Comments on: Investment and luck

By: dsquared

dsquared — Wed, 28 Jan 2004 15:43:43 +0000

Yeh I know. The point I was sort of trying to make is that Paulos’ example very much depends on the low power of statistical tests and the likelihood of Type 2 errors when trying to find people who can pick stocks. In actual fact, there’s a lot more data to go on and I’d expect that it would be possible to find robust evidence that some people can pick stocks.

By: Andrew Boucher

Andrew Boucher — Wed, 28 Jan 2004 14:38:23 +0000

“I think that the point I’d make in response to this is that an individual analyst usually covers between 5 and 10 stocks, and analysts are typically assessed over periods of time much shorter than a year. If someone really did have a consistent track record of not making a bad call in ten years by pure chance, I think it would be way out in the tail of the distribution.” Show me one analyst who has not made a “bad” call over ten years covering 5 to 10 stocks.

By: dsquared

dsquared — Wed, 28 Jan 2004 13:01:14 +0000

I think that the point I’d make in response to this is that an individual analyst usually covers between 5 and 10 stocks, and analysts are typically assessed over periods of time much shorter than a year. If someone really did have a consistent track record of not making a bad call in ten years by pure chance, I think it would be way out in the tail of the distribution.

By: Andrew Boucher

Andrew Boucher — Wed, 28 Jan 2004 12:24:24 +0000

“It should be fairly easy (given appropriate data) to determine if those long-term overperformers are beneficiaries of luck or skill. Given a 20-year period of data, look at the first ten years, and identify the consistent overperformers. ” This of course isn’t necessarily true. What’s true of 10 years can also be true of 20. (Unless there’s something magical about 10-20 which you haven’t made clear, repeat your argument for 5-10.) There can of course be trends even in long periods. There was roughly a 20-year bull market in the U.S. from the 1980s to 2000. So take the case of Goldman Sachs’ Abby Cohen, who was taken as a genius during this time because she would repeat, “Buy stocks.” Was her one-note luck or was it skill?

By: Mats

Mats — Tue, 27 Jan 2004 20:10:27 +0000

Thanks matthew2, I hadn’t seen that one, think it’s a brilliant illustration to Taleb’s point. Then I think Taleb’s point actually has been discussed quite a lot in theoretical litterature – will a competitive market be efficient enough in identifying and sorting out the bad traders? If not, it won’t of course be much efficient in other ways either. I think I saw an article a couple of years ago in Econometrica discussing this. The dominating idea then was (as I read it) that market mechanisms were to weak to separate skill from luck, leaving too good opportunities to dismal agents (traders) for the economy to root out (by selection) inefficiencies.

By: Mike Kozlowski

Mike Kozlowski — Tue, 27 Jan 2004 19:06:08 +0000

It should be fairly easy (given appropriate data) to determine if those long-term overperformers are beneficiaries of luck or skill. Given a 20-year period of data, look at the first ten years, and identify the consistent overperformers. Now compare the performance of that group versus the general market over the next ten years. If their performance was due to a string of luck, there’s no reason to expect that luck to continue for the next decade, so they should track the general market; if their performance was due to skill, they’ll continue to outperform in that second decade.

By: harry

harry — Tue, 27 Jan 2004 18:45:27 +0000

Not quite, since you can’t invest directly in an index, so fund managers use proxies (to minimise transaction costs). So even index funds vary around the performance of the index.

By: wcw

wcw — Tue, 27 Jan 2004 18:43:19 +0000

efficiency can exist in the complete absence of investment skill; all that is required for efficiency is internal consistency and rapid communication. it is meaningful pricing that cannot exist if there is no such thing as skill. indexing, by ascribing utility to market prices, implicitly recognizes that investment skill exists. it’s been a while since I looked into this, but a few years back an NBER working paper did a clever backwards look at what assumptions it would take to have zero investment in active management. hold on, let me Google.. here: http://ideas.repec.org/p/nbr/nberwo/7069.html “To justify such a zero-investment strategy, we find that a mean-variance investor would need to believe that less than 1 out of every 100,000 managers has an expected alpha greater than 25 basis points per month.” now, 25 bp/mo outperformance is huge, and I am ready to believe that fewer than one in 10^5 investors has the latent potential to relize it. seems clear by the amount of active management that exists in the world that “the market” in this case believes otherwise.

By: Odd Ray of Hope

Odd Ray of Hope — Tue, 27 Jan 2004 18:07:03 +0000

“you pretty much have to believe that investment skill exists. otherwise, markets are meaningless except as an internally consistent mechanism to eliminate arbitrage” Financial markets can be efficient by properly pricing assets in light of available information and investor appetites, so the amount of forecasting skill available might not be related to efficiency. Index funds allow us all to avoid the trickiness (and fees) of separating luck from skill.

By: Matthew2

Matthew2 — Tue, 27 Jan 2004 17:47:23 +0000

It’s the reverse of that old scam (at least in the literature, I’ve not heard of it in real life) where the con-artist sends out 1000 letters to people telling them who will win tonight’s big football game, 500 team A and 500 team B. Then say team A wins; for next week’s big game he sends out 500 letters to those to whom he’d sent a letter saying team A would win, this time with 250 letters saying team C will win and 250 saying team D will win. And so on, until about 8 lucky recipients have received 7 letters each correctly telling them who would win that night’s big game. This time around you ask for money to continue your brilliant forecasting record…

By: Matt

Matt — Tue, 27 Jan 2004 17:22:54 +0000

Of course, better-than-average performance of any particular investor may just be random walking—but if there is a non-random component to investment (and you need to estimate the probability of that) then it makes some sense to find a good performer and try to do something similar.

By: WillieStyle

WillieStyle — Tue, 27 Jan 2004 17:10:32 +0000

Do such creatures exist? Warren Buffet? Besides, my post was purely theoretical.

By: wcw

wcw — Tue, 27 Jan 2004 17:08:53 +0000

yes, luck. luck is also the major contributor to success in other fields of human endeavor. that said, you pretty much have to believe that investment skill exists. otherwise, markets are meaningless except as an internally consistent mechanism to eliminate arbitrage. the tricky-if-not-impossible task is determining which outperformers actually have skill. simplistic market simulations almost always show luck swamping skill.

By: Chris Bertram

Chris Bertram — Tue, 27 Jan 2004 17:06:13 +0000

select only those brokers who are at least 1 standard [deviation] above the mean, … 10 years in a row Do such creatures exist?

By: WillieStyle

WillieStyle — Tue, 27 Jan 2004 17:00:35 +0000

I’m sorry that should be “standard deviation” not distribution.