Blind to luck

In a good article on how graduating in a recession does long-lasting damage to one’s career, Tim Harford says “it’s easy to overlook luck.”

It is indeed. Evidence for this has been uncovered in experiments by Nattavudh Powdthavee and Yohanes Riyanto. They got students in Singapore and Thailand to bet upon tosses of a fair coin and found that people were willing to pay to back the bet of students who had correctly called previous tosses. “An average person is often happy to pay for what could only be described as transparently useless advice” they conclude.

This is startling. But it has been corroborated by other research: experiments in Barcelona have found exactly the same thing.

It’s also been found in the real world. This paper finds that investors:

fail to understand that, in large populations of mutual funds, a few will outperform by pure chance...In addition, investors do not sufficiently account for volatility and are thus likely to confuse risk taking with skill. In large mutual fund populations, this can lead to an over-allocation of capital to lucky past winners.

People over-estimate the signal-to-noise ratio in what is really volatile data, and so under-estimate the role of luck. A recent paper by economists at Elm Partners shows this. They asked people: how many tosses would you need to see to be 95% confident of distinguishing between a far coin and one with a 60% chance of coming up heads? The correct answer is 143. But most subjects answered 40 or less.

All this suggests people are indeed blind to the importance of luck and are too quick to see patterns: the technical term for this is apophenia.

The truth is, though, that luck is everywhere. William Goldman famously said that “nobody knows anything”, and that success is largely unpredictable. But nevertheless we laud those who are lucky enough to have backed success as if they know what they were doing. As Ed Smith writes in his lovely book, Luck: “randomness is routinely misinterpreted as skill.”

Why do people do this? I suspect it’s not just because of a lack of statistical literacy: many of the subjects in the experiments I’ve cited had taken statistics classes. It’s also because of two reinforcing biases. One is the outcome bias. We judge a performance by its result so if a team wins the game, or if a fund manager beats the market, we infer that they did well rather than got lucky. The other is the narrative fallacy. We are story-telling animals. We seek links between things and detailed explanations even if the truth is only that a bit of good luck happened, then a bit of bad. I suspect that most football punditry is like this.

All this is about how we attribute skill rather than luck to other people. But of course, we also do so to ourselves, and asymmetrically: good results are down to skill and bad to luck. A study of day traders has confirmed what you probably suspected:

Retail day traders in the forex market attribute random success to their own skill and, as a consequence, increase risk taking.

The upshot of all this is that the successful are apt to become bumptious arrogant prats because they attribute their success to their own talents rather than luck. And observers are apt to take them at their inflated self-estimation.

Why for example did the housing, communities and local government select committee ask Mike Ashley yesterday for his views on reviving high streets? Does Mr Ashley really know more than anybody else with years of working in retail? Or were MPs failing to see that companies can succeed in much the same way that some species do – because the environment selects for mutations which are in fact random and unintended? The mere fact the question is rarely asked (not just of Ashley) is itself significant.

This, of course, colours our whole social and political structure. Our tendency to see skill where there is just luck causes the successful to have an exaggerated sense of entitlement and the rest of us to be overly deferential to them. Very few people are luck egalitarians. This is one way – of perhaps many – in which inequality sustains itself.

Comments

[Robert Mitchell]

The finance way to bet is to sell a bond to three people: one provides principal, one takes the interest rate risk, the third takes default risk. You bet the principal. If you lose, the default risk buyer pays. He too can issue a sliced bond so his default risk is covered. Thus the endless cycle continues. You make free bets, as long as you are good at selling sliced up bonds (derivatives).

[dilbert dogbert]

An murikan saying: Born on Third Base and Thinks He Hit a Homerun. Applies to our current holder of the oval office.