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The Success Equation, Untangling Skill and Luck

The Success EquationWe like to read around here – and just recently got done with one that has been on the wishlist (it’s more like a… when the kids are quiet for 10 minutes and there’s not a client dinner or conference in town or presentation for a business deal – as time permits list, but I digress) for quite some time: Michael Mauboussin’s, “The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing.”

The title caught our eye right away, being in the business of untangling luck and skill to a certain extent in helping clients identify and invest in alternative investment managers. The question at the end of the day is whether the impressive track record a client is considering investing in is the result of skill, or whether it is luck. If you’re a chess player – or even tennis, it’s nearly all skill. If you’re a hockey player… it’s way more luck than your agent would care to admit.


And what about an investment manager?  How much of that track record is skill versus luck. The manager themselves usually portrays it as skillful, and charges as if it were entirely skill – but even the most successful of managers have to admit there is some skill in there. How much, and what questions should you be asking to determine the role of skill and luck are the parts of Mauboussin’s book we’re most interested in.

Here’s his handy graphic breaking down the major sports, slot machines, roulette, and trading in the stock market on a pure luck to pure skill continuum.

New Picture

Mauboussin tells us that where skill is the dominant factor, history is a useful teacher, but where luck is the dominant force, history is a poor teacher. And that the type of feedback you get is a good tool to measure how much luck there is in your endeavor. On skill side, there is a very close relationship between cause and effect; but feedback on the luck side is often misleading – where good decisions can lead to failure and poor decisions lead to success in the short run (due to luck).  For more on the latter – read anything by Nassim Taleb, who’s made a career pointing out that a lot of the skill you see in the world (the banker, insurance company, option trader, etc) is nothing more than the result of 1 out of a million people destined to be quite lucky.

Essentially – what worked in the past may not work in the future on a heavy luck endeavor (such as investments), which I guess the regulators knew long ago when they made it a requirement to put the ‘past performance is not necessarily indicative of future results’ disclaimer on investment documents.

To measure the effect of luck, he introduces us to the James Stein estimator and the ‘shrinkage factor’ (straight out of Seinfeld), shows us how reversion to the mean is highly dependent on how much luck is involved, and discusses how even when you know how much skill there is – you’re in trouble because skills deteriorate (he quotes a source as saying the peak age for matters of finance is 53, and after that our skills start to deteriorate).

We enjoyed two parts in particular.

One, the discussion of ‘the paradox of skill’, which he explains: as skill improves, performance becomes more consistent, and therefore luck becomes more important. Mathematically, if the variance in skill becomes smaller than the variance in luck – luck becomes the dominant factor. In his own words:

“When everyone in business, sports, and investing copies the best practices of others, luck plays a greater role in how well they do.”

He shows stats supporting this from baseball, where all of the hitters have gotten better, but the rough averages have remained the same. Why? Becasue the pitchers have gotten better too!  But the interesting part of this to us is in the investment realm, and more importantly – the alternative investment realm. The discussion sure gets you thinking about our modern world of global markets, derivatives, and mangers earning billions; and whether the world has become so skilled in analyzing and trading them – that any performance is due mainly to luck, and due for a healthy reversion to the mean?  It makes us think of all the money in systematic trend following, and whether there is a real world experiment in the ‘paradox of skill’ happening there before our very eyes. Are any variations in the performance of trend follower A versus Trend Follower Z due to luck? Are they outperforming due to luck in including Coffee in their list of markets – luck in risking 0.25% per trade and getting an extra Hog trade versus the guy who’s model was risking just 0.20%? And so on.  Are those differences skill, or luck?

We also enjoyed Mauboussin’s discussion of the ‘dumb money effect’, which we know as emotional investing, or getting in at the highs, and out at the lows (see our discussions on it here, here, here). He shows some stats calculating it costs investors 1% in returns each year, and that institutional investors  have foregone $170 Billion in value over a couple decades because of this dumb money effect.

Why do we do it?  We’re hardwired that way, with Mauboussin showing a survey where 2/3rds of respondents admitted they tend to rely more on judgement when analysis becomes more complex, and how we tend to give disproportionate weight to whatever has happened most recently, buying when at all time highs and getting out when at lows, causing some specific losses:

“Individual investors consistently earn results that are 50-75 percent those of market itself due to bad timing.”

And if this dumb money effect is so prevalent among individual investors and institutional alike – should we really expect our managers to be immune from it? It’s not too hard to imagine an investment manager doing their own version of the dumb money effect – changing a model around after a streak of losses, adding more markets on a model which is doing well to expand its exposure, and so forth. This is the danger to perceived skill – where changes meant to help actually result in pushing the inevitable reversion to the mean back further.

