DNA-Money on last Sunday carried this review:
What looks like a talented performance could be sheer luck. As Nassim Nicholas Taleb writes in Fooled by Randomness: The Hidden Role of Chance in Life and in Markets, “ If one puts an infinite number of monkeys in front of (strongly built) typewriters, and lets them clap away, there is a certainty that one of them would come out with an exact version of the Iliad. Upon examination, this may be less interesting a concept than it appears at first: Such probability is ridiculously low. But let us carry the reasoning one step beyond. Now that we have found that hero among monkeys, would any reader invest his life’s savings on a bet that the monkey would write the Odyssey next?”
So, the past performance in various aspects of life is not a good indicator of things to come, or is it? “I do not deny that if someone performed better than the crowd in the past, there is a presumption of his ability to do better in the future. But the presumption might be weak, very weak, to the point of being useless in decision making. Why? Because it all depends on two factors: The randomness content of his profession and the number of monkeys in operation,” writes Taleb.
Randomness is obviously a complicated word for chance. To prove his point, Taleb considers a situation where in he has 10,000 fictional investment managers. It is assumed that during a year, each one of them has 50% probability of making $10,000 or 50% probability of losing $10,000. It is also assumed that once a manager has had a bad year, i.e. he has lost $10,000, he is thrown out of the sample. “Thus, we will operate like the legendary speculator George Soros who was said to tell his managers gathered in a room: “Half of you guys will be out by next year,” writes the author.
A toss of a coin decides who wins and who looses. “Heads and the manager will make $10,000 every year, tails and he will lose $10,000. We run it for the first year. At the end of the year, we expect 5,000 managers to be up $10,000 each, and 5000 down $10,000. Now, we run the game a second year. Again, we can expect 2,500 managers to be two years in a row; another year, 1,250; a fourth one, 625; a fifth, 313. We have now, simply in a fair game, 313 managers who made money for five years in a row. Out of pure luck,” he writes.
Taleb then makes the argument a lot more interesting. An urn having 45 black and 55 red balls comes in. Every time a ball is drawn, the urn is replaced with a similar ball. If a black ball is drawn then it is assumed that the investment manager earns $10,000 and if a red ball is drawn he is expected to lose $10,000. As Taleb points out, “The manager is thus expected to earn $10,000 with 45% probability, and lose $10,000 with 55%.”
So, at the end of the first year, from a total investment manager population of 10,000, 4,500 managers would have earned a profit of $10,000. The remaining 5,500 managers i.e. 55% of the initial investment manager population, would have lost money and hence not a part of the sample.
“At the end of the first year, we still expect to have 4,500 managers turning a profit (45% of them), the second, 45% of that number, 2025. The third, 911; the fourth, 410; the fifth, 184. Let us give the surviving managers names and dress them in business suits. True, they represent less than 2% of the original cohort. But they will get attention. Nobody will mention the other 98%.”
The point being made here is that a small proportion of bad investment managers can come up with a great track record. Hence, as Taleb writes, “the number of managers with great track records in a given market depends far more on the number of people who started in the investment business (in place of going to dental school), rather than their ability to produce profits.”
And like always, this performance of the select few investment managers will be picked up by the business media, and they’ll go to town about it, making a hero out of them. “We would get very interesting and helpful comments on his remarkable style, his incisive mind, and the influences that helped him achieve that success. Some analysts may attribute his achievement to precise elements among his childhood experiences. His biographer will dwell on the wonderful role models provided by his parents; we would be supplied with black and white pictures in the middle of the book of a great mind in the making,” writes Taleb.
If in the next year, the performance is not up to the mark, the same media will try its best to tear the guy apart. The media likes to create heroes, only to pull them down on the first available opportunity.
“And the following year, should he stop outperforming ( recall that the odds of having a good year have stayed at 50%) they would start laying blame, finding fault with the relaxation in his work ethics, or his dissipated lifestyle. They will find something he did before he was successful that he has subsequently stopped doing, and attribute his failure to that. The truth will be, however, that he simply ran out of luck.”
And as far as the media is concerned, writes Taleb, “People do not realise that the media is paid to get your attention. For a journalist, silence surpasses any word.” But will we ever see a day when a journalist views the matter like a historian and says, “Today the market went up, but this information is not too relevant as it emanates mostly from noise.”