Steve Forbes: Michael, good to have you with us. Before we begin the interview: Investors Think Twice, great book. Especially chapter 8, “Sorting Luck From Skill,” which we’ll get to in a moment and will be the basis of a new book yet to come.  Three numbers: 9, 7.5 and 6. You’ve made the point the S&P averages, say, about 9% growth. Mutual funds maybe 7.5%. Individuals, even if they invest in mutual funds, 5.5% to 6%. What is going on here?  Michael Mauboussin: Yeah, Steve, those are the most probably depressing statistics in all of investing, right? As you point out, 9% is what the market does over the long term. 7.5% is what mutual funds earn, and the difference is primarily fees that mutual fund managers charge. But that we could probably live with because, on balance, the only way to get excess returns is through active management.  The most depressing one is the bottom one, right? Which is what investors earn, which is typically about 60% to 70% of the market’s returns. And you say, ‘Well, why are they doing so much worse than mutual funds?” Because they’re probably investing in mutual funds.  And the answer is: Timing. Or I should say, bad timing. That is, most individuals tend to buy when things have done well and sell when things have done poorly. So they miss out on the subsequent rises when they sell, and of course the subsequent reversals when things have done very well in the past. They buy high and sell low instead of what you’re supposed to do.  Forbes: That gets to a paradox, by the way, of mutual funds – that is, people who are in load funds tend to do better than those in no loads. Why? Even though they’re getting shafted by high fees, they don’t move their money as much, precisely because they do know they’re going to pay a penalty.  Forbes: Now, you said the word “individuals,” but you also make the point institutional investors are prey to this. That they leave – you’ve calculated or others have calculated – $170 billion. They have a short-term time horizon, by your likes, three years. And you say one third of the relative underperformance is asset allocation and two thirds is individual managers.  Mauboussin: Also a crucial point. So you could understand why mom and pop mutual funds maybe would do poorly, but this pervades institutions as well. And it’s interesting. The American ethic, or probably Western ethic, is hard work equates to better outcomes. So doing things tends to be a good thing.  That’s not always true in the world of investing. I think many managers or endowments and pension funds feel like moving money around is a really crucial way to improve the performance. But again, their timing tends to be very poor. You cited that number, $170 billion. Researchers studied this that they left, well, the opportunity cost in effect was $170 billion. Now, the base is still trillions, but it’s not an insubstantial sum of money that they’re leaving on the table. So, yes, our time horizons tend to be too short, and we’ve got this sense of activity equating to results, which in the world of investing simply doesn’t work.  Forbes: So the hot hand. In other words, a manager who does well will get the job; a manager who underperforms will lose the job, even though the underperformer may come back. How do investors learn to accept the fact even skilled managers – and we’ll get to skill in a moment – have periods of underperformance?  Forbes: A baseball team is going to have a period where it’s not going to do well.  Mauboussin: Exactly. I love talking with sports metaphors. The hot hand, by the way – most sports fans and certainly athletes believe in the notion of a hot hand. That is, if you’ve done well recently, you’ve made your recent shot, you’ll make the next one with a higher probability. Where the inverse, of course, is where if you’ve missed it, you’re going to miss with a higher probability.  But statisticians have poured over this for a number of years, and I think, at best, there’s little evidence for the hot hand. The problem is, though, we still act as if it occurs. And to your point, there was a really fascinating study. It was over 3,000 plan sponsors – these are endowment funds and pension funds, the folks that are doing this for a living.  Forbes: They’re supposed to know what they’re doing.  Mauboussin: They’re supposed to know what they’re doing. And what they did is they typically hired folks that had outperformed the market recently. And they fired them for a bunch of reasons, but the number one reason they fired them is they had underperformed their benchmarks recently. And to wit, of course, the next 24 months, the folks that they fired did better than the folks that they hired. So had they simply sat on their hands, they would have been better off.  So that is the message of the hot hand. And it’s mean reversion as well; when things have done very well in a mean reverting system, be cautious, because the most likely next move is down. And when they’ve done poorly, the next likely move is up.  Boy, the Boston Red Sox; people don’t like talking about that in New York, but the Boston Red Sox are a great case. They started off the season I think 0-6, and I think at one point were 2-10.  