Since entering 1st grade, my older son has been really into two different kinds of games – Chess and Monopoly. As expected, I am his default opponent whenever he feels like playing either one. Especially on weekends, when he assumes I have nothing better to do anyway!
Anyway, I have noticed an interesting behavioral pattern over many weeks of playing. While my son hates losing in general (need to rewire him on that), he is relatively calmer in accepting defeat at Chess. But when he gets defeated at Monopoly, he totally loses his marbles.
After experiencing several instances of this behavior, I had to ultimately sit him down and explain how Chess is a game of skill while Monopoly is a game of luck. Of course, it’s hard for a 6-year-old to understand the difference, but I think he got the gist of it when I told him the difference between thinking through a Chess move and rolling the dice in Monopoly.
This explanation seems to be working so far. While it helped restore a much-needed weekend peace in my household, it also brought me back to the ‘Skill-Luck Continuum’ framework by one of my favorite finance practitioners, academic and author Michael Mauboussin. Both as a parent and venture investor, I feel this is a good opportunity to do a refresher on MM’s work untangling skill and luck, as well as apply his lens to my own life experience.
Straight out of a dictionary, skill is defined as the ability to use one’s knowledge effectively and readily in execution or performance. Essentially, having perfect skill means the ability to re-create the same performance each time across repeated rounds of a game.
Luck, on the other hand, is much harder to define. The dictionary defines it as a force that brings good fortune or adversity or favoring chance. However, I like the 3 conditions outlined by Mauboussin, that need to be satisfied for luck to be at play:
1/ Operates for an individual or organization.
2/ Is either good or bad.
3/ It’s reasonable to expect that a different outcome could have occurred.
An awesome thought test by MM for this is – “Can you lose this game on purpose?”. If it’s 100% yes, it’s perfect skill. If not, there is definitely some luck involved.
B. The Continuum
All outcomes in life are a mix of skill and luck. So all professional and personal games that we play can be plotted on a skill-luck continuum, with the extreme left being 100% skill and the extreme right being 100% luck. Anything in the middle is a blend.
C. Insights from the Modern World
MM highlights the following insights regarding the interplay of skill and luck in today’s world:
1/ Outliers require both extreme skill and extreme luck – that’s when the likes of Michael Jordan, Bill Gates, and Warren Buffet become what they did.
2/ Mean-reversion* – on the 100% skill side, there is no reversion to the mean. On the 100% luck side, there is a complete reversion to mean.
*Mean-reversion means an outcome that is far from average will be followed by an outcome with an expected value that is closer to the average.
3/ Paradox of skill – in the modern world, as skill improves, the role of luck becomes even more important. Across diverse areas such as sports, business, and money management, it has been observed that the difference between the very best player and the average player has been steadily going down compared to the previous generation. For eg., in the Olympic marathon, the time difference between the 1st place and the 20th place has come down from ~39 mins in 1932 to 5-7 mins as of today.
Standard deviations of baseball batting averages, managers generating excess returns over the benchmark, and the quality of physical or digital goods have all been steadily declining.
Absolute skill has never been higher while relative skill has never been narrower, thus increasing the role of luck in the modern world.
4/ Convexity in payoffs – convexity means for a small change in quality, there is a huge change in payoff. From tennis grand slam prize money to Big Tech market caps, the modern world is littered with winner-takes-all dynamics wherein the gap between the payoffs of the #1 and #2 ranked players is really wide, even though their absolute skills are relatively similar.
D. Suggested Approaches For Skill vs. Luck Games
MM recommends the following two approaches for each end of the continuum:
1/ ‘Practice’ for skill-heavy games
This is where Malcolm Gladwell’s famous 10,000 hour rule applies. More inputs lead to better skills that in turn, are directly correlated to better outputs.
2/ ‘Process’ for luck-heavy games
You can’t improve your luck, you can only manage it. The idea is to focus on what’s in your control.
A good way is to design a process that improves your odds, and play only when you have an ‘edge’. For example:
- In poker, place small bets most of the time to avoid ruin, but go all-in when the hand is strong.
- Choose to play only against weak opponents.
- When faced with a strong opponent, change the rules of the game (see my post on AI wars ‘David (Microsoft) vs Goliath (Google)‘).
- Iterate by running small experiments (check out the Business Model Canvas by Steve Blank).
- Invest in inefficient markets.
- Have an adequately diversified portfolio.
E. Applying to My Life Experience
Let me plot various games from my own life on MM’s skill-luck continuum:
In any creative field, it’s extremely hard to pick winners. J.K. Rowling was rejected by multiple publishers. Classics like Star Wars and Jurassic Park initially struggled to get greenlit by studios for several years.
