7/16/2015

Skill Versus Luck And Investment Performance

ValueWalk

(http://stocktwi
(https://twit
(https://

(http://www.valuewalk.com)

(http://www.valuewalk.com)

Home (http://www.valuewalk.com/)
Value Investors

News

About

Books

VALUE INVESTING (http://www.valuewalk.com/sign-email/)

Videos (http://www.valuewalk.com/category/videos/)

Links (http://www.valuewalk.com/links/)

Stock Screeners

Timeless Reading

Register (http://www.valuewalk.com/register)

Netflix: The Knowledge Effect in Real-Time Analysts Play Catch-up (http://www.valuewalk.com/2015/07/netflix-the-knowledge-effect-in-real-time-analysts-pla

BREAKING

Skill Versus Luck And Investment

Performance

Get our free daily newslette

Email Address

Posted By: VW Staff (http://www.valuewalk.com/author/valuewalk-staff/)

Posted date: July 02, 2015 10:57:12 AM
In: Value Investing (http://www.valuewalk.com/category/value-investing-2/)
No Comments (http://www.valuewalk.com/2015/07/skill-versus-luck-and-investmentperformance/#comments)

View previous campaigns.

(http://us4.campaign-archive1.com/home/?
u=c3eb7a1d092fc854772c834e0&id=299e

Subscribe

Skill Versus Luck And Investment Performance by Caltech

(http://www.caltech.edu/)
Bradford Cornell (mailto:bcornell@hss.caltech.edu)
California Institute Of Technology
Pasadena, CA 91125
626 564-2001

Get The Full Seth Klarman Series in PDF

Get the entire 10-part series on Seth Klarman in PDF.
Save it to your desktop, read it on your tablet, or email
to your colleagues.
Email Address

GET THE PDF

Abstract
This article presents a simple procedure for assessing the relative impact of luck and
skill in determining investment performance. The procedure is then applied to the
large cap value managers. The results are consistent with earlier work that suggests
that the great majority of the cross-sectional variation in fund performance is due to
random noise.

http://www.valuewalk.com/2015/07/skill-versus-luck-and-investment-performance/?utm_campaign=EMAIL_DAILY&utm_medium=email&utm_source=mailchimp&

1/5

7/16/2015

Skill Versus Luck And Investment Performance

Introduction: The basic problem of Skill Versus Luck

Successful investing, like most activities in life, is based on a combination of skill and
serendipity. Distinguishing between the two is critical for forward looking decision
making because skill is relatively permanent while serendipity, or luck, by definition is
not. An investment manger who is skillful this year presumably will be skillful next
year. An investment manager who was lucky this year is no more likely to be lucky
next year than any other manager.
The problem is that skill and luck are not independently observable. Instead all that
can be observed is their combined impact which is here called performance. The
central question, therefore, is to determine how much can be learned about skill by
observing performance. It turns out that there is a straightforward way to investigate
that question based on application of the bivariate normal distribution. Though the
results presented here are well known in statistics, they are not commonly applied in
the context of assessing portfolio managers. As shown, they can serve as the basis of a
simple and useful model for assessing the skill of competing fund managers. To
illustrate how the model works, I use the procedure to analyze the performance of
large cap equity managers tracked by Morningstar, Inc. (NASDAQ:MORN
(http://www.valuewalk.com/stock-data/?stock_symbol=NASDAQ:MORN)). It turns
out, as one might expect given the volatility of asset prices, that the relative
performance of managers in any given year provides little information about
management skill.

A simple model for assessing luck and skill

To develop the model, assume that there exists a measure of performance, p, that
reflects the sum of skill, s, and luck, L. This formulation has a straightforward
interpretation in terms of portfolio management. In that context, p represents the
observed return on a specific portfolio, s represents the added expected return due to
the skill of the investment manager, and L represents the impact of idiosyncratic risk
on the portfolios return over the observed holding period.
More specifically, assume that both luck and skill are normally distributed in the cross
section and that

(http://www.valuewalk.com/wp-content/uploads/2015/07/Skill-Versus-Luck-1.jpg)
where s ~ n(E(s), sd(s)) and L ~ n(0, sd(L)). By definition, the mean of the luck
distribution is zero. Because p = L + s, p and s are distributed as bivariate normal with
mean vector [E(s), 0] and covariance matrix