Mauboussin: But of course now, at least at this moment, they’re leading the American League East. So short time periods in mean reversion series can be very misleading.  Time Horizons Are Too Short  Forbes: Now, one can understand individuals being prey to their emotions. But why this short-term time horizon among institutional managers. And is it getting worse, not better?  Mauboussin: That’s a tough one to answer. I think that the typical horizon – and there’s been academic research on this as well – is about three years. So an institutional manager will say, “I’ll give my money manager about three years.” But it turns out, that is too short a period of time.  And, by the way, three years sounds totally sensible, especially in the career path of a chief investment officer of one of these funds. But it is too short for many, many strategies. So whether it’s getting worse or better, I think there are debates on both sides. I think the general sense is that there’s more short-termism in the world today, both at corporations and at money managers, than we’ve seen in the past. Although I think if you go back in history, in almost any decade there was lamenting about short-termism. So the complaint itself is not new, but certainly it seems to be continuing.  Investing Is More Luck Than Skill  Forbes: Now, we get to something that’ll make a headline, but you’ve got to explain this. You say that in investing there is more luck than skill, which will have all professionals ready to strangle you. We will protect you.  Mauboussin: Right. Well, thank you, first of all. But in the sense, it’s almost a compliment, not something that’s so negative. And here’s one of the ways I will explain this: The first thing I would like to say is you can think about any activity in life as having a continuum from pure skill and no luck to pure luck and no skill.  Forbes: Pure luck being the slot machine.  Mauboussin: That would be if we go play a chess match or we play tennis or run a race – the better fellow is going to probably win, will win. And then slots as you point out, lottery, these things are pure luck. And almost everything in life is somewhere in the middle of these two extremes. The question is: Where does it lie?  Now, there’s a really interesting idea called the “paradox of skill.” And what that says is when people compete with one another, the more skillful they are the more uniform their results become – the more luck becomes important. This is another way of saying the efficient market hypothesis, which is if it’s a very competitive world out there – there are low barriers to entry, everybody’s got the same information, the same computers and reading the same academic research – it’s going to be very, very competitive. And then luck is going to become very important.  Forbes: You use your sports analogy: Ted Williams, .406, 1941.  Forbes: They’ve wondered why no one in baseball has hit .406 or broken .400 since then, and the point has been made, and you and others have cited it: Playing is much more skillful today than it was then.  Mauboussin: Exactly. So here’s the way to explain Ted Williams, perhaps. You think about batting averages – it’s a sort of normal distribution, right? The mean is about .260 when pitchers are hitting, about .260 with a standard deviation. In 1941, the standard deviation of batting average was about 31%.  So Ted Williams, I don’t know what that comes out to, about a five standard deviation event. He was, obviously, extremely, extremely good. What’s happened in the subsequent period is that standard deviation has come down.  So, if Ted Williams had the same standard deviation performance today, he would hit about .385. Which would still be off the charts, but it would be under 400. So why are there no 400 hitters today? It’s not because, as you point out, players are worse. In fact, indeed, almost by any measure they’re going to be better. It’s because the standard deviation of performance has narrowed and hence no one can get to that extreme performance.  By the way, there’s a way to test that in other realms as well, and that would be things where there is no luck – running races, swimming races. And what we’ve seen consistently is the times are collapsing. The difference between gold, silver, and bronze is much narrower today than it was a generation, two, or three ago. So that’s the prediction of the paradox of skill, and you can see that in all the numbers as well.  Forbes: Now, when you look at a manager, you make the point, “Three years: No.” Five years, maybe, ten years, yet research shows that ten years ain’t going to predict the next ten years. So what’s an investor to do? How is an investor to find real skill or just luck with a hot hand?  Mauboussin: Another great question. First, I should say, for investing, we always talk about years, which is natural. One, three, five, ten years. But, in fact, what you’re really trying to do is gather the sample size. So how many decisions that manager is making. So there are some strategies, if it’s generating lots of decisions or trades, you can evaluate it in a fairly short period of time. But for, for example, a long-only mutual fund manager who’s not making that many decisions, then you really do need to extend the time horizon.  