In my last article, I’ve discussed the principles of risk. Risk is difficult to quantify based on just observing outcomes – I highlighted the key insight that good outcomes don’t mean good decision making & bad outcomes don’t necessarily mean poor decision making. Evaluating risk by measuring outcomes, while easy and efficient, exposes us to large unforeseen risks In this article, I make an assertion that a fundamental mis-pricing of skill and luck is often the source of risk.:
Max v/s Jim – a tale of two orthogonal universes
Let’s say I had 2 friends, Jim & Max, who shared my apartment at Columbia university the year 2011.
Max heard about a new virtual currency from his nerdy chat groups called Bitcoin. He was excited by the technology & bought 100$ worth of bitcoins in April 2011. In that month, Bitcoin was trading at 1$ per month, so Max bought 100 coins. Fast forward to April 2021, Bitcoin was trading at 59,778$ per coin in that month. Max sold all his coins and made ~6 million dollars.
Now, lets come to Jim – Jim finished his neuro-surgery residency program at the Irving Medical Center. He then completed a fellowship and joined UCSF Medical Center in San Francisco. Jim was very talented and assisted the lead surgeon in conducting several neuro surgeries. His income quickly rose & as this chart indicates, he was in the highest income bracket of doctors in the United States.
In the year 2021, Jim’s net worth rose to 6 million $. Let’s say I end up in US after 10 years and meet both Max and Jim. I have no background or information on what they have done all these years. All I can see is the lifestyle of Jim and Max, the neighbourhood they stay in, they type of car they own and so on. I cannot differentiate the cause and nature of wealth of each individual & the type of risks they’ve taken to acquire it.
Although what money can buy is the same, its a completely different story in analyzing risks involved in acquiring that money. Insights into these risks will also help us how each guy is likely to do in the next 10 years. Just by knowing net worth at a point, there is no way you can reasonably predict if that net worth will increase or drop in future.
Lets study the difference in wealth of Jim & Max.
Story of Max – Heaven on Earth
If someone had to analyze risks in bitcoin way back in 2011, there were dime a dozen risks. Out of 1000 parallel universes that could have emerged from 2011-21, probably 990 universes would have seen Max’s initial 100 dollars become 0. Some such reasons for bitcoin failure could have been tight regulations on holding/trading bitcoins, a fraud/extortion or terrorist attack traced back to bitcoins leading to a huge crack down, or bitcoin technology could not scale, or a deep technological flaw or prohibitive costs etc. It was a long shot for bitcoin to be accepted by the whole world as a de-facto digital gold. Although Max would have been successful in only 10 out of 1000 universes, his good fortune is that the universe we are living in right now happens to be 1 out of those 10 universes.
Story of Jim – Sweat, blood and toil
Now lets take the case of Jim – Jim had a high degree of skill and regardless of where you place him, he would likely move towards success. His rate of success might be different in each scenario – in some worlds, he might grow rapidly, in some other worlds his growth would have been steadier. For eg, if he chose to work in New York or San Francisco, his net worth would increase much faster than being in a Pittsburgh or Tampa or Cincinnati. There is also a likelihood that Jim ends up as a failure- For eg, in some parallel universe, Jim can lose his license to practice medicine because of gross negligence while conducting a surgery.
But if we look at 1000 parallel universes, you could safely bet that Jim would be considered successful in 900 out of those 1000. Degree of skill & luck determines the risk involved in acquiring the assets & the likelihood of holding those assets in future.
This leads us to a simplistic yet powerful formula to understand life in general, that is:
Skill v/s Luck Dynamics
Lets explore the dynamics of this equation with some illustrations. Lets say we plot outcomes on the y-axis and list of all parallel universes on the x-axis. Each point on x-axis, represents a unique world with a specific level of skill and a given amount of luck. Lets draw a horizontal line to x-axis – this line represents the same level of outcome for different combinations of skill and luck in each universe.
Since output level is same, as we move up the skill curve, the amount of luck needed to achieve the same outcome drops.
So for 3 points, 1, 2 and 3, skill in universe 1 is less than that in universe 2 which is less than that in universe 3.
An inverse relationship exists between skill & luck – as skill increases, luck drops and vice versa. We’ll come back to this vital concept when In introduce tools to manage risk in my next article.
So in our previous example, Max as a bitcoin enthusiast demonstrated a low level of skill while investing his 100$ in bitcoin. While he understood the technical aspects of bitcoin mining, he had no clue on the factors that could make bitcoin commercially successful.
Jim on the other hand had acquired high level of skill. So in every parallel universe, Max needed a huge swing of luck to match the net-worth of Jim who needed just a small help from luck to become successful.
