Paradox of Investment Skill

The Paradox of investment skill is the concept that as individuals become better at investment activity, the difference between the best, average and worst gets smaller. As skill of the group increases, luck plays a bigger role. Telling the difference between relative ‘lucky’ outcomes also becomes more difficult.

The idea of a paradox of investment skill is interesting for a variety of reasons.

First, no matter how smart the smartest person on the planet is they cannot be smarter than all market participants in aggregate. Sure, incredible outliers like Carl Icahn, Bill Ackman and the like will exist. But these individuals and their respective firms will no more have a corner on market information than the myriad of individuals with specialized knowledge working in their individual trade. As a result, there should always be room for the little guy to compete. It’s a physical and logistical impossibility that superior actors could always outmatch combined market participation across all groups.

Second, the concept, considered broadly, would seem to suggest some form of efficient market where superior outcomes are determined only by luck. Similar arguments have been made over time. Nassim Talib’s book ‘Fooled by Randomness’ shares similar opinions. Luck, he points out, forms a major basis for a number of the disproportionate successes that occur in markets.

Talib argues that most players are participating incorrectly. The approach to follow, according to Talib, is to avoiding an investment “blowup”. In Talib’s view, market opportunity only occurs when unforced errors occur. All other market movements are noise, generated by the aggregate sum of market participations and the bizarre characteristics of human psychology at work en-masse. Which is where the real risk lies.

Talib is correct in his observation that the most effective market participants are not necessarily better than their peers from the standpoint of pure skill. Instead, Talib argues, these individuals are more observant about human nature and are willing to wait for a mispriced bet. This is an oversimplification to be sure.

The smartest and most capable participants who play market psychology right are certain to get superior returns by capitalizing on mispriced bets with conviction. Combined with other talents, their results will be outperformance relative to their peers. And, done consistently, the laws of compounding are bound to make the results disproportionately observable, especially over extended periods of time. This simple fact seems to invalidate the concerns for the paradox of skill. In finance, small marginal edges cascade into tectonic outcomes over a ten or thirty year periods. Rather than present a paradox, this outcome seems natural.

Performance hierarchies appear regularly in nature. In financial markets they can and do occur in spite of multiple well informed participants. Just as water flows to the lowest point, Capital flows to its highest and best use.

To the statistically minded, the board game Monopoly is an oversimplified way to think about how compounding in a capitalist system works. In the game, chance plays a part in the early part of the game. There are spaces on the board statistically likely to produce superior outcomes. Players who understand the math of winning certain locations early have more chances of gaining rents from other players that will cascade later in the game.

A system like the stock market with some understandable behavioral and statistical characteristics should result in some degree of uniformity over time. After all, there is a profit incentive for participants to create uniformity. Engaged market participants also create liquidity for one another so on and so forth.

Some businesses and participants by their nature are just much more likely on average to produce superior long term returns. How a capitalist system should work for society is a different argument for a different time. What proponents of the paradox of skill misses is the power of the human will.

The idea that a market cannot be intentionally acted on with some skill is a very narrow view of the world. Capitalism works so exceptionally well because good ideas are allowed to breed and create great and wonderful new things. Real skill can produce repeatable outcomes. Managers, and foremost, entrepreneurs, who discover a market dislocation and create something new fall wholly outside of the paradox of skill.

Markets only grow over time if more value is introduced. A paradox of skill that prevents new participants from entering the market is incongruent with nature. The paradox overlooks the fact that new things can be created and are created all the time. The staying power of many of the titans of Wall Street suggest they are not all statistical anomalies, but superior investors over extended periods.

Investors and managers should seek to invent new ways of doing business, new financial products, better processes. It should be understood that the disproportionate rewards of a market system will flow to people who create these things. New wealth is created when value for others is created. When a good or service superior to previously available alternatives is created the paradox of skill plays no part.

Incidentally, more innovation occurs within large corporations than in small firms. Why shouldn’t it? Larger companies are better capitalized, often better organized and must fight to maintain their competitive position in a market. Again, turn to biology for examples. The biggest apex predators have dominance over the food chain. Adaptive behaviors or evolutions of animals competing within a niche frequently result in new specializations. Animals gain a foothold in their environment or die out when they are no longer competitive in their niche or they evolve.

Properly considered, value can also be created by participating in markets in ways statistically rare compared to others. Invention may not be needed as much as behavioral adaptation with markets as they grow and change. Consider the buy and hold investor and the average investor.

The average investor that trades in and out of a stock in short periods of time incurs frictional transaction costs in their quest for value creation. The buy and hold investor by contrast is benefited from not incurring additional taxes on his purchase and sale. Market psychology makes the ability hold the investment harder than simply buying and selling with market prices as instructive rather than helpful tool.

Other adaptive characteristics that would differentiate from the average investor include but are not limited to the flowing:

Avoiding Debt – Recourse debt injects unavoidable risk into the equity equation. Increased leverage only enhances the statistical likeliness of a negative outcome. Only less debt reduces this increased likelihood of asset forfeiture to near zero.

Frequent transactions (execution risk) – occurs as a result of too much action. Taking the rational position that human beings are fallible means that on occasion even the best investors will create errors. Risk can only be reduced by taking less action in favor of mispriced bets with deep margins of safety.

Intentionally limited datasets (focus risk) – similar to execution risk is the observation that managers have a finite capacity for activity. Dunbar’s number limits regular social circles to 150 participants. It is reasonable to assume that there is an upper limit on the number of investments that can be well understood by investors. Investors seeking to adapt should determine their upper limit and stick to domains of limited expertise.

What is clear from this analysis is that investors facing odds where outcomes appear nominal are best served by seeking out new ideas. It is far more likely that investors as a group are more homogeneous not necessarily more skillful. A slight advantage over the group is a material advantage over the long term. Exceptional performance will only result from a unique or statistically uncommon value creation or market participation method. Waiting for lady luck to bestow her gifts is not paradoxical, but foolish and average.

For further reading on the paradox of skill. A great discussion can be found in The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing by Michael Mauboussin.