If I am a skilful tennis player, it is obvious. I win more points, games, sets and matches. There will be the occasional dose of bad fortune and the waxing and waning of form, but it is easy to tell if I have skill. In many activities results alone are sufficient to gauge ability. Investment is not one such activity. Skilful investors will often appear incompetent, amateurs can outstrip professionals and idleness can better action. This is what we would expect in any environment where randomness has a prominent influence on outcomes. It is not, however, just bad luck that talented investors must contend with; in a dynamic system, they must always question whether their perceived skill remains effective.
We can think of skill as there being a consistent link between process and (desired) outcome. Hitting a forehand in tennis 70mph onto the baseline 95 times out of 100 is a skill. It is specific, deliberate and repeated. The ease in identifying skill depends, however, on the task in question. If luck has a meaningful involvement, then skill becomes incredibly challenging to locate with any level of confidence.
The effect of randomness is the most obvious problem faced by skilful investors. It means that they can attempt to apply a skill in a consistent fashion but achieve disappointing outcomes. They will also lose to others who have less skill and may come to be perceived as having no skill. The notion that skilful investors are often thwarted by misfortune, however, is based upon a significant and precarious assumption – that investing skill is stable.
An oft-used analogy for the luck and skill dichotomy in investing is that of poker. A game that clearly mixes elements of both. The problem with this comparison is that financial markets and poker are different types of system. Poker is a system with a fixed set of rules attached; although player behaviour may alter, we can understand and model potential outcomes. Financial markets are a complex adaptive system; akin to a game where we don’t know all of the rules and some are likely to change through time.
Defining skill in an activity with amorphous rules is not an easy task. Even if an investor possessed evident skill that delivered strong results in the past, we cannot be certain that it will work in future. It is not sufficient to know whether skill exists, we need to judge whether it can persist. Such doubts are exacerbated by the randomness of markets, which mean the skilful often appear as if they are not. Even skilful investors do not receive continually positive rewards and feedback. When struggling, they must constantly wrestle with the quandary of whether to persevere because poor results are just noise or adapt because the requirements of the game are no longer the same.
To better understand investment skill, it is critical to disabuse the notion that there is such a thing as a ‘skilful investor’. Skilful at what exactly? Using skill in such a broad sense renders it entirely devoid of meaning. It is one of the reasons that people often appear so willing to follow a previously successful fund manager when they stray outside of their narrow circle of competence, with inevitably grim consequences.
The more that chance influences the outcomes of an activity the more important it is to separate skill into its component parts because headline results alone can be incredibly misleading. It is far better to think of investing as a vast array of specific and distinct activities – varying by instrument, market, time horizon and discipline. If there is any hope of identifying and monitoring skill, then it is critical to be precise about what it is and how it may change.
Defining a specific investment skill is just the beginning. We also need to understand why the skill is likely to deliver some benefit or advantage and whether the skill is still relevant – how sure are we about the rules of the game? It is difficult becoming a skilful investor and difficult remaining one.
Behavioural Investment 