Now, lets complicate things by introducing ‘bad luck’. Lets make the Y-Axis of outcome move on both sides – so the top represents a success and bottom represents negative outcome or failure. Lets draw another horizontal line below x-axis – this line represents a negative outcome that stays constant across all parallel universes. Now to achieve this negative outcome, notice that ‘bad luck’ curve has to move as follows ..so if you add the pink and green curve, you end up with a flat horizontal line of negative outcomes or failure.
As noted earlier, when a person has high level of skill, to achieve a good outcome he needs a small bit of luck. At the same time, to achieve a disastrous outcome, he needs a huge slice of misfortune to come his way. In the previous example, Jim had to commit a blunder, a fraud or gross negligence to risk a really disastrous outcome that could lead to a loss of license.
So key learning is, when you have high skill, luck becomes asymmetric – a small good luck is enough to lead to success. But to push you to a failure, you need a large slice of bad luck. What this also means is that a highly skilled person develops a certain amount of resilience to bad luck in the long term.
Self-serving bias – how we perceive self
Not knowing where you are on the skill v/s luck chart creates risk. Greater the difference between where you think you are & where you actually are, greater is the risk you are exposed to. To understand this, Let’s suppose you are actually at point A in the skill/luck chart. You got hit by a negative outcome.
Your mind starts talking to you at this point & says
“Hey man, you are currently at B, a much higher level of risk. The fact that you had a negative outcome just means that you got hit by extreme bad luck. Luck is not under your control, so don’t be too hard on yourself. There is nothing you could have done to change the outcome”
I call this mind-talk as ‘rolling up the skill curve’. Rolling up the skill curve creates a bias we commonly refer to as ‘self-serving’ bias. So the purple zone is where your skill/bad luck actually is but in your mind, you are actually in the red zone with higher level of skill/bad luck.
The effect of rolling up the skill curve is to accept that you got hit by a huge slice of bad luck & that there’s nothing you could have done differently.
Now let’s see what happens when you are successful. You are actually at point A, with a given skill level and some good luck assisting you. Your mind says ” Hey man, you are a genius. You made this outcome happen with sheer hard-work, attitude & knowledge“.
Effectively your mind again rolls you up the skill curve to a point B where your perceived skill clearly overwhelms your perceived luck. Net effect is that you give less credit to the possibility that you just might have been a beneficiary of good luck.
So again, you are actually in the purple zone of skill/luck but your mind perceives itself to be in the red zone.
Self-serving bias is one of the most widespread biases we have as humans. You hear them all the time from politicians, CEOs, economists, entrepreneurs – you name it.. they are so common that each of us can easily list 10 scenarios where we demonstrated this bias..
Envy bias – how we perceive others
Now let’s look at how our mind perceives outcomes of others – Suppose our friend had a positive outcome and he is actually at point A on the skill-luck curve. When it comes to others, we roll down the skill curve and our mind takes us to point B. While self-serving bias rolls up the skill curve, this phenomena rolls us down the skill curve.
Point B is low skill-high luck point – our mind reasons with us that B’s success was largely due to a stroke of good luck. This nature of ‘I won because of my skill but you won because of your luck ” is what I call the ‘Envy bias’. You will find the argument that
” He got rich because he was in the right industry”
“He made it because he comes from a rich family”
“He used his Harvard network to find right investors”
Then there is the third kind of bias where you roll up the skill curve to attribute higher skill to other’s outcomes. This is because we usually defer to authority and I call this the ‘authority bias’. For example, if Elon Musk is investing in Bitcoins, I am going to invest in Bitcoins because whatever Elon Musk does must be right. Here are some examples of Envy & Authority bias.
Why do biases exist?
The fact that risk originates from these biases makes us think – why do we have these biases in the first place. I’m studying a specific class of people that include investors, poker players and war generals to understand how they identify and remove such biases from decision making. Unlike a lot of us, these 3 classes of people lose hard cash or life if they become victims of these biases – I’m assuming they have built processes to identify and mitigate such biases. In this matter, politicians, academicians, economists & bureaucrats are the worst teachers – they are the biggest victims of these biases as they have little/no incentive to correct these biases.
A large body of behavioural psychology studies seems to suggest that our mind, as part of evolution, serves 3 purposes :
- It wants us to be happy to ensure highest chances of survival.
- It wants to us to be confident. Envy & self serving bias help us be happy and confident..
- It wants us to take the path of least resistance to make things easy for us. Authority bias is an attempt to make life simple by following what experts do.
In this path of confidence, happiness & simplicity, our mind often puts us into a huge trouble in the long term. More on that in the next article.
- Outcome is a combination of skill and luck
- Risk originates when we don’t know where we stand on the skill vs luck curve
- Highly skilled person/teams need small good luck for success & large slice of bad luck for failure
- Self serving bias under-prices luck in good times & over-prices luck in bad times
- Envy bias under prices skill of others & authority bias overprices skill of others