The Maleficent 7

The Magnificent Seven is a terrific 1960 movie “western” about seven gunfighters hired to protect a small Mexican village from marauding bandits. A re-make is currently in the works and the “original is itself a re-make of Akira Kurosawa’s Japanese classic, Seven Samurai. Meanwhile, Maleficent is the “Mistress of All Evil” in Sleeping Beauty who curses the infant princess to prick her finger on the spindle of a spinning wheel and die before the sun sets on her sixteenth birthday. Today I’m offering up a mash-up from these movies to outline what I’m calling the Maleficent 7 – seven inherent human problems and limitations that impede our ability to make good decisions generally and especially about money.

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Worth Reading

I wrote about probability earlier this week within the context of the unlikely and astonishing conclusion to this past Sunday’s Vikings v. Ravens NFL game. Such probability questions are looked at again here, with the added bonus of showing how a poker hand with similarly unlikely outcomes could have played out. Enjoy.  

If Ravens-Vikings Was A Poker Game

Betting on Investment Skill

In 2006, the TradingMarkets/Playboy 2006 Stock Picking Contest was won by Playboy’s Miss May of 1998, Deanna Brooks (shown right). Her portfolio, which bet heavily on oil and gold stocks, gained 46.43 percent on the year and every stock in it provided double-digit returns. She liked Yamana Gold because “What girl doesn’t like a little bling? I’m hot for gold this year.…” It wasn’t her only nugget of sterling analysis. She also liked Petrobras because “oil is making money” and IBM because computers “aren’t going away.” She wasn’t the only Playmate to find a rich vein of success. A higher percentage of participating Playmates bested the S&P 500’s 2006 returns than active money managers. Think about that for a moment. Over the course of a full year, a bunch of Playmates outperformed a whopping majority of highly trained and experienced professionals with vast resources who spend all day every day trying to beat the market.

It’s easy to say that the Playmates got lucky, and they did. But we’d never expect a guy swimming laps at the YMCA to beat Michael Phelps across the pool, a girl off the street to beat a Grandmaster in chess, or an unschooled janitor to solve an insanely complex math problem amidst a spot of cleaning in the afternoon that the best and the brightest need years to figure out. Not even once.

If something like that actually were to happen, we’d treat is as a marvel (as the movie, Good Will Hunting, excerpted above, does), not just as a whimsical curiosity to be used for the purposes of garnering a bit of publicity and ogling attractive women.

It’s tempting simply to say that the contest is too small a sample size to be meaningful and move on. Had she stuck with investing, Miss May’s performance would miss and miss by a lot, probably sooner rather than later, as all investment performance tends to be mean reverting. But we also know that sample size doesn’t mean much when little luck is involved. It doesn’t matter how many times I race Michael Phelps. The chances of my winning will always be vanishingly small — effectively zero.

It’s also important to emphasize (as Michael Mauboussin did in his excellent book, The Success Equation and at The Big Picture Conference recently) the paradox of skill when it comes to investing. As overall skill improves, aggregate performance improves and luck becomes more important to individual outcomes. On account of the growth and development of the investment industry, John Bogle could quite consistently write his senior thesis at Princeton on the successes of active fund management and then go on some years later to found Vanguard and become the primary developer and intellectual forefather of indexing. In other words, the ever-increasing aggregate skill (supplemented by massive computing power) of the investment world has come largely to cancel itself out.

These explanations are good as far as they go, but they hardly tell the entire story. Lady Luck is crucial to investment outcomes. There is no getting around it. Managing one’s portfolio so as to benefit the most from good luck and (even more importantly) to get hurt the least by bad luck are the keys to investment management. Doing so well is a remarkable skill, but not the sort of skill that’s commonly assumed, even (especially!) by professionals. 

More to the point, if investment returns depend that heavily on luck and real investment skill is that elusive and rare, what should we do with our (or our clients’) money? For some answers, we turn to the world of…poker? That’s right — poker. 