(http://www.valuewalk.com/wp-content/uploads/2015/07/Skill-Versus-Luck-3.jpg)
Because luck cannot be correlated with skill, otherwise there would be a predictable
component of luck, it follows that

http://www.valuewalk.com/2015/07/skill-versus-luck-and-investment-performance/?utm_campaign=EMAIL_DAILY&utm_medium=email&utm_source=mailchimp&

2/5

7/16/2015

Skill Versus Luck And Investment Performance

(http://www.valuewalk.com/wp-content/uploads/2015/07/Skill-Versus-Luck-4.jpg)
For the bivariate normal distribution, it is well known from the statistical literature1
that

(http://www.valuewalk.com/wp-content/uploads/2015/07/Skill-Versus-Luck-5.jpg)
Substituting the relations from (2) into (3) gives,

(http://www.valuewalk.com/wp-content/uploads/2015/07/Skill-Versus-Luck-6.jpg)
Because E(L) = 0, it follows that E(p) = E(s) so equation (4) can be written,

(http://www.valuewalk.com/wp-content/uploads/2015/07/Skill-Versus-Luck-7.jpg)
Equation (5) is the basic model. It states that when performance is observed in excess
of the mean, the assessment of skill is adjusted upward, but not all the way to the
observed level of performance, p. Instead, the assessment of s is adjusted upward by
the observed superior performance, p-E(s), times the ratio of the variance of s to the
variance of p. Therefore, the assessment of skill based on the observation of
performance depends critically on var(s)/var(p).
Notice that in both limiting cases, equation (5) makes intuitive sense. If var(L) is much
larger than var(s), then var(p) >> var(s) in which case E(s|p) goes to E(s). That is
reasonable because if performance is dominated by luck, then observation of
performance should play little role in the assessment of skill. On the over hand, if
var(s) >> var(L) then var(s) is approximately equal to var(p), which implies E(s|p)
goes to p. That makes sense because if luck has a relatively minor impact on
performance, then observed performance is a precise measure of skill.

http://www.valuewalk.com/2015/07/skill-versus-luck-and-investment-performance/?utm_campaign=EMAIL_DAILY&utm_medium=email&utm_source=mailchimp&

3/5

7/16/2015

Skill Versus Luck And Investment Performance

(http://www.valuewalk.com/wp-content/uploads/2015/07/Skill-Versus-Luck-8.jpg)
See full PDF below.

Like this article? Sign up for our free newsletter

(http://www.valuewalk.com/sign-email/) to get articles delivered to
your inbox
(http://stocktwits.com/widgets/share)

Next
Previous
(http://www.valuewalk.com/2015/07/u(http://www.valuewalk.com/2015/07/puertos-strategy-isis/)
rico-prepa-3/)

(http://www.valuewalk.com/2015/07/puerto-

Puerto Ricos PREPA Averts

U.S. Strategy In Real Time:

http://www.valuewalk.com/2015/07/skill-versus-luck-and-investment-performance/?utm_campaign=EMAIL_DAILY&utm_medium=email&utm_source=mailchimp&

4/5

7/16/2015

Skill Versus Luck And Investment Performance

rico-prepa3/)

Puerto Ricos PREPA Averts

U.S. Strategy In Real Time: (http://www.valuewalk.com/2015/07/uDefault With $1.9 Bil
Dueling With An Enemy That
s-strategyPayment
Moves
(http://www.valuewalk.com/2015/07/puerto(http://www.valuewalk.com/2015/07/u-isis/)
rico-prepa-3/)
s-strategy-isis/)

ABOUT THE AUTHOR

VW Staff (http://www.valuewalk.com/author/valuewalkstaff/)

(http://www.valuewalk.com)

0 Comments
Recommend

ValueWalk

Share

Login

Sort by Newest

Start the discussion

Be the first to comment.

Subscribe

Add Disqus to your site

Privacy

Copyright 2015 ValueWalk - Privacy Policy (http://www.valuewalk.com/legal-disclaimer-valuewalk/)

http://www.valuewalk.com/2015/07/skill-versus-luck-and-investment-performance/?utm_campaign=EMAIL_DAILY&utm_medium=email&utm_source=mailchimp&

5/5