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By Christine Benz | 06-12-2013 12:00 PM

How Much Luck in Investing Success?

Michael Mauboussin explains why humans tend to overweight the role of skill and underestimate the role of luck in investing success--and how we can correct for our perceptions.

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Christine Benz: Hi, I am Christine Benz for, and I’m here at the Morningstar Investment Conference joined today by Michael Mauboussin. He is head of global financial strategies for Credit Suisse, and he is also author of the book The Success Equation. Michael, thank you so much for being here.

Michael Mauboussin: Thanks, Christine, great to see you.

Benz: Michael, you did a keynote presentation Wednesday in which you talked about the fact that investors tend to systematically overestimate the roll of skill and underestimate the role of luck in terms of making their investment decisions. Let's talk a little bit more about that. First, why does that happen? Why do we tend to believe that perhaps we’re better than we actually are?

Mauboussin: So, Christine, it's so interesting. There is actually a little part of the left hemisphere of our brains called the interpreter, and whenever we see an effect, for example, performance for our portfolio, we try to attach a cost to it. So, basically, it's this cause-and-effect loop that our minds are trying to close all the time. And whenever we see especially good results, our minds naturally think that that's because of skill.

Basically, the interpreter knows nothing about luck, so we can't really account for the substantial role of luck in investing. So, it's this very interesting natural phenomenon that we all do that when we see success, we associate it with skill, even if luck is the key contributing factor.

Benz: So, a follow-up question would be, how does that lead to behavioral traps? If we tend to believe that we are more skillful than we actually are, how can that get us into trouble when we're managing our own portfolios?

Mauboussin: I see two big behavioral traps. One, I'll say is mostly for money managers and that tends to be overconfidence, so a belief that they know what the future is going to hold to a greater degree than they actually do. And the way that typically shows up is projecting ranges of outcomes that are vastly too narrow, so they don't take into consideration all the possible outcomes.

For individual investors, I think the way it shows up primarily is performance-chasing. We tend to buy things that have done well only to suffer for the subsequent corrections, and we tend to sell things after they've done poorly only to miss the potential rally as a consequence. So, as you know, a very well-known fact, you guys have talked a lot about this, markets have returned, say, 8% or 9% over the longer term, and mutual funds have returned little bit less than that. But the average individual investor only earns about 50% to 60% of the market returns primarily because of bad timing. So trying to get rid of that bad timing I think is one of the best possible ways to improve on the behavioral elements.

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