Fooled By Randomness

(The Problem with ‘Track Record’
as a Basis for Selection of a Mutual Fund)

Understanding Randomness or How You Too Could Be

Investment Genius for the Day

Nassim Nicholas Taleb is his extraordinary book Fooled By Randomness (2001) states the following regarding the investment performance of a fictionally created universe of investment managers whose performance is created with the use of a random-number generating machine called a Monte Carlo generator (named for the historical appellation for roulette wheel):

“Let us use the Monte Carlo generator introduced earlier and construct a population of 10,000 fictional investment managers (the generator is not terribly necessary since we can use a coin, or even do plain algebra, but it is considerably more illustrative – and fun). Assume that they each have a perfectly fair game; each one has a 50% probability of losing $10,000. Let us introduce an additional restriction; once a manager has a single bad year, he is thrown out of the sample, good-bye and have a nice life. Thus we will operate like the legendary speculator George Soros who was said to tell his managers gathered in a room: “half of your guys will be out by next year” (with an Eastern European accent). Like Soros, we have extremely high standards; we are looking only for managers with an unblemished record. We have no patience for low performers.

The Monte Carlo generator will toss a coin; heads and the manager will make $10,000 over the 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 5,000 to be down $10,000. Now we run the game a second year. Again, we can expect 2,500 managers to be up 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.” (Nassim Taleb, Fooled By Randomness, pg. 128)

Mr. Taleb goes on to explain as follows:

“(T)he expectation of the maximum of track records, with which we are concerned, depends more on the size of the initial sample, than on the individual odds per manager. In other words 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 on their ability to produce profits”. (FBR, pg. 129)

Or, directly to the point at hand, Mr. Taleb states:

“The information that a person made money in the past, just by itself, is neither meaningful nor relevant. We need to know the size of the population from which he came. In other words, without knowing how many managers out there have tried and failed, we will not be able to assess the validity of the track record. If the population includes ten managers, then I would give the performer half my savings without a blink. If the initial population is composed of 10,000 manager, I would ignore the results. The latter situation is generally the case; these days so many people have been drawn to the financial markets.” (FBR, pg. 130)

What It Means

So, just by luck, a certain small percentage of mutual fund managers will have great track records. So could you, armed with a coin and the strength to keep flipping. Is it likely, that you, or any one mutual fund manager, will have a great track record over time? No. But, just based on sheer luck, some will and we will call them “genius” and put them on the financial television programs. Is it likely that a manager who “happened” to produce a superior track record one period (say the 1980s) would produce a superior track record in the next period (the 1990s)? Absolutely not! This is borne out by the research. (See the Fallacy of Persistency elsewhere on this web site.) We can not state this strongly enough: the precious touchstone upon which mutual funds stake their claim to fame, superior track record, is, upon proper examination simply “statistical fluke”, with the future track record of the so-called financial expert destined for ordinariness or worse. We are talking here about major ‘distortion’, an entire industry based on statistical confusion and the propensity of investors to be Fooled by Randomness.

In the final analysis, reliance on “track record”, is an Investment Illusion for investors. It blinds us from the high costs of betting on the so-called “genius” of the moment. We say ‘high costs’ for, almost by definition in the investment business, the genius’ expertise does not come cheap. (See Costs elsewhere on this web site.) Moreover, it takes us in the wrong direction. It takes us away from that which truly matters. The mis-focus on track records serves to distract from the more critical determinants of investment performance, factors such as controlling Costs and engaging in proper asset allocation.