there are 30 teams that play 162 games during the regular season, or ~2,430 in total. Because there are 9 innings in a game, that means that nearly 22,000 innings are played over a season. I've a friend, Scott Hudson, who tracks the statistics - sabermetrics - like no one else. Pitch velocity, perceived pitch velocity (based on where the baseball is released in the pitcher's throwing motion), pitch angle, left handed, right handed, batting average, ERA, slugging percentage, walks, strikes, base speed, ground balls, fly balls, day game, night game, etc., etc. etc. Data is everywhere!
But there's a conundrum in baseball. Why has no player since 1941 batted over .400 for the season? After all, there were only 600 players in the league in 1941. Blacks were excluded from the game (I'm still floored by the stupidity of racism) and there was very little international recruiting. Flash forward to today and we have over 1,200 players in major league baseball. Today, players are recruited from around the world and thus the pool of talent is much deeper than it was in the early 40's. Today's players are better fed, better trained, and more skilled than players of yesterday. Why then has no professional player had a single season batting average above .400 in the last 77 years?
I started crunching numbers to figure out what happened. After narrowing the number of players down to only those that had been up to bat several hundred times during the season, the average batting average for all of those players in 1941 was .281. In 2017, it was .275. That's a pretty steady average....and yet Ted Williams hit .406 in 1941. In 2017, the highest individual batting average was held by Mookie Betts at .346.
What the heck happened?
I thought about the paradox of skill. Players today are stronger and better than players of yesteryear, but they are playing against more talented players, too! In other words, ABSOLUTE skill had increased, but RELATIVE skill had decreased in the process!
I was able to look at the math and figure it out. In statistics, there is this thing called a standard deviation that lets you see how numbers "vary" around an average. For instance, think about your IQ. The "average" IQ in America is 100, but people's IQs vary from one another. After all, some people are super-smart and others, unfortunately, are not. If you plot everyone's IQ on a graph, you will create a chart that looks like the one below.
Understanding the Math
When you look at the numbers, where the graph "peaks" is the average. It's where most people are. Numbers to the left of the peak are "below average" and numbers to the right of the peak are "above average." The graph falls off to the left and right because a much smaller number of people have exceptionally high or exceptionally low numbers. You can plot this kind of thing for IQ scores, incomes, net worths, or batting averages; and the graphs look similar.
Now, take a look at the blue line in the graph above. It represents the distribution of batting averages for players in 1941. Do you see how it has a "flatter" peak? That means there was a wider RELATIVE difference in the batting averages of the individual players in 1941. Why? While there were some incredibly talented players in the game back then, there were also players that were RELATIVELY much less talented. That comment applies to pitchers, fielders, and hitters. In 2017 however, as illustrated by the orange line, the peak is much, much sharper. That "sharper" peak indicates that the RELATIVE difference BETWEEN players in 2017 was much smaller than it was in 1941. As a result, it is much, much harder to have a .406 batting average in the modern era.
I don't want to take you too far into the math, but it is important that you have a sense of what those differences mean. What Ted Williams did in batting .406 was amazing. His skill was incredible, but we can't deny that he (like everyone else) had luck involved in his life, too. If your an "average" hitter, your average is within 1 standard deviation of all batting averages. In 1941, what Ted Williams did was a 4 standard deviation event. That is unreal! To do the same thing in 2017 though, because the level of relative skill is so much narrower, a .406 batting average would be a 5 standard deviation event. The odds of that happening are incredibly low, which is why getting there would require much more luck than it did in 1941!
By the way, you can see the same kind of thing in Olympic sports. Take the marathon as an example. Fifty-two years ago, the 20th place runner was 12 minutes behind the gold medal winner of the race. At the 2016 Olympics, the 20th placed runner was only ~6 minutes behind the winner. Relative skills are narrowing!
The thing is, the 20th place runner in 2016 would have beaten the 1966 gold medal winner by 6 minutes! It's frustrating to compete, because even though ABSOLUTE skill may have improved, it's RELATIVE skill that matters.
Application to Investing
If the paradox of skill is applicable to sports, then it is certainly applicable to investing. To give you a sense of the all important "why," just consider these statistics:
And that "luck" part is so challenging. If the old model of evaluating mutual funds was based on past performance, and if that performance is increasingly based on random luck, then to evaluate mutual funds based solely on past performance today means you're betting on someone's luck continuing.
Does that make any rational sense? No, it doesn't.
But man-oh-man does past performance sell. Some people claim that mutual fund companies have a business strategy of creating many different mutual funds because - while they might not know which ones will "kill it" in any given year, a few of them will "get lucky" and outperform the market. Financial journals (aka "financial pornography") will write glowing reports on the brilliance of the fund company's leadership and its keen insight into the market. Investor money will then flood into those funds because of the past performance hype. Of course, that particular fund probably won't be hit by lightning twice with back-to-back annual outperformance, so the fund may underperform the following year, leading to a lot of investor unhappiness.
And over and over it goes.
Peter Thiel is one of my favorite "thinkers." If you don't know him, he was one of the founders of PayPal and an early investor in Facebook. He was once asked to share his favorite interview question and he replied, "What do you believe to be true that other people don't?" Awesome question.
His response to his own question was even better. He said that he believes that most people believe that business people like competition. Of course that is not true and Thiel went on to say so. Business people love to find niches where there is very little competition and where the potential for profit is very, very high...precisely because there is no competition...or because the competitors are weak.
In other words, he said that business owners like to find places where they can apply their RELATIVE differentiated skills/solutions! It's much harder to make money when everyone else has similar solutions and skills.
The paradox of skill is embedded in Peter Thiel's thought processes. While it may be fun to go head-to-head with an equally matched competitor and test your skills, from a business perspective, it's so much smarter to find a lot of weak competitors. Or ideally, no competitors at all.
The investing world is big and highly competitive. It is a "red ocean," with a lot of blood in the water. Because of that, it is very, very difficult to have substantially differentiated performance, over time, and after expenses. That is why I recommend being very, very careful with how much you spend on your professional talent (active managers). More talent is a usually a good thing, but talent usually comes at a cost. When it comes to investing, the bang for the buck in active management usually isn't there. Too often, people buy last year's home run king only to find that he's this year's disappointment. Not only that, but he's a big drag on your payroll. It's the paradox of skill.
When we introduce our investment process to a prospective client, we are frequently asked how we identify "the best" money managers, mutual funds, etc. Our answer is that almost none of the investments we utilize are managed by a person or team of managers where the goal is to find the elusive "alpha" of above market returns. Just capturing average market returns is what we are after...regardless of the investment weather. If we are trying to shoot the lights out, we'll recommend a few private equity opportunities, but only after they've been thoroughly vetted. Even then, they are for a VERY LIMITED portion of our client's money. Other than that, we employ evidence-based indexing strategies. The costs are very low, the tax benefits are usually better than the vast majority of active management approaches, and all of that has a positive influence on net returns. It just makes sense. And it saves cents. Over time, those cents add up to dollars.
As always, let me know if I can help. Oh, and give me some feedback on this one. I hope I didn't bore you too much with the math.
Bruce Wing is the president of Strategic Wealth, LLC, a fee-based Registered Investment Adviser located on the north side of Atlanta.
Entrepreneur, financial guy, husband and father of two great kids.