Wednesday, February 16, 2011

Untangling skill and luck

Thanks to this article, I was able to locate an interesting PDF document about investor skill and luck. Here's a little snippet:
Outcomes from many activities—including sports, business, and investing—are the combination
of skill and luck. Most people recognize that skill and luck play a role in results, yet they have a
poor sense of the relative contribution of each. The ability to properly untangle skill and luck leads
to much better thinking about most day-to-day outcomes, and allows for sharply improved
decision making.

The process of asset allocation in the institutional investment industry is a practical example of
the failure to conceptualize skill and luck. In the aggregate, institutional money tends to flow to
assets that have done well and fails to consider sufficiently the role of luck. One recent study
suggested that this misallocation of resources had cost these portfolios $170 billion from 1985 to
2006. The study’s authors conclude that those institutions “could have saved hundreds of billions
of dollars in assets if they had simply stayed the course” instead of moving money based on a
naive extrapolation of past results.

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