Of Skill, Luck and the Absolute Relative Paradox

Last weekend, my friend Swami complained over coffee to my broker friend Jigneshbhai:

“For the past 3 years, your favorite fund manager, Prashant Jain of HDFC Mutual Fund, has not beaten the market index, and you told me that he manages the best performing funds in the country.”

Clearly Swami was not in a good mood, like so often in the recent past. His holdings in the funds managed by Jain (who was portrayed as a star as his schemes had beaten the market for most of the past one and a half decade) had made him unhappy.

“These institutions keep track of all the latest happenings and up-to-date developments with research and all, and we pay them a fee, and they still can’t give me the best returns. These fund managers are no good!”

Amid Swami’s spell of fury, my broker friend was nonchalant as usual. Swami was looking up to him waiting for him to respond, which he finally did.

“Well, Jain is unable to beat the market not because he is no good. But because of the exact opposite – because he is so good. And because some of the other fund managers he is competing with are also so good.”

That foxed both Swami and me.

That kind of appreciation for fund managers and their skills, especially when Swami was complaining that they were not performing was more than what we could handle.

Clearly many of them had failed to beat the market indexes over the past couple of years. Many who used to be stars had dropped to the lowest rungs. Moreover, how can someone fail because he is so good? We were taught that you fail because you are no good.

Jigneshbhai perhaps understood the confusion in our minds. “Well, investing is a bit like cricket. At the highest level, it is a game of skill and chance.”

“What does cricket have to do with my non performing funds?” fumed Swami.

“Take a look at the batting averages. Apart from Bradman and a couple of exceptions, if you look at the best batsmen in history who have played 80 or more tests, their averages hover, more or less, between 50 and 56.”

Swami was getting a bit impatient as the discussion seemed to have suddenly turned from Jain’s non-performing funds to cricket.

Jigneshbhai continued, even while we wondered what he was trying to say.

“And if you consider players of the recent past – say 20 years or so when cricket got more professional and competitive – you will realize that the batting averages of the top batsmen in that era are even closer between 51 and 54.”

“So what’s the point?” now an increasingly impatient Swami asked.

“Well, the point is that as everyone gets better coaching, equipment and training, their level of skill increases but the differential reduces.”

“And as everyone gets more skillful, the final averages in a game where both skill and luck matter is often determined by luck. That is the paradox.”

Not quite convinced, Swami looked at me. I did not have any idea how to react, but intuitively it sounded a bit perplexing.

That the more skills you have, the more luck plays a role? Not quite something that fitted our mental models.

But Jigneshbhai was convinced. “Investing is a similar game of skill and luck.”

“As it gets more professional and institutionalized with everyone having access to the same things, everyone’s skills get better, but the difference between any two of them reduces.”

“So the reason so few end up outperforming significantly is not because they are not good, it is because they are so good.”

Swami and I were listening and seemed to get a bit of it now.

So it is like a class of toppers – where there is so little to choose from among a bunch of bright folks. Who tops perhaps depends more on the paper they get than their skills.

While we were trying to digest it, Jigneshbhai continued.

wsjluck“As absolute skills increase and relative difference reduces, luck plays a role in out-performance. That is the paradox.”

It started making some sense. Maybe there was some logic to it.

But Swami was still paying the fees and still disappointed. We were still wondering what it meant for us.

“So what does it mean to us?” popped up Swami.

Just then, the wealthy man from the sprawling bungalow who had been listening to our conversation for the past few minutes dropped in to our table.

“For you it really does not matter whether it is skill or luck. Let them fight the paradox. You have the choice of betting on one or some or all of them. Or just bet on the index.”

“The important thing for your goals is that bet you must – size-ably for it to matter and prudently for it to not. That’s a skill you must master, and leave the rest to luck.”

Alpha and the Paradox of Skill

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