Investing Is More Luck Than Talent
nautil.us
nautil.us
The application is that if you replace energy with money, and atoms with people, then the same equations hold for a model of people who randomly exchange money. Therefore if investments were truly random, you would expect the distribution of investors' wealth to follow an exponential distribution, not a power law! This directly contradicts the article.
Interestingly enough, the bottom 99% follows an exponential distribution, while the top 1% follows a power-law, and the transition is very sharp (eg, wealth plots have a "kink" in them).
Brief introduction to econophysics for the mathematically inclined: https://arxiv.org/abs/0709.3662
1. Coin flipping is not a fit analogy, despite the fact that it's parroted in financial discussions ad nauseum. Take this quote from the article, for example:
Maybe the string of investment and managerial decisions that made one person’s company successful, and that seem so very wise in retrospect, were actually just the entrepreneurial equivalent of flipping a coin 20 times and getting all heads. The chances of that happening are about 1 in 1 million, so if enough people try it, someone is bound to get lucky and look like a coin-flipping genius—purely by chance.
What? How do you map the theoretical probabilities of individual entrepreneurial decisions to the chance of a heads or tails on a coin flip? Is the chance of getting into YC 50%? Is the chance of securing venture capital in a Series A round 50%? How about? This is before we even consider that the theoretical chance for each decision will obviously not be the same for everyone, whereas a coin flip is. This is important because it's not falsifiable if we can't map decisions to probabilities. It's also important because the numbers could be wildly different. If each entrepreneurial decision has a 50% chance of success, that might result in a 1 in 1 million chance of getting rich. But what if the actual chances of success for each entrepreneurial decision in lieu of the coin-flip mapping result in a 1 in 4 quadrillion chance of success? One result indicates that essentially all successes could be due to chance, the other suggests the opposite.
2. The author uses very fuzzy measurements with no empirical basis in reality to support the model. For example:
To make the game more realistic, assume that if investors’ wealth declines below some level they have to drop out of the game, and are replaced by newly rich players emerging from the middle class. Eventually, the game will reach a kind of equilibrium—one in which the number of players going up is always balanced by the number going down, so that the overall distribution of wealth reaches a steady state and doesn’t change anymore.
Wait a second, why are we assuming that this game reaches an equilibrium? We can't just use textbook economics here - there is no reason to assume the "game" won't be weighted towards more players dropping out than moving up or vice versa.
3. The author tries to repair the issues with chance being theoretically equal in my first point with the following:
Still, it is possible to get a crude sense of the effect of talent by modifying the investment game to include two types of players. Normal investors are just like those in the first game: They flip a coin with heads yielding a return of 30 percent, and tails producing a loss of 10 percent. But the talented investors are more skilled at playing the market: They earn slightly more than 30 percent when the coin comes up heads, and lose slightly less than 10 percent when the coin comes up tails. Now we set the players loose and ask an empirical question: How big can this “talent differential” be and still stay statistically consistent with the power law wealth distribution we see in the real world?
Where are these numbers coming from? How are these a rigorous, empirical model of talent and the subsequent chance differential? By this point in the article the entire game is becoming so "in the clouds" that it doesn't have any basis in reality anymore. It's like I came up with a "law" based on one extremely convoluted thought experiment and attempted to extrapolate it to the entire market in real-world conditions.
Basically, the author's model is narrow in some places, vague in others and overall does not empirically prove the premises it attempts to build upon. He hand waves the (extremely common) power law distribution as a sort of magic wand that smooths away all the lack of rigor. There's just not much evidence that the model reflects the real world.
No, it means that you're using the wrong model. There are lots of models of "random" behavior. You can't just pick one out because you like it, and conclude that a system isn't "random" because the model you've chosen doesn't fit the data.
The article isn't especially convincing either, but at least they're describing a model that looks somewhat like money, and produces a distribution that matches what's observed in reality. You're describing a model that looks like atoms, and concluding that money isn't random because it doesn't look like atoms.
Curious that there's such a sharp change in distributions. It seems like the top 1% participate in a very different sort of financial network than do the remaining 99%. Since the majority's wealth follows such a basic physical theory, their organization must be completely unstructured.
