Differentiating Skill and Luck in Financial Markets with Streaks

ResearchBlogging.org

Speaking of luck, we just released a paper onto SSRN about luck and skill entitled Differentiating Skill and Luck in Financial Markets with Streaks. This paper, which I worked on with Andrew Mauboussin (a brilliant high school student who worked in our lab this summer), examines the relationship between skill and luck using mutual fund performance streaks. This builds on some of my previous work in baseball hitting streaks (a popular article here), using the assumption that streaks are good determinants of skill: when luck meets extraordinary skill, you get very long performance streaks. But when luck meets middling skill, very long streaks are generally absent.

The question we tried to answer in this paper was whether or not the distribution of streaks in the financial world over many decades could be explained by the overall performance of the market plus luck (via a Monte Carlo simulation), or whether these long streaks are longer than simply expected by chance and are indicative of true skill. Spoiler: there is skill involved in mutual fund performance, at least according to our methodology. But you’ll have to read the paper to find out the details.

For further reading, here’s a great discussion of skill and luck by Michael Mauboussin entitled Untangling Skill and Luck (pdf). Here’s one fun part from the article:

There’s a simple and elegant test of whether there is skill in an activity: ask whether you can lose on purpose. If you can’t lose on purpose, or if it’s really hard, luck likely dominates that activity. If it’s easy to lose on purpose, skill is more important.

Andrew Mauboussin, & Samuel Arbesman (2010). Differentiating Skill and Luck in Financial Markets with Streaks SSRN: http://ssrn.com/abstract=1664031

One Response to “Differentiating Skill and Luck in Financial Markets with Streaks”

  1. Tariq Rauf January 9, 2011 at 10:01 pm Permalink

    I really enjoyed this post.

    However, the last point from the “Untangling Skill and Luck” article seems somewhat incomplete to me in the context of team sport. There might be skill involved even if you don’t loose.