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The Skill Paradox Is a Myth in Investing

publication date: Oct 16, 2020
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author/source: Brian Nelson, CFA
"If I'd just tried for them dinky singles, I could've batted around .600." - Babe Ruth
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"In investing, the trend toward conformity is clear. For example, portfolios today look more like their benchmarks than they did thirty years ago. The average active share, a measure of how different a mutual fund portfolio is compared to its benchmark, has fallen from 75 percent in 1980 to about 60 percent in 2010 in the United States. Leaders in sports as well as in business fear straying too far from convention, even in cases where the convention isn't all that great (page 174)." - The Success Equation (2012)
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By Brian Nelson, CFA
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Michael Mauboussin's 2012 book The Success Equation is an exploration of how to assess the role of luck and skill in various areas such as sports and business. Among other nuggets of wisdom, Mauboussin talks about the important concept of base rates, using the example of green taxicabs. He writes that if we know that 85% of taxicabs in a city are green, we can assume that when we see a taxicab, there's an 85% probability it's green. In the absence of specific evidence about an individual situation, think in terms of base rates.
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The role of base rates is very important in investing. For example, if we know that 78% of large cap funds underperformed the S&P 500 during the past five years, be careful who you take ideas from -- there's a good chance that their processes and ideas may result in continued underperformance. Understanding base rates is probably more important this day and age as investors are bombarded with information continuously. Ask: what's the base rate for investors dishing out wisdom? Should you listen?
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Mauboussin also writes about the importance of differentiating between experience and expertise. He includes a quote from Professor Gregory Northcraft, a psychologist at the University of Illinois, in the book: "There are a lot of areas where people who have experience think they're experts, but the difference is that experts have predictive models, and people who have experience have models that aren't necessarily predictive (page 23)." He talks about the need for deliberate practice (the hard work and thousands of hours needed to master a skill), and how investors should seek to differentiate between experience and expertise to understand the value of predictions about the future.
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One of the clear signs of expertise, for example, is one's ability to make accurate predictions, or use a model that effectively ties cause to effect. In investing, for example, the Valuentum team has built and updated 20,000 discounted cash-flow models over nearly 10 years, testing cause and effect. One might conclude that this expertise alone trumps the experience of most investors that may be passive onlookers of market price movements for decades, making little connection between what actually drives stock returns.
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The book goes into many examples of how "statistical significance" is hurting many professional fields, perhaps one of my favorites a comical reference to a paper published in the peer-reviewed journal The Proceedings of the Royal Society B. You might have heard of this one. The work suggested that women who ate breakfast cereal were more likely to give birth to boys than girls. Hard to believe this "stuff" gets published in peer reviewed journals, but such work may be no more significant than some of the most widely disseminated beliefs in finance, which brings me to the main point of this article.
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Whether it's Sharpe's arithmetic (which can easily be dismissed by assuming one large investor underperforms leading to hundreds of smaller investors outperforming) or how Bogle uses dividend yield as an incremental measure of total return (as opposed to capital appreciation that would have been achieved had the dividend not been paid) or the very basic construct of factor investing, itself, (which falls flat as most factors are based on ambiguous, realized and backward-looking data)--Mauboussin's take on the paradox of skill in investing is just as disappointing.
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Let's define the paradox of skill first. The paradox of skill is the view that as more and more participants of a sport or business become more skilled, the variance between the outcomes narrows. It may be fair to say that the opposite may also be true. As more and more participants of a sport or business become less skilled, the variance between the outcomes might also narrow. Mauboussin uses the examples of batting averages and earned run averages in baseball as well as marathon runners to illustrate his view. However, Mauboussin admits that there are other endeavors such as professional basketball, where, as skill has improved, the variance of outcomes has actually increased. 
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At best, it's a mixed bag as to whether a paradox exists in sports. Mauboussin points to the high standard deviation of tall players as to why the paradox of skill may not be applicable to basketball players, but nonetheless, just like the paradox of skill isn't relevant to basketball (based on statistical observation), there may be plausible reasons why the paradox of skill shouldn't apply to other areas such as baseball or investing either (after perhaps correcting for other statistical variables). To name a few confounding considerations when it comes to the win-loss records in baseball: Players' level of skill varies through the course of the year, players get hurt and traded, and the season is just too long; even the best players have to sit out games.
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Then there's the observation that over time, the variance of batting averages has shrunk. The justification goes that both pitchers and batters have become more proficient at their trades, cancelling out any improvements (and that as all batters have become more skilled in time, the variance in their performance has declined). But just like the standard deviation of tall players in basketball may help explain in part why the paradox of skill doesn't exist in basketball, the nature of batting averages in baseball might easily be explained by baseball players focusing more on hitting the long ball. Look at how the game has changed.
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Image: The game of baseball has changed during the past 100 years. While many point to a declining standard deviation and coefficient of variation in batting averages for evidence of a paradox of skill in baseball, it's more likely the game has changed. Players are hitting more homeruns, sacrificing batting average as a result. Source: Baseball Almanac.
