Fooled by randomness - Role of luck vs skill

Currently I am reading Howard Mark, Chairman of Oaktree memo’s. It’s must read for every investors. In one of the letter he hadsummarizedTasim Taleb book “Fooled by Randomness” and emphasied that its essential todifferentiatethe role of luck vs skill For me the biggest takeaway is - Some time it can be a mistake to look for patterns in our own success, without differentiating between luck and skill. While evaluating factors which lead to superb returns in any stock, we should also evaluate whether we have foreseen that at the time of buying or just got lucky.

Role of Luck (November 2002 Memo)

Randomness (or luck) plays a huge part in life’s results, and outcomes that hinge on random events should be viewed as different from those that do not. Thus, when considering whether an investment record is likely to be repeated, it is essential to think about the role of randomness in the manager’s results, and whether the performance resulted from skill or simply being lucky.

$10 million earned through Russian roulette does not have the same value as $10 million earned through the diligent and artful practice of dentistry. They are the same, can buy the same goods, except that one’s dependence on randomness is greater than the other. To your accountant, though, they would be identical. . . . Yet, deep down, I cannot help but consider them as qualitatively different. (p. 28)

**Every record should be considered in light of the other outcomes a Taleb calls them “alternative histories” a that could have occurred just as easily as the “visible histories” that did. **

Clearly my way of judging matters is probabilistic in nature; it relies on the notion of what could have probably happened. (p.29)

If we have heard of [history’s great generals and inventors], it is simply because they took considerable risks, along with thousands of others, and happened to win. They were intelligent, courageous, noble (at times), had the highest possible obtainable culture in their day a but so did thousands of others who live in the musty footnotes of history. (p. 35)

Think about the aggressive backgammon player who can’t win without a roll of double sixes. He accepts the cube a doubling the stakes a and then gets his “boxcars.” It might have been an unwise bet, with its one-in-36 chance of success, but because it succeeded, everybody considers him brilliant. We should think about how probable it was that something other than double sixes would materialize, and thus how lucky the player was to have won. This says a lot about his likelihood of winning again.

As my friend Bruce Newberg says over our backgammon games, “there are probabilities, and then there are outcomes.” The fact that something’s improbable doesn’t mean it won’t happen. And the fact that something happened doesn’t mean it wasn’t improbable. (I can’t stress this essential point enough.) Every once in a while, someone makes a risky bet on an improbable or uncertain outcome and ends up looking like a genius. But we should recognize that it happened because of luck and boldness, not skill.

In the short run, a great deal of investment success can result from just being in the right place at the right time. I always say the keys to profit are aggressiveness, timing and skill, and if you have enough aggressiveness at the right time, you don’t need that much skill. My image is of a blindfolded dart thrower. He heaves it wildly just as someone knocks over the target. His dart finds the bulls-eye and he’s proclaimed the champ.

. . . at a given time in the markets, the most profitable traders are likely to be those that are best fit to the latest cycle. This does not happen too often with dentists or pianists a because of the nature of randomness. (p.74)

The easy way to see this is that in boom times, the highest returns often go to those who take the most risk. That doesn’t say anything about their being the best investors.

Warren Buffett’s appendix to the fourth revised edition of “The Intelligent Investor” describes a contest in which each of the 225 million Americans starts with $1 and flips a coin once a day. The people who get it right on day one collect a dollar from those who were wrong and go on to flip again on day two, and so forth. Ten days later, 220,000 people have called it right ten times in a row and won $1,000. “They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvelous insights they bring to the field of flipping.” After another ten days, we’re down to 215 survivors who’ve been right 20 times in a row and have won $1 million. They write books on “How I Turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning” and sell tickets to seminars. Sound familiar?

Thus randomness contributes to (or wrecks) investment records to a degree that few people appreciate fully. As a result, the dangers that lurk in thus-far-successful strategies often are under-rated.

Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet, under a numbing false sense of security. . . . Second, unlike a well-defined precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality. . . . One is thus capable of unwittingly playing Russian roulette a and calling it by some alternative “low risk” name. (p. 28)

Perhaps a good way to sum up Taleb’s views is by excerpting from a table found on page 3 of his book. He lists in the first column a number of things that easily can be mistaken for

The table reminds me of a key difference between the “I know” and “I don’t know” schools. “I don’t know” investors are acutely conscious of the things in the first column; “I know” investors routinely mistake them for things in the second.

**I think Taleb’s dichotomization is sheer brilliance. We all know that when things go right, luck looks like skill. Coincidence looks like causality. A “lucky idiot” looks like a skilled investor. **Of course, knowing that randomness can have this effect doesn’t make it easy to distinguish between lucky investors and skillful investors. But we must keep trying.

I find that I agree with essentially all of Taleb’s important points.

**Investors are right (and wrong) all the time for the “wrong reason.” **Someone buys a stock because he expects a certain development; it doesn’t occur; the market takes the stock up anyway; he looks good (and invariably accepts credit).

**The correctness of a decision can’t be judged from the outcome. **Nevertheless, that’s how people assess them. A good decision is one that’s optimal at the time it’s made, when the future is by definition unknown. **Thus correct decisions are often unsuccessful, and vice versa. **

**Randomness alone can produce just about any outcome in the short run. **The effect of random events is analogous to the contribution from beta discussed on page six. In portfolios that are allowed to reflect them fully, market movements can easily swamp the skillfulness of the manager (or lack thereof). But certainly market movements cannot be credited to the manager (unless he’s the rare timer who’s capable of getting it right repeatedly).

**For these reasons, investors often receive credit they don’t deserve. **One good coup can be enough to build a reputation, but clearly a coup can arise out of randomness alone. Few of these “geniuses” are right more than once or twice in a row.

**Thus it’s essential to have a large number of observations a lots of years of data a **

Howard Marks is a great investor. I read his memos every quarter. Also, I am reading his book, “The Most Important Thing” now. Wonderful read. Will post a summary once I am through.

Sorry I was ignorant of the same. I apologise and will correct myself. Thank you ··· On 10/26/17, Manish Vachhani wrote: > > > Fooled by randomness - Role of luck vs skill > > I think you have copy/pasted this article from >…