For the 1%, then, the question is what the structure is. It might be 'scale free' network [1], or fractal, so it could be due to preferential attachment [2], which would mean those who have lots of money find it easier to make more money (via things like investments or rent-taking), or due to competition between fit nodes [3], which would make sense in that those in the 1% are likely to be merging / acquiring others.
I guess what this means isn't too surprising: if you aren't in the 1% now, you need to claw your way in before you can take advantage of these network effects to grow your wealth in any meaningful way. If you aren't in the 1%, you might be successful, but it will be mostly due to luck.
But I wonder if the network effects can be taken advantage of without the wealth to start. Following this line of thinking [4], the wealth flows due to social networking, not due to financial networking. If you can connect with the 1%'s social sphere, you stand a much better chance at becoming a part of that financial class.
[1] https://en.wikipedia.org/wiki/Scale-free_network [2] https://en.wikipedia.org/wiki/Preferential_attachment [3] https://en.wikipedia.org/wiki/Fitness_model_(network_theory) [4] https://www.quora.com/What-is-the-most-effective-yet-efficie...
If you are usual HN demographic I can guarantee you actually are. 32k/year is all it takes: http://www.investopedia.com/articles/personal-finance/050615...
I suspect the downvotes are from people who assume you are intentionally misunderstanding the parent
However, I like to think of a downvote is paperwork, not an insult. It's a great point, I just think the conversation flows better without it.
Really brings to light how bad global inequality really is!
So through a US lens, I'm guessing a certain percentage of HN readers who work in senior positions in the valley or NYC would be 1%, and of course a random assortment of other readers, but the vast majority of software engineers etc. would NOT be 1% on a single income.
But that does not hold in society. Preferences of people are highly dependent. If a singer has gotten praise from one person, it is more likely that s/he is getting praise from the next one as well (assuming these can share their preferences), and by more I mean more than what would be expected from singing talent alone. I am quite sure there was a social psychology research on specifically this example, how people rank music in groups, but for some reason I can't find it from google just now.
From the investment point of view, I think Piketty showed that larger investors seem to get better returns on their investments. You can debate causality, correlation and luck here probably endlessly, though.
https://www.princeton.edu/~mjs3/salganik_dodds_watts06_full....
"Could the differences between the very rich and the hugely rich [...] be the result of pure, dumb luck?"
So if the model you're looking at indicates power law distribution at the top, that seems to lend further support to the author's thesis.
Those in the bottom 99% of investors may still be capturing at least some of the increase in world wealth over time. Then again, maybe not: or not much. I'd have to read the article to know if the answer to that question is there, and I can't afford the extra time, alas.
It's not only statistically impossible for Buffett to be a fluke, it's statistically impossible for him not to possess a a skill providing a substantial edge in market investing. Not a "1% a year" type skill.
Nowadays and for the last 20 years or so, Buffett has been managing hundreds of billions of dollars. The immense size of his portfolio restricts his opportunities to a far smaller pool of potential investments and his edge over the market has clearly declined because of that restriction. But he's still beating the market the vast majority of the time.
And the coin flipping paradigm is wrong. The odds of beating the market by 10%+ a year is not a 50-50 proposition. It's more like a 1 in 10 chance. So re-run your stats with Buffett going 50 for 53 on 1 in 10 shots.
His preferred approach has always been to buy entire companies, usually private companies, outright. Where there is no highly liquid market, there cannot be an efficient market in the theoretical sense. He prefers to invest when it is actually possible to possess information or insights that have not been widely distributed to other potential buyers via public disclosure. There is a similar dynamic at work in real estate, where local knowledge allows outsized returns to some participants.
The main source of free cashflow for Berkshire Hathaway has always been insurance, itself a risk-based industry. His main advantage has been to rigidly underwrite for profit, not for volume, giving access to cheap float.
None of these things are easily duplicated by regular folks and their advantage diminishes sharply with scale, as Buffett himself has warned Berkshire Hathaway shareholders for year after year.
I admire him and I think he's a useful foil to purely statistical views. But I also think luck plays its part. He's flubbed billions of dollars on both foreseeable (textiles) and less foreseeable (airlines) events.
He didn't get into insurance until about 20 years after he started investing. His greatest returns were before it.
