Skill vs. Luck (part 1)

Shallow men believe in luck. Strong men believe in cause and effect.
Ralph Waldo Emerson

For years, the role of luck in management has been underestimated. Society generally values ​​terms such as hard work, meritocracy and others, ruling out randomness in virtually any model. Even nepotism is more accepted than luck. Luck is treated as an excuse. At Steering Bird, we want to review the scope of Skill vs. Luck.

Skill vs. Luck

Luck is the pretext of the unsuccessful.
Pablo Neruda

Usually, when we are successful, we tend to attribute it to our skills and when something goes wrong, we tend to say it is bad luck. Also, it is easier to admit that there was some good luck in our victories than a lack of skill in our losses. This is called selfish attribution bias.

However, in many aspects such as: business, investment or sports, it is not easy to differentiate luck from skill. Among those who have studied the role of luck, we highlight the work of Michael Mauboussin, his book “The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing” (2012) and the publications he made before the book.

The results of many activities, such as sports, business, and investments, are the combination of skill and luck. Most people recognize that skill and luck play a role in the results, but fail to estimate the extent of each one’s relative contribution. The ability to properly identify the roles of skill and luck leads us to think much better about most day-to-day results and allows us to improve decision-making.

Narrative Fallacy

We love stories and have a yearning to understand the relationship between cause and effect.
Michael Mauboussin

One of the stories Mauboussin comments, collected from a report by L.A. Times (December 30, 1977), is as follows:

The Lotería Nacional (Spain) (founded in 1763), organizes since 1818 a Special Christmas Draw, colloquially called “El Gordo”. This raffle is the largest in the world, according to the amount of the payment. In the mid-1970s, a man searched for a ticket with the last two digits ending in 48. He found it, bought it, and then won the lottery. When asked why he was so determined to find that number, he replied “I dreamed of the number seven for seven straight nights. And 7 times 7 is 48”.

Thus, it indicates that, “we love stories and have a yearning to understand the relationship between cause and effect. As a result, statistical reasoning is hard, and we start to view the past as something that was inevitable”. This is the Narrative Fallacy.

Skill and Luck

To the soldier, luck is merely another word for skill.
Patrick MacGill

Before continuing, we must define the concepts of skill and luck:

Skill is “the ability to use one’s knowledge effectively and readily in execution or performance” (Mauboussin, 2010). We can understand it as a process to achieve a specific objective. Skill tends to be stable.

Luck is “the events or circumstances that operate for or against an individual” (Mauboussin, 2010). Thus, luck is beyond skill. We can understand it as a distribution that has a zero average in the long term. Luck tends to be transitory.

Skill-Luck Continuum

I’m a greater believer in luck, and I find the harder I work the more I have of it.
Thomas Jefferson

Mauboussin proposes the Skill-Luck Continuum to explain that practically all activities combine some degree of skill and luck.

At one extreme is pure skill, like chess. This discipline requires years of study, training and practice to master it. It is practically impossible to beat an opponent due to luck. It takes more skill than the other.

At the other extreme is pure luck, where gambling is located. The odds of winning are always in favor of the house, even when you are going to play with some strategy. Big wins are the result of luck.

Reversion to the Mean

What goes up must come down.
Isaac Newton

There is one important issue: The results of any activity that combines skill and luck will involve a topic that is called Reversion or Regression to the Mean. It means that an extreme result (positive or negative) would be followed by a outcome that has an expected value closer to the mean. Mauboussin indicates that “Reversion to the mean is a tricky concept, and the relative contributions of skill and luck shed light on its significance for various activities”.

Explained in another way, Reversion to the Mean is the tendency of some variables to return to their mean values in the long term. When an exceptional result occurs and chance influences, there is a change in the trend of the facts, which leads to convergence with the mean when the results return to normal. This is because the chances of an exceptional event being repeated decrease.

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