Newsletter 13: Luck Versus Skill

One definition of luck is: “a chance occurrence, out of one’s control and unpredictable.”  On the other hand, skill therefore could be defined as “driving predictable outcomes based on intervention.”  An example of something that is almost purely luck, based on this definition: no matter how hard you try when playing the lottery, your outcome will be random and unpredictable, with no change to your odds of winning regardless of how much effort you exert.  On the other hand, a concert violinist will always be better than a novice because that activity is mostly skill-based, and since years of practice can hone the violinist’s ability. 

While those extreme cases of luck and skill are straightforward, most real-world endeavors contain components of both skill and luck- and it is oftentimes difficult to determine where luck ends and skill begins.  Recently, I have been studying luck versus skill, to try and gain a better understanding at Ocampo Capital of how I can accentuate the skill components and optimize within the luck components of what we do.  Through this exercise, I believe I could drive better outcomes for Ocampo Capital Fund I’s portfolio companies, and therefore also improve outcomes for our investors. 

Ironically, right in the middle of my study I had a firsthand experience with an event, for which the impact on individuals was both totally unpredictable and out of one’s control: the Palisades fire.  The Palisades fire was what author Nassim Taleb would call a “black swan”: highly improbable (and therefore prone to be viewed by many as non-existent), but one that is not totally unknowable.  As one could imagine, after the evacuation everyone in our town waited on pins and needles to hear the fate of our homes: knowing we had zero ability to control the wind direction, wind speed, and other factors.  Our fates were totally dependent on luck.

The world of finance is unlike a wildfire, in that it contains large components of skill and of luck.  One way of assessing whether skill is more prevalent is by looking at the persistence of outperformance by various participants: the more persistent one’s outperformance over time (or said differently, the longer the time it takes for performance to revert to the mean), the more skill plays a role.  According to the Journal of Corporate Finance, the weight of skill versus the weight of luck differs depending on the area of finance.  In the case of public markets equity trading, reversion to the mean occurs relatively quickly- meaning luck plays a larger role than does skill for a majority of participants (but not all- just look at Warren Buffett).  On the other hand, top quartile venture capital general partners have a high level of persistence across time and across venture funds- skill oftentimes plays a larger role in outcomes in venture capital. 

But it isn’t as simple as that.  As I said earlier, it is very difficult to determine which characteristics are defined by luck or by skill.  And even if that is understood, how can you positively impact each with one’s actions? 

In the case of skill-based components, outcomes are enhanced by sheer practice- such as with a violinist’s music, a basketball player’s shot, or optimizing a company’s operational execution.  For items determined by luck, it is important to understand the limits of your knowledge, maintain flexibility and optionality, do not confuse outcomes with inputs, and remove components of luck where you can. 

For instance, to say that our house is still standing after the Palisades fire because I went for a run that morning and saw the winds picking up is absurd.  That would be confusing an outcome with an input, and making a faulty inference.  But on the other hand, really knowing how my process (the “cause”) leads to eventual results (the “effect”) for Ocampo Capital is crucial for the luck components.  And constantly refining and improving the skill-based components, building upon my career as a consumer operator, will also drive improved results.

But it never hurts to have good luck too.