This post is based on and inspired by ideas from the book Fooled by Randomness by Nassim Taleb. It’s one of the most insightful books I’ve ever read. It’s about the role of chance in life, and how we are often blind to and fooled by it.
Get it and read it.
It ESPECIALLY applies to money and the markets.
The points I make in this post are derived from his book. Here we go:
Have you ever played Russian roulette?
I’m kidding. I haven’t.
Because that’s stupid!
Because as exciting as it sounds, I just can’t stomach the worst possible outcome. It’s not an acceptable risk. Not even to play once.
No matter how smart I am (or how smart I think I am), the outcome is ruled by randomness. By chance.
What kind of idiot would play Russian roulette?
I’m going to sweeten the pot for the player a little by using an example from Mr. Taleb’s book Fooled by Randomness.
Let’s say a billionaire playboy decided to have some fun, and offered anyone who is willing $10 million dollars to play Russian roulette once.
Some people would play. (but definitely not me!)
There would be many very rich people in the world, and also a lot of deaths caused by self-inflicted, non-suicide related gunshot wounds to the head (probably televised).
Some may decide to play a second or third time.
Would there be anyone who won four or five times in a row?
Yes, there would be a lot of those.
If you play a game like this long enough, however, the chance of the bad outcome being realized eventually catches up with you.
What if thousands of people took this bet once a year starting at the age of 25. How many would make it to age 50?
With enough people in the sample, it’s a mathematical certainty that a handful of people would make it to age 50. They’d be very rich. They’d be famous.
What is strange about this?
Their wealth and fame (I’m sure they’d be famous) has been entirely dependent on randomness. On luck. It had nothing to do with skill.
What are the statistical chances of this lucky 50 year old winning again next year, since he already has such an impressive track record? Is it better than 5 times out of 6?
- Would you have confidence in their track record?
- Would you make a bet on it?
- Would you feel their chances are better than those playing Russian roulette for the first time at age 25?
A lot of people would assume the person with the best track record would have a better chance of winning again. But they don’t.
Thinking that way is irrational, but it’s human nature.
So what are the statistical chances of the rich 50 year old winning again?
It’s exactly the same. 5 in 6 chance of winning.
1 in 6 chance of losing for everybody, every time you play, regardless of past outcomes.
Twenty wins in a row doesn’t mean shit. Your chances are still one in six of blowing your brains out next time.
The difference is, this lucky 50 year old has benefitted from a string of outcomes that are statistically extremely unlikely, but possible in a large enough sample of people.
Sounds like Wall Street!!!
What! How could I say that!!!
Surely I wouldn’t try to make this comparison to the stock market and finances!!!!!!!
Lucky or Smart
Let’s apply this example to mutual fund managers. (This example can also apply to anyone who claims to have a skill for managing money) Everybody wants to find a way to beat the S&P 500. Finding a high-performing mutual fund manager with a great record is the way to beat it!!
Let’s take a very large sample of thousands and thousands of mutual funds managers. They all need to make their own calls about what sectors are going to be hot, and what direction the markets will move in those sectors throughout the year.
What are the statistical chances, regardless of skill or intelligence, that some of these investors picked the right sector and the right direction of the market for most of their trades throughout the year based purely on luck?
There would be a handful of these. Some of them would be extremely intelligent, and some would be idiots, and you would have everything in between. It is statistically possible that their success is based largely on luck.
Most of these managers would be rewarded with bonuses, raises, and promotions.
They’ll get high ratings from Morningstar and other companies that rate mutual funds. They will get stories about themselves and their fund in print, TV, and the Internet.
Some will go on to have a second or third successful year, maybe someone writes a book about them, and they give lectures on how they choose where to invest. They are able to look back at their success and explain what drove their decisions and how they KNEW it would work.
How many of these managers luck is extremely similar to the world’s richest 50 year old Russian roulette player? How much of it is true predictive ability? True skill? How can we prove it?
I wouldn’t try to prove it with their track record. The roulette player has an impressive track record too. We have to admit that the markets are subject to a lot of randomness. Skill might play a part, but how much is anyone’s guess.
This is a point the book Fooled by Randomness tries to make. To paraphrase Mr. Taleb, he is not saying that Warren Buffett is not skilled, only that a large enough population of random investors will almost certainly produce someone with a track record similar to him based solely on luck.
So even if you can accept that there may be more randomness, more luck in investing than you previously realized, what’s the point???
Track records mean almost nothing in the market
- Are you choosing someone to manage your money based on his or her track record over the past few years?
- Did you sign up for a day trading course because you saw the track record of someone who has been very successful doing so? (I hope no one fell for that one)
- Are you investing in certain Morningstar approved mutual funds because of their great track record over the last five years?
- Are you impressed with the track record of your neighbor’s money manager? He only takes 2%!!! What a deal! He’ll make you rich too!
Then you’re in for a big surprise.
Those results are quite possibly based largely on chance. Largely based on cycles in the market that happens to fit that particular trader’s style for that particular time frame.
Not because he’s smart. Because the market fits his trading style for now.
This doesn’t last forever.
What happens when the market changes? That super-successful trader gets wiped out, and everyone wonders why.
The future does not always look like the past
We love to make decisions about how to invest our money in the future based on what happened in the past. Since we are on the subject of blasphemy, I’ll push my luck a little more today.
Let me address the sacred S&P 500 Index as the safest long term investment known to man on earth (a slight exaggeration, but many swear by it). Many accept that an investment in the S&P 500 over the long term will yield on average 7-9%, depending on who you ask. This is based on the past history of the index and confidence in the future of the U.S. economy.
Warren Buffett himself has instructed that the money he leaves to his wife be mostly invested in the S&P 500 instead of in his own company, or with a fancy money manager somewhere. He has confidence in the future growth of the S&P 500.
He does not have confidence in his own company’s ability to beat this index in the future.
Ok. I’m not smarter than Warren Buffett. But I do like to use my common sense once in a while. Just because something happened in the past doesn’t mean it will happen in the future. Statistically, it’s highly likely these returns should continue. But it is by no means certain.
I wouldn’t bet my life on it. I wouldn’t even bet my retirement on it.
That’s why I don’t just sink everything into index funds and call it a day.
There is the possibility that the S&P 500 could flatten, or even go negative over the next twenty years. Nobody wants to believe that. Hardly anyone DOES believe that. That doesn’t mean it’s impossible. I’m hedging my bets.
If you look at my website, it’s main focus is real estate. I have a large chunk of money invested in the S&P 500. I have a larger amount invested in real estate.
I love real estate!!!
Because I’ve done better with real estate than I have with the S&P 500. That’s the whole point of my website. I document my journey in debt-free real estate rentals.
So am I way off? Is it fair to bash Wall Street like this?
What’s the one secret I used to buy rentals cheap?
Rich on Money