Business Times

Skill, luck and reversion to the mean

By Kajanga Kulatunga

Businesses, especially those in the public domain have been increasingly spending money on public relations firms and some earnings announcements have now reached cult proportions. A regulatory obligation which was dominated by heavy-eyed analysts and retirees are now at times hosted by celebrities and must have sound bites to feed the 24-hour business channels. This presents challenges to sort out the noise from real facts which can have a meaningful impact on the future value generation within a business.

Many believe that large multimillion and multibillion rupee (dollar) companies are engines of discipline, efficiency, organization, and quality. How could they not be and still be as powerful and successful as they are? A closer look however reveals that most businesses, in fact, succeed in spite of themselves.
In retrospect, this shouldn't have been too surprising. No matter how large a corporation becomes, no matter what personal brand it acquires, the brand doesn't run things—people do. And people, of course, are flawed. Investors fall prey to the mistaken assumption that people always try to do the right thing, are all basically competent, and that a book will be as good as its cover.

Companies thrive on their customers and investors assuming this. A good company will always strive for quality, but simultaneously strive with equal intensity for the appearance of quality. Because achieving quality and achieving the appearance of quality often require entirely separate efforts, it's not uncommon for a large disparity to develop between the two. Think of Golden Key locally and Enron and most Wall Street banks globally. That it's easier to look accomplished and professional than to be accomplished and professional is less a testament to how easy it is to look good than how hard it is to be good.

Often companies go overboard to project an image of being “different” and “above their competition” since most senior management simply don’t understand how the company’s earnings got there in the first place. It is entirely possible (and there are plenty of real life examples) of companies who have done nothing different for up to a decade, only to see their internal value and share price trade within a 90% price volatility band. Companies and investors by extension tend to underestimate one of the most powerful forces of mathematics, that of mean reversion. Mean reversion is misunderstood due mainly to the lack of proper tools in understanding the role of skill versus luck in decision making, be it in running a company or choosing which businesses to invest.

Outcomes from many activities—including sports, business, and investing—are the combination of skill and luck. Most people recognize that skill and luck play a role in results, yet they have a poor sense of the relative contribution of each. The ability to properly untangle skill and luck leads to much better thinking about most day-to-day outcomes, and allows for sharply improved decision making.

The outcomes of any activity that combine skill and luck will exhibit reversion to the mean. More technically, an extreme outcome (good or bad) will be followed by an outcome that has an expected value closer to the mean. Reversion to the mean is a trick concept, and the relative contributions of skill and luck shed light on its significance for various activities.

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. Chess falls in very closely to the pure skill category, while gambling in the pure luck category. Most other activities in life are somewhere in the middle. Probably the single biggest challenge in assessing the relative contribution of skill and luck is that in most cases we can only observe outcomes. There’s no problem with outcomes at the extremes of all skill or all luck, because you know what you are getting. But almost all interesting activities have a blend of skill and luck, and it is critical to have a sense of the relative contributions of each. We need to tidy up the jumble of outcomes.

Investors have been badly spoilt by the tremendous run of the Colombo stock market over the last two years. It is time to take an honest assessment and prepare to experience ordinary returns from here on at best and a major correction at worse. Company management who have lulled themselves into thinking that it was some new fangled management technique that “grew shareholder value” would be found wanting as returns begin to mean revert, due nothing but the nature of skill and luck.

(Kajanga is an Investment Specialist based in Sydney, Australia. You can write to him at kajangak@gmail.com).

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