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Everyone knows that your swing will be a lot different if you're trying to poke one over the infield or slap one down the line for a hit than it would be in trying to hit the ball 450 feet in the left-center field stands. The Babe Ruth quote at the top of this article hits the nail on the head of what we're witnessing with respect to batting averages today (there is a big tradeoff between hitting for power and hitting for average), and why nobody has hit over .400 since Ted Williams in 1941. The incentives of the game of baseball have clearly changed to focus more on home runs. Look at this quote.
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If you're 10 years old and your coach says get on top of the ball, tell him no. In the big leagues these things that they call ground balls are outs. They don't pay you for ground balls, they pay you for doubles and for homers. -- Josh Donaldson
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The same is true with investing. The game has changed and so have incentives, and not in a good way. In the book, Mauboussin talks about agency costs that arise when a money manager has different interests than the investor. He references Charles Ellis, the founder of Greenwich Associates, in explaining how the "profession is about managing portfolios so as to maximize long-term returns, while the business (of investing) is about generating earnings as an investment firm (page 173)." Today, agency costs are soaring as indexing continues to proliferate.
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At Valuentum and in any endeavor I do, we'll continue to strive to manage portfolios to maximize long-term returns and achieve goals, no matter what. However, it's worth noting that it's also very difficult to outperform the market consistently and over longer periods of time if one doesn't purposely try to deviate from the market. Today, however, as "academic quant" proliferates, diversification has become (too) universal, and the ways of concentrated undiversified value investors such as Warren Buffett have become less popular. 
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Holding more than 20 stocks in a stock portfolio pretty much eliminates unsystematic (firm-specific) risk, pushing the returns of heavily diversified portfolios to the market average, reducing the standard deviation of excess returns. That's why we limit our newsletter portfolios to about 15-20 securities and heavily weight our favorites. If we were to hold too many equities and on an equal-weighted basis, their returns effectively would cancel each other out, and in such a case it might make more sense to hold a passive index. Over-diversification is the enemy of outperformance, and the means by which to achieve mediocrity. 
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Here's a quick take from Morningstar that  hits the nail on the head on the risks of over-diversification:
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While much of academia has focused on the risk of not being diversified enough, we believe that there's a practical risk to being too diversified. When you own too many companies, it becomes nearly impossible to know your companies really well. Instead of having a competitive insight, you begin to run the risk of missing things. You may miss something important in the 10-K, skip on investigating the firm's second competitor, and so on. When you lose your focus and move outside your circle of competence, you lose your competitive advantage as an investor. Instead of playing with weak opponents for big stakes, you begin to become the weak opponent.
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Unfortunately, Mauboussin, while highlighting in his own words in The Success Equation (see quote at top of this article) how stock portfolios have conformed over time due to a reduction of active share brought about by myriad influences in how active managers are "playing the game," completely misses using this explanation as the correct conclusion for the observation of declining standard deviations of excess returns. There is no paradox of skill in investing. Investors are conforming to the same playbook due to conflicting incentives (perhaps even driving active management skill levels collectively lower), and this is resulting in what we're seeing today. 
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Unlike his work in evaluating baseball and basketball, Mauboussin seems to completely miss that active mutual funds and ETFs are also only 15% of the market. In the case of investing, analyzing the standard deviation of returns of 15% of the stock market, as in active funds and ETFs, tells us little about luck or skill. Warning about the use of small sample sizes early in the book, the combination of this errant conclusion has only padded the indexing propaganda making The Success Equation an absolute tragedy of a text, and I must say it hurts me a lot to say it (I know how much work goes into writing a book, and I generally enjoy Mauboussin's work).
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Maubousin even notes that famous researchers Amos Tversky and Daniel Kahneman wrote in their 1971 paper, "Believe in the Law of Small Numbers," that humans have "'strong intuitions' that are 'wrong in fundamental respects,' a shortcoming 'shared by naïve subjects and by trained scientists.' The flaw, simply stated, is that (humans) have a tendency to believe that a small sample of a population is representative of the whole population (page 216, 217)." With that said, here is what I think is driving reduced standard deviations among excess returns, from Value Trap:
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The peculiar connection between 1) the propagation of spurious (quant) factors, 2) quant's influence on fundamental investment frameworks (e.g. some fundamental value investors think in terms of quant value factors)--an effect that reduces the dispersion of skill and returns as professional approaches become more congruent and undifferentiated (think conformity)--and 3) severe active fund underperformance during the past 15 years is the primary reason why I do not believe professional active investors are becoming more skilled, and that's why they are underperforming after fees, as outlined in the popular "paradox of skill" thesis. [They may be becoming less skilled as quant and passive proliferates.] My view is that, as indexing and factor investing proliferates, alpha is actually shifting from professional active investors to other parts of the stock market. For example, other investors--defined as hedge funds, pension funds, life insurance companies, and individuals by the Investment Company Institute--hold roughly 70% of the stock market, as of 2019. Households own about 30-40% of the stock market, by some estimates.
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There's a lot of value in reading The Success Equation, but you have to be careful to come to your own conclusion. There is no paradox of skill in investing. Mr. Mauboussin may soon be coming out with the second edition of Expectations Investing, and I thoroughly expect it to be a much better read focusing on many of the key themes of Value Trap. Be careful not in what you read, but rather in the conclusions you draw from your reading. I wish Mauboussin could re-write The Success Equation
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Maybe he will.
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Brian Nelson owns shares in SPY, SCHG, DIA, VOT, and QQQ. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.

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Alexander Skabry (Lockport)
 

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