Mistaking luck for skill

The markets for commodities - stocks, oil, grains - reflect the information known to millions of participants across the world. These are standardized instruments - one share of IBM, one barrel of Texas light sweet crude and one bushel of wheat - all will have the same price (each) anywhere in the world (adjusted for transportation costs). To make a transaction happen, there has to be a willing buyer and a willing seller. The price of IBM share is at $85 because the buyers and sellers have independently and mutually settled on that price. Both the buyers and sellers know that the economy is stalling, Obama is leading in the polls, the winter is approaching, Christmas shopping will be tepid, employment is tanking, companies are pulling back on capital expenditures, the ice caps are melting.... and all the information you and I know. The price of $85 reflects all of this information. It is, however, surprising that there are many people out there - in the print, on TV and in stock markets who believe that the price is going up (or down) and they may point to information already known to the world as if the entire world is stupid enough not to take that into consideration.

Suppose you think that the IBM price is going up next week and bought a large number of calls on IBM, there is over 50% chance that you will be right and make bunch of money. If you do, will you attribute that to luck or skill? Most seem to want to attribute it to skill. The problem is that if it was luck, there is a possibility that it does not show up in the next trade. Every year, there is a list of mutual fund managers who “outperformed” the market. However, the year after, we get another crop of mutual fund managers, who “outperformed. Alpha (risk adjusted excess returns) is notoriously inconsistent – proof that “outperformance” is largely driven by luck than skill.