You can’t help but feel a little hopeless upon finishing the book – and realizing just how much of investing (and life) is due to luck instead of skill. But the lesson to be learned shouldn’t be to pack it in and put your money under the mattress. The lesson for us is to realize luck’s part, to realize that impressive winning streaks are just that – streaks. That depressing losing streaks are just that – streaks. And that some luck (or lack thereof) means reversions to the mean, so avoid getting in at the tops and out at the bottoms.. avoid the dumb money effect. The lesson for us is that process matters a lot more than outcome in the short run, and that the more you base your investment decisions on the recent past, the more likely you are to be disappointed.


Weekend Reads: That was Unexpected

The Bank of Japan decided to play a little trick or treat (depending on your positions) on the world this Halloween. They announced more QE, which sent Nikkei futures ‘Limit Up’ to new 7 years highs, US stocks to all time highs, Metals down a couple percent, and foreign currencies all lower against the US Dollar. A treat for trend followers, to be sure. Have a fun and safe Halloween:

Bank of Japan QE:

Japan Just Boosted QE And The Nikkei Exploded To A 7-Year High – (Business Insider)

When One Door Closes — (Reformed Broker)

Bank of Japan Unexpectedly Eases Policy – (The Wall Street Journal)


GLD’s Fall From Grace – (A Wealth of Common Sense)

The worst possible case for the worst possible idea, the gold standard – (The Washington Post)


The Scariest Halloween Costume Is A Cockroach That Performs Root Canals – (Five Thirty Eight)

The Scary Commodities This Halloween – (Attain’s Alternatives Blog)

Why We Like Being Scared – (The Economist)


Before you complain about the CTA again, read this – (Crains Chicago)

College: The Great Unleveler – (Ritholtz)


Senate Update: With 4 Days Left, Here’s The State Of The Races – (Five Thirty Eight)

Guns, Pot and Taxes: A 2014 State Ballot Guide – (Bloomberg)

The Scary Commodities this Halloween

Halloween is here once more, and everyone around the office is gearing up: carving pumpkins, buying candy for trick or treat-ers, and last minute runs to the store for costumes. To get everyone else in the mood, we found some Halloween like similarities in the futures markets we couldn’t help but share.


Last year, it was the US Dollar/Euro Currency Battle Signal that got us excited for Halloween (Who doesn’t love bat man?)… and now that Bat Signal has transformed into one of the most feared villains in the galaxy… Jabba the Hutt, of course.

USD EUR(Disclaimer: Past performance is not necessarily indicative of future results)


A couple weeks ago we went in depth about the US Dollar having its best quarter in years , and how Managed Futures has historically benefited from it (past performance is not necessarily indicative of future results), but what else is out there on Halloween Eve?

Scary Vs:

We’re talking a shock to the system…. That Damned V Reversal. Here’s Why you should be Afraid of the V-Shaped Reversal

That Damned V(Disclaimer: Past performance is not necessarily indicative of future results)

V for Vendetta


Everyone needs their fill of snickers, Milky Way, 3 musketeers on Halloween. But where that chocolate comes from has but the market in limbo the past couple of weeks. It appears, the Cocoa market decided to get nice and scary (volatile) just in time for the ghosts and goblins to come out. That’s just your basic up move of around 12% and -13.5% fall in about a month and a half… nothing to see here, move along.

(Disclaimer: Past performance is not necessarily indicative of future results)

Sugar: Super Scary

For those that don’t like Chocolate (see here), there’s the laffy taffies, the warheads, the sour patch kids… basically… Sugar…. And lots of it. The market jumped out it’s mountain trend to start the year and has been choppy ever since.

Sugar(Disclaimer: Past performance is not necessarily indicative of future results)

We don’t expect sugar prices to go up anytime soon just because of Halloween, but recent studies show that the brain has the same reaction of cocaine as to sugar, suggesting that there might never be low demand.

Sugar Cocaine


That’s enough to maybe sway one of two people to be long sugar for the couple of the next couple years (or maybe short depending if the government calls for harsher restrictions).

We’ll leave that explanation to the journalists who make you really step back and think about it.  Here’s John Oliver from  Last Week Tonight doing his best to explain Sugar.  Have a happy Halloween, and don’t have too much sugar.

Past, Present, and Future in 30 Year Bond Futures

While everyone was watching the US Stock market bounce +5% over the last 8 trading days, there were a few hours of sheer terror/excitement (depending on what side of the trade you were on) in the 30 year US Bond Futures market at 10:00 am hour on October 22nd. What? Say you… I don’t remember any big moves in bonds at that time. And if you were looking at the so called ‘front month’ contract, you would be correct.  The December 2014 bond futures traded in a range of 142-10 to 142-12 between 10 am and 1 pm last Wednesday, as you can see below.

