By Lindsey Rust
What role do skill and luck play in our failures or successes? Skill, defined as the ability to apply knowledge readily in execution or performance, can be improved through diligent practice, increasing chances of a desired outcome. On the other hand, luck is unpredictable and brought by chance. As described by Michael Mauboussin in what he calls the "paradox of skill," when the outcome of an activity combines skill and luck, as skill improves, luck becomes more important in shaping results.
All outcomes in our lives can be placed on a spectrum from pure luck to pure skill. Thinking of results as the sum of a draw from a distribution of skill and a draw from a distribution of luck, statistical theorem can be used to show that:
Variance(skill) + Variance(luck) = Variance(result)
In many areas, absolute skill has been improving, but the variance of skill has been shrinking. As an example, take the sport of marathon running. Compared to 1932, marathon runners today have access to better nutrition advice, scientifically-based training plans, and coaching, which has resulted in faster average times. This improvement in skill can be seen in Olympic gold medal times, as the gold medal men's marathon time in the 2012 Olympics was 23.5 minutes faster than the gold medal time from 1932. However, the difference between the 1st and 20th place times was 39 minutes in 1932 and only 7 minutes in 2012. As the variance in skill decreases and the variance in luck remains stable, luck is playing a growing role in determining winners and losers.
The same can be seen in the world of investing. As the absolute skill level of most investors grows over time, the relative difference in their skillset becomes narrower. As investors with similar skills compete against each other, luck often triumphs.
See also:
Michael Mauboussin talk on The Paradox of Skill and other topics
Credit Suisse Paper, Alpha and the Paradox of Skill