The latest book by Michael Mauboussin explores the impact of luck and skill in business, sports, and investing. Since 1993, Mauboussin has been an adjunct professor at the Columbia Graduate School of Business, where he has won awards for his teaching. It is easy to see why he is so popular with students. Mauboussin was extremely well received when he spoke to CFA Society Toronto about his last book, Think Twice: Harnessing the Power of Counterintuition (Harvard Business Review Press, 2012). Prior to that, he wrote More Than You Know: Finding Financial Wisdom in Unconventional Places (Columbia University Press, 2006). All three books are insightful and well worth reading.

A key motivation of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing is the fact that sports offer a rich vein of skill-versus-luck analysis. Sports data, combined with statistical analysis and behavioral psychology, contribute valuably to the study of business management and investing.

The Success Equation covers several compelling themes, including the luck-versus-skill continuum, the importance of sample size, mean reversion and dynamic processes, and key lessons in improving the art of guesswork.

The luck-versus-skill continuum ranges from all luck (e.g., roulette) to all skill (e.g., running marathons). Between these extremes, hockey has a large luck component whereas basketball primarily involves skill. The analysis of this topic draws heavily on athletics because of the vast and detailed records generated by sports and the many practical lessons that can be extracted from them. Recognizing where an activity lies on the luck-versus-skill continuum can shape strategy, hone skills, help in dealing with uncertainty, and improve performance in numerous ways that are relevant to investing.

Sample size is key to understanding luck versus skill. Investors should

1. consider the sample size (if an activity is controlled mainly by luck, a small sample will not do),
2. understand history, which helps in skill-based activities more than in luck-based activities, and
3. categorize events by simple/complex payoff and narrow/extreme outcome.

The complex/extreme combination resembles the “black swans” highlighted in Nassim Taleb’s work. Mauboussin notes that most financial blowups have resulted from naively applying statistical methods in a world of black swans.

Mean reversion and dynamic processes are related. Understanding the mean-reversion process is critical in investing because one can do all the right things but still underperform until the odds catch up. Just as important, however, is recognizing a dynamic process. A change in the process revises the odds and shifts mean reversion to a new mean.

The book ends with 10 key ways to improve one’s chances at guesswork. In addition to the three ways discussed earlier, they include learning from feedback, looking for ways in which situations may interact, and knowing one’s limitations.

Among my favorite aspects of the book is the discussion of the “interpreter” part of the brain. Behavioral psychology is one of Mauboussin’s strengths and figures prominently in his writings. For example, he contributed an excellent chapter to a recent Research Foundation of CFA Institute book on behavioral investing.¹ The interpreter region of the brain is in the left hemisphere and acts continuously and unprompted. It assimilates everything we perceive and interprets that input to form a cause-and-effect narrative within our sphere of self-image and beliefs. Simply stated, humans love stories.

Helpfully, the interpreter is often right and gets us through unexpected, risky situations. Unfortunately, it can also concoct nonsensical cause-and-effect explanations, especially when luck is involved, totally misleading our logic. Mauboussin illustrates this point exceptionally well in both business management and investing.

Grappling with intuition is a small but significant part of the process of dealing with uncertainty. Intuition often merely scratches the surface of an investment or business issue. We humans have a well-proven knack for acting on insufficient data with a great deal of confidence.

IQ versus RQ is another useful analytical device explored by Mauboussin. RQ (rationality quotient) is quite distinct from IQ (intelligence quotient). RQ involves adaptive behavioral acts, judicious decision making, efficient behavioral regulation, goal prioritization, reflectivity, and proper calibration of evidence. IQ does not confer RQ. The study of RQ is a fairly new field, and the concept is not yet fully understood. Nevertheless, it is quite important; several examples in the book show how otherwise bright people can make simple mistakes in judgment.

Mauboussin’s writing style makes for a highly enjoyable and comprehensible read. Sports-based examples are used effectively throughout. Most readers will readily recognize the differing natures of the various sports and grasp how an understanding of those differences translates into the analysis of investment and business problems. Also commendable is Mauboussin’s conscientious provision of academic references. Some 60 pages, about 20% of the total, are devoted to notes and citations that amplify points and offer background and further reading.

The Success Equation makes a valuable contribution to the literature on decision making when both luck and skill are involved. It is thoroughly researched and well written. I highly recommend the book to anyone interested in making better investment choices.

—B.G.