Outcome Bias

While I was concluding a difficult cross-country trip last evening, my Chargers were wrapping up a surprising win against the Indianapolis Colts. To clinch the win, Nick Novak hit a 50-yard field goal, his fourth of the night, with 2 minutes left to give the Chargers a 19-9 lead. ESPN’s highlights are shown below.

There should be at least three clear takeaways from these highlights and from the game itself:

1. The Bolts’ “powders” are the best uniforms in sports;
2. Rookie receiver Keenan Allen was a steal in the 3rd round of the draft (full disclosure: he was a teammate of my younger son at Cal); and
3. Kicking that last field goal was a mistake.

My focus here is #3.

Birthday Luck

I had been fitfully and uncomfortably sleeping, dreaming of a small dog licking my leg and stealing my snack. I awoke to find an escaped boxer with a cute face avoiding my eyes and licking her lips. Once the flight attendant found her rightful owner, who was not nearly as embarrassed as she should have been, I reassess my situation.

I’m still more than an hour behind schedule and said to be losing even more ground on account of intense headwinds. I’m still scrunched into a long metal tube with the seat-back in front of me compressing my kneecaps into my hips while hurtling cross-country, still several hours from arrival home in San Diego. I’m tired from lots of planes and being away from home for too long. I’m not in the most conducive spot I can imagine for counting my blessings.

But count them I shall, as part of this birthday reflection.  “Birthday luck” describes a nuclear explosion of luck that is supposed to happen inside you on that day, giving you the ability to do anything. I don’t really have birthday luck, of course, but my luck is so good that it’s hard to tell the difference.

We are self-serving creatures to the core, of course, and self-serving bias is our ongoing tendency to attribute our successes to skill and our failures to very bad luck. Being an early investor in tech stocks was really smart while being long and wrong in 2001 was really unfortunate. But the reality is that luck (and, if you have a spiritual bent, grace) plays an enormous role in our lives – both good and bad – just as luck plays an enormous role in many specific endeavors, from investing to poker to winning a Nobel Prize.  In fact, if we’re honest, we’ll recognize that many of the best things in our lives required absolutely nothing of us and what we count as our greatest successes usually require great skill and even more luck.

That my birth, which I celebrate tomorrow, was into a loving and stable family that valued education and industry was not my doing. That I was born into a land of freedom and opportunity that would allow and even provide the means for a child of working class parents with no educational background and one high school diploma between them to pursue and secure a world-class education was not my doing. I merely had to provide sufficient effort. That I was blessed with some ability and interest in a field that provides a good living and constant stimulation was not my doing. I merely had to provide sufficient industry. That I have a boss who supports and encourages me in work I love is not my doing. That I married extremely well and have three terrific and productive children who have also married extremely well is only partly my doing (and surely less my doing than I’d like to think). The wonder of delightful grandchildren is grace personified.

I could have been born in the 7^th Century. I could have been born in North Korea. I could have been born into a family that abused me. I could have had to struggle for even minor educational advancement. My boss could be a jerk. My children could be disdainful. My wife could be a little less wonderful (though I doubt it). My grandchildren might never visit. As Frederick Buechner puts it, “all moments are key moments and life itself is grace.”

So truly – happy birthday to me. For much of it – verily, for most of what’s happy about it – I have luck (and grace) to thank.

Overselling Competitive Balance

The New York Times has a piece out trumpeting competitive balance in baseball and highlighting the fact that “the 2013 baseball playoffs include more teams from the bottom 10 in payrolls than the top 10.” Big spenders include the Dodgers, Red Sox and Tigers while the Pirates, Indians, Rays and Athletics are play-off teams despite being relative penny-pinchers. The Yankees, perennial spending leaders with a payroll in the range of $230 million this season, are watching at home while the Rays (spending very roughly a quarter of that amount) are still playing. The conclusion from the Times: “Market size matters, but not as much as shrewd management.” That analysis isn’t quite wrong, but it is more than a bit incomplete with respect to the data and leaves out a crucial element to the story: luck.