But while all was calm in the front month, there was a huge move going on in the June 2015 back month contract. Wednesday was the first trading day for that contract, and it quickly jumped from 141 to 152, a percentage gain of 7%, with a volume of over 16,000+ contracts in just 2 hrs. Compare the two moves below:

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The Secret Club That Runs the World

The Secret Club that Runs the WorldWow, the editor really got carried away with that title. We picked up a copy of Kate Kelly’s (great name) book ‘The Secret Club That Runs the World – Inside the Fraternity of Commodity Traders’ the other day, and after finishing it off – think the title probably should have been something more like:  A few traders who took enormously large risks, made fortunes, lost fortunes, and then faded into relative obscurity. But that might not have sold so well.

Beyond the critique of the title, however; this was quite an entertaining read for anyone involved in the commodity futures markets – and especially the energy markets.  The book touches a lot of different areas, including profiles on former regulators Bart Chilton and Gary Gensler; the dangers of indexing commodities after a huge run up, and how commodities were the red headed step child at Morgan Stanley.

But those parts are mostly just filler between the more entertaining sections discussing the incredible ups and downs of Pierre Andurand and his Energy Trading Hedge Fund Blue Gold Capital Management (since closed down), the behind the scenes drama as physical commodity giants Glencore and Xstrata tiptoed around a merger, and the bizarre tale of huge proprietary trading masked as hedging at Delta Airlines.

The Andurand/Blue Crest story is worth the price of admission alone.  Andurand is like a characterization of a hedge fund mogul for a movie. There’s his 11 million pound house in London, Goldman Sachs ties, ownership in a kickboxing league, a custom Bugati sports car, Elton John playing at parties, and – of course – the proverbial Russian model for a wife.  And then there’s the incredible performance:  +209% in 2008, +55% in 2009, and +13% in 2010 as assets under management surpassed $2 Billion; followed by a terrible day in 2011 when the firm lost close to half a billion dollars (in a day!).  About 16 months later, the fund shut down and sent home all the money to clients. Past Performance is Not Necessarily Indicative of Future Results.

This quote summed up Andurand (and our amazement on how they could have raised over $2 Billion).

“Everyone knew of Andurand’s appetite for emormous bets – and his reputation for relaxed risk management.”

Andurand has gone on to launch a new firm, Andurand Capital, which reportedly was one of the best performing funds in 2013, but we can’t help but imagine what one of our favorite authors, Nassim Taleb, might say about him.  Mr. Taleb might view the performance as little more than the personification of the role luck plays in investment outcomes. He may view Andurand as a human winning lottery ticket – the one trader out of tens of thousands trying to do the same thing who got the sequence of many best just right (although there were some that were notably wrong).  All we know is that we’ll keep rooting for the guy, so there’s more stories of mansions, private planes and model wives.

The rest of the story, excepting the regulator parts, is nearly as interesting – especially the stories around Delta Airlines mostly botched attempts at hedging their fuel costs, making for a good quick read that will have you at the very least, feeling a little emasculated over the size of your bets in the energy sector.

Invest like a Billionaire?

When someone first starts investing, there is the sort of high that comes with it; a high that convinces you that you just might be the next Warren Buffet. Sure. You watched a couple investing tips videos on Youtube, and you think you found some ETFs (with extremely low or no fees) that no one else knows about.

The thing is, that feeling never really goes away. The overly active investors are confident that with a little hard work they too will eventually become Warren Buffet. We all know the likelihood of that, so instead the people at Direxion decided to take that idea and turn it into an ETF. What are we talking about? The newly launched ETF Direxion iBillionaire (IBLN). Now you can feel like you’re trading with the greats, without actually doing it. Here is the description:

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Who needs the USDA when you can Live Tweet Crop Conditions

What gets Ag folks excited on a Monday morning on Twitter? Live Tweeting crop conditions. All day, the people of the “2014 Pro Farmer Midwest Crop Tour,” have been tweeting their hearts out with the hashtag #PFtour14 to show the conditions of corn and soybeans across the Midwestern states.

Crop Tour Logo

The goal of this four day tour is to provide accurate information of the condition of corn and soybeans as harvest season approaches. We can’t think of a better way to do such a thing then traveling state to state live tweeting the conditions in the field in real time.

Now you might be wondering, doesn’t the USDA already collect data from around the country to provide the conditions of various crops? Yes, but this crop tour is unique in that they don’t want to focus on  yield numbers specifically, but the big picture.

“Don’t focus on yield calculations from individual fields,” says Brian Grete, Pro Farmer senior market analyst and leader of the tour’s eastern leg. “That isn’t what we are trying to do, and we actually discourage scouts from tweeting individual yield results. Instead, we look at the entire area we cover as one big corn field. Twitter is most useful for getting a general idea of what scouts are finding. And the pictures are valuable.”

Essentially, give people the opportunity to tweet about the condition of their corn with pictures, and you got yourself one heck of a trend (pun intended). Take a look at some of the pictures from the first day of the tour, via the Ohio County Journal.

Corn 1 [Read more...]