An exec at Time Warner had this to say during a guest lecture in MM’s class at Columbia Business School:
We have no idea what’s going to be a hit. We try and run numbers, or apply formulaes, but we really have no idea whether it will work.Exec at Time Warner
While writing as a creative art is mostly a skill, luck also plays a role in what eventually becomes popular. For eg., even an average work of a popular author will generate more sales than the great work of an unknown author (check out my post ‘The Success Flywheel‘ for more on this phenomenon).
My approach: focus on Practice. Put in reps and continuously learn from observation and feedback.
2/ Venture investing
Classic early-stage venture capital (in today’s terminologies, that would be anything from pre-seed to Series A) is ruled by power laws (see my posts ‘Conviction vs Randomness in Venture Investing‘ and ‘Only Need To Get a Few Right!‘ on this). Given the high levels of uncertainty at this stage of company building, the eventual outcome is a widely distributed set of probabilities. Ergo, picking is really hard.
Data also corroborates this view. In this Venture Unlocked podcast by Samir Kaji, Miriam Rivera of Ulu Ventures cited data from Horsley Bridge that shows for the absolute top-tier of funds like Sequoia and Benchmark, a mere 4.5% of their companies have generated ~2/3rd of all their returns.
Of course, the track record of funds like Union Square Ventures and Benchmark where they have repeatedly beaten benchmark returns across decades of multiple vintages, also suggests that some VCs have more skill than others.
If I had to put venture capital as an industry on the continuum, I would give a higher proportion to luck relative to skill in the blend.
My approach: focus on Process. Respect power law. Identify and double-down on your ‘edge’. Take enough shots at the goal. Ensure asymmetric upside (when you win, you win big).
3/ Public market investing
I have no hesitation in calling myself, as well as many of my successful peers, major beneficiaries of the post-’08 ZIRP decade. For cusp Millennials like us, our peak career years coincided with a never-seen-before era of loose monetary policy, leading to a worldwide economic boom and asset inflation. I am not sure if I will see another decade where the economies of the US, China, and India are all ripping at the same time.
Of course, there was still some skill at play wherein a few were better positioned than others to take advantage of this wave, and they did. But still, a rising tide lifts all boats, as everyone who worked in tech over the last decade would testify to.
With respect to public markets, I totally agree with what Howard Marks says in his 2014 Memo ‘Getting Lucky‘:
But in investing, it’s hard to know what will happen and impossible to know when it will happen. Many things influence performance other than (a) investors’ hard work and skill and (b) the market’s dependable discounting of information about the future. Luck-randomness, or the occurrence of things beyond our knowledge and control – plays a huge part in outcomes.Howard Marks (Getting Lucky)
So, while the inherent randomness in the world ensures that successful investing requires significant luck, a skillful investor is right more often, over a long period of time.
My approach: focus on Process. Acknowledge how hard it really is to beat the index. Respect randomness. Act as a permanent owner of businesses. Benefit from compounding. Remember that you only need to get a few right.
This is the hardest game to analyze. As parents, we all strive for control – the ability to craft, almost guarantee, our kids’ destiny. We read books, talk to other parents, listen to podcasts, hound teachers, and constantly iterate on what is and isn’t working. We continuously gather skills and tools in our yearning to discover the ‘playbook’.
The reality, however, is much harsher. There is no playbook for nurturing humans. There is just too much unique context, too many variables, too many uncertainties, too many externalities – basically, too much randomness. In this dynamic, it’s essentially a fool’s errand to predict anything.
I loved a thought that I recently read on X, and which was also echoed by a few other parents in our school community – “parents can only hope to give a modicum of downside protection to their kids. They can’t guarantee the upside”.
Approach: focus on Process (and Philosophy). Acknowledge the uncontrollables. Let it be organic.
Layering the work of Michael Mauboussin on top of my own life experience, here’s what I am netting out to on this topic:
- All games in life are a blend of skill and luck.
- The modern world is highly random and the future, for the most part, is unknown and unknowable.
- Ergo, barring a few specific games, most of modern life is highly influenced by luck.
- On top of this, payoffs are getting increasingly convex, courtesy of power laws.
- Given these realities, an effective approach to life is to focus on the ‘process’ over outcomes (see my post ‘Conquering Uncertainty, Dhoni & Vinod Khosla Style‘).
- Work to discover your ‘edge’ and back it up with deliberate execution that tilts the odds in your favor just a little bit each day.
to my weekly newsletter where in addition to my long-form posts, I will also share a weekly recap of all my social posts & writings, what I loved to read & watch that week + other useful insights & analysis exclusively for my subscribers.