But the essential answer to that is to focus on process, not outcome. And by the way, this is another thing; I think broadly speaking our society has gotten very outcome focused. I’m just going to give you a trivial example.  Let’s say we’re playing blackjack in Las Vegas and the dealer deals you a 17, what should you do in that situation? Well, you could ask for a hit, he could flip a four, and you can make your hand.  Forbes: 17 or over, stick with it.  Forbes: Under 17, go with the hit.  Mauboussin: Well, that’s the rule, right? But that would have been a bad process, but an excellent outcome for you, right? What we really want to focus on is the process: That you’re making those good decisions. Of course, standard blackjack strategy tells you what to do to maximize your probabilities of success.  So to me, it’s focusing on the process. And for investing, that process typically boils down to three specific things: One is a focus on the analytical process of that manager. The second would be the focus on the behavioral aspects, psychological. And the third, I would say, would be organizational – are there constraints within the organization that impede that manager’s ability to perform?  So How Do We Find Skill?  Forbes: How does an investor cope with what you just said?  Forbes: I mean, what, let’s go down that list. Take the first one on process.  Forbes: Is this how they find value versus running the business? Walk us through.  Mauboussin: Let me first say that for the average investor, if he or she is interested in doing this, it takes a lot of work to really sort out what managers are doing. If you’re not interested in doing that, or not compelled to do that, indexing makes an enormous amount of sense. For average people, indexing is a logical strategy. But if you want to roll up your sleeves a little bit, here’s how I might think about that.  For analytical, I would look for two things: The first is always looking for what we would call an edge. And an edge means that there’s a difference between the fundamentals and the expectations.  Let me bring in another metaphor here to make that a little clearer, and it’s not too far afield.  That would be horse racing. So you go to the horse race and there are odds on the tote board. That is the expectation of the performance of the horse. And then there’s fundamentals: How fast that horse is going to run. Now, if you studied tens of thousands of horse races, it turns out the markets are pretty efficient. The ordinal finishes of the horses, first, second, third, as predicted by the odds, is pretty much what happens. But from time to time, we know, there are mis-pricings. There are odds on the tote board that just don’t well describe how that horse is likely to run. And that’s what the sharp handicappers are after.  Bring that over to the world of investing, and that’s the same thing. We don’t have odds on the tote board, but we have something called the stock price. So we reverse engineer the expectations built into that price. We say, “What has to happen for that to make sense?”  And then we look at how the fundamentals are likely to unfold. It’s a probabilistic exercise. That would be the first piece. The second piece, analytically, is bet size, which is once you have an edge, how much do you bet in your portfolio? That’s a second key component which is often overlooked.  Forbes: Now, so how do you define value? How do you get the edge? Or is this one of those situations where there are various ways you can get value, the key is just to stick to the discipline?  Mauboussin: Well, I teach at Columbia Business School, so I have to come back with a classic Ben Graham kind of answer to this. Value, to me, is the present value of future cash flows, which would be relevant for any financial asset – present value of future cash flows.  Value would be buying something for substantially less than what it’s worth, based on that stream of cash flows. It’s as simple as that. And the margin of safety, of course, reflects the distance –  Forbes: How do you know what the cash flows are going to be?  Mauboussin: You don’t. It’s probabilistic, so you don’t know what the cash flows are. So this is what I would say: An expectations approach which would take three steps. Step number one is to say “Here’s the stock price, let me reverse engineer what has to happen for that stock price to make sense.”  Let me just pick an example. No recommendation, but Cisco, say, is at $14 a share. What has to happen for its financial performance to make sense? The second thing I’ll do is try to do some research and analysis of the financial and strategic characteristics of that company and say, “Are they likely to do better or worse than what the market implies?”  And then, third and finally, I can make the decision to buy, to sell, or to do nothing, which in many cases is the right answer. So figure out what’s built in, figure out what’s likely to happen, and then it becomes almost an over-under, versus saying I know precisely what those cash flows will be in the future.
The Columbia Business School Professor and Chief Strategist at Legg Mason sits down with Steve Forbes for an enlightening discussion on luck and skill.