Mauboussin: Understanding the Process Can Help Separate Luck and Skill in Investing

AAII editor Charles Rotblut, CFA, interviewed Michael Mauboussin, head of Global Financial Strategies at Credit Suisse, about the role of both luck and skill in investing (subscription required). According to Mauboussin, to separate skill from luck, you first have to look at the process that generates the output you are looking to achieve. In order to assess the process, you need to look at three important elements:

  • Analytical: “having an ability to find situations in which you believe something the world doesn’t believe and in which you have a good foundation for such a belief.
  • Behavioral: “we are all subject to behavioral mistakes and cognitive biases. Are you aware of those things and are you taking steps to manage or mitigate them?”
  • Institutional: “this relates to the constraints in your personal or professional life that don’t allow you to do the best thing possible in terms of your process.”

Mauboussin says that if you have a process that has a sound analytical foundation, and you are aware of the behavioral biases around that process and institutional constraints don’t get in the way of following the process, then a bad outcome in the short term can be tolerated because the process will ultimately yield success.

For investors, the role of luck and skill presents a challenge because most investors weigh past performance very heavily in the selection of mutual funds and strategies and don’t understand the process that generated that performance. Mauboussin says that using a “check-list” is a good way to objectively assess a process. For example, he notes that his own personal check-list includes valuing the benefits of diversification, looking for reasonable fees, and staying within one’s “circle of competence”, which is a term used to describe staying focused on things that you understand and avoiding those things you may not have a grasp of.