Jake Locker, Randomness and Outcomes

I often write about the relative importance of luck and skill in various endeavors, including sports and investing (here, for example) and how the outcomes in such things — heavily influenced by luck — can cause us to miss important aspects of the process involved, which is much more important in the long run (for example, here). This past week’s loss by my San Diego Chargers to the Tennessee Titans provides a terrific example of how these things work.

Titan quarterback Jake Locker is 2-1 after three games and has thrown zero interceptions so far this season. He also led the Titans on a 94-yard drive for a touchdown to beat the Bolts as time expired (against a very soft zone defense — arrrggggg!). However, Locker’s overall statistics this season are virtually identical to last year’s mediocre numbers when the Titans had a blah 6-10 record (as Grantland’s Bill Barnwell has carefully pointed out). Is he much improved or not?

It’s too early to tell for sure, but the following play (courtesy of Bolts from the Blue) offers one good data point and a helpful jumping off point toward my still quite tentative view that the overall statistics may be a better gauge of where he is than Locker’s won-loss record and lack of picks so far this season.

Wow.

Marcus Gilchrist of the Chargers flat-out drops an interception with just seconds left in the game that would have secured the win for my guys. It isn’t on the level of the late-game Marlon McCree post-interception fumble that cost the Chargers a 2007 play-off game to New England (I was in the stands for that one), but it’s still pretty bad.  Obviously, the play isn’t Locker’s fault in that he hit Delanie Walker in stride and Walker tipped the football straight to Gilchrist. But think for a bit what this play demonstrates.

If Marcus makes the pick, the outcome (Titans loss) could cause us to conclude that Locker isn’t really progressing.  We’d look at his losing record and think that he could only score 13 points at home against the Chargers and couldn’t get it done in the two-minute drill. But since Gilchrist dropped the ball and the Titans went on the win, we may now forget that Locker badly missed a wide open Damian Williams in the end zone just before the game-winning play, didn’t make a great throw on the final play (although it was pretty good) and that Locker was just 2-for-11 on throws that traveled 15 yards or more in the air for the game.

These events provide great examples of how outcomes can disguise crucial elements of the process that — together with a significant amount of randomness — dictates those outcomes.  For example, the Gilchrist drop shows how and why players who outperform for a given stretch tend to regress toward the mean. That’s also why, despite the sample size being much too small to be sure, a lot of talent and, as a very young quarterback, a much better chance of significant improvement than more seasoned pros, it seems more probable that Locker is the player we thought he was last year than a budding star, despite some very good outcomes to this point in the season.

Picasso, Skill and Luck

In 2007, Newsweek named a 1907 painting by Pablo Picasso that came to be known as Les Demoiselles d’Avignon (shown left) as the most important painting in the previous 100 years.  But when the then modestly successful Picasso first showed the piece to a small group of artists, dealers and friends, things did not go well. 

A Cartoon About Sports

It’s a terrific commentary on the intersection of luck, skill, narrative and uncertainty in sports by Molly Brooks. As Ed Smith emphasizes in his fine book, “[u]ncertainty is a pain to predict, but a joy to follow.” This cartoon illustrates the point beautifully. Please take a look at the whole thing (linked below).

A Cartoon About Sports

Luck Be a Lady Tonight

The self-serving bias is our tendency to see the good stuff that happens as our doing (“we had a great week of practice, worked really hard and executed on Sunday”) while the bad stuff is rarely our fault (“It just wasn’t our night” or “we simply couldn’t catch a break” or “we would have won if the refereeing hadn’t been so awful”).  Thus desirable results are typically due to our skill and hard work — not luck — while lousy results are outside of our control and frequently the offspring of being unlucky.

Two fine recent books undermine this outlook by (rightly) attributing a surprising amount of what happens to us — both good and bad — to luck.