Buffett/Graham believe in concentrated portfolio, not having too many positions in your portfolio, because if you have more than 20 or so positions its difficult to know any of them well. So this means when his portfolio grew in size, he started losing opportunities in the public markets because many companies were too small for him to buy enough of to have a reasonable position. So he ended up investing in larger cap companies, and buying smaller cap companies outright.
And his biggest flub wasn't textiles or airlines, it was maintaining Berkshire Hathaway as his investment vehicle. He gives a free ride (no fees) to investors on half his results, and because of the double portfolio size restricting his investment options, his returns are lower. He would have had a substantially higher returns if he just invested his own money, or if he had kept running an investment partnership and taking fees. He's cost himself at least $100B in personal wealth.
But despite his very infrequent mistakes, he's beat the market by well over 10% a year during his investment career, and there is almost no luck in that.
He himself has said that the easy days are long over. The actual stock market continues to form a closer and closer approximation of weak EMH.
> But despite his very infrequent mistakes, he's beat the market by well over 10% a year during his investment career, and there is almost no luck in that.
He beat the stock market, by and large, by not participating in it.
Owning insurance companies and buying companies outright is not a strategy I can pursue with my 401(k).
I like Warren Buffett. I've read the first 50 Berkshire Hathaway letters. I think both he and EMH proponents are "correct", but largely they talk past each other. Where they agree is that what works for Warren Buffett only really works for Warren Buffett. His literal advice to regular investors is to buy index funds.
On the one hand that sounds like what you're saying - the market is becoming more efficient. On the other hand, I propose that there is no evidence the market will become more efficient continually, and the new normal is due to the rise of software eating the industry.
It's physically impossible for the market to be efficient.*
Just try to use the efficiency for anything (set up any series of steps where one of the steps is "...because the market is efficient, therefore...") and whatever you've just set up just plain won't work.
Since it's impossible, instead of any version of the efficient market hypothesis people should just say "God's will" (as in God's will that prices should reflect available information), and it will show how silly they are.
* you can email me if you'd like a rigorous proof that it is impossible
The weak EMH is pretty simple: there's money to be made in arbitrage, but the act of arbitrage spreads information. So a price quickly converges to reflect available information. The harder participants try to beat the market, the harder it becomes.
What's left is the lurch of prices upon truly novel information arriving. Stocks appear to move up and down at random, because future events are not fully predictable. If they were, prices would stabilise around the "true" price and remain stuck there.
A similar argument has been used to show that time travel has not and will never be invented. Arbitrage across time would be even more profitable than arbitrage across space.
Could you elaborate? I'm not sure I follow.
Information gets cheaper, faster and more accessible over time but I believe that there's a diminishing return in how much more efficient the market can get without another huge jump in technology.
For example, HFT (specifically, the sort where you're actually thinking about the speed of light) is not categorically improving dramatically year after year anymore. The market is getting more efficient, sure, but it's getting more efficient very slowly, and would argue the rate of efficiency increases is decreasing. Without another categorical jump in technology (e.g. significant AI, quantum computing, etc) that dramatically improves data cleanliness or accessibility, I don't see the market getting significantly more efficient than it is now. And I don't agree that the market is yet at weak EMH.
"We find that the secret to Buffett’s success is his preference for cheap, safe, high-quality stocks combined with his consistent use of leverage to magnify returns while surviving the inevitable large absolute and relative drawdowns this entails. Indeed, we find that stocks with the characteristics favored by Buffett have done well in general, that Buffett applies about 1.6-to-1 leverage financed partly using insurance float with a low financing rate, and that leveraging safe stocks can largely explain Buffett’s performance."
It also has problems with the classifications of his investments. It's a common problem for academic analysis of investing, if value investing works then I should be able to outperform solely buy purchasing stocks at low PE ratios, right? This doesn't work, so value investing "can't" work.
The truth is it's a skill. You have to be able to find businesses with long term competitive advantages selling at a substantial discount to their intrinsic value. You have to have the courage of your conviction through market cycles and not abandon your purchases even cheaper. You have to eliminate sources of bias in your analysis (Buffett won't look at it's price before he analyses a business so his valuation isn't affected). If you read Buffett there are a ton of things he does to limit bias in his job.
None of this can be academically measured.
> this paper only starts in 1976
Explaining Buffett's performance since 1976 is an informative exercise.
It's still possible to get better returns than average on the market: After all, most of congress does this. But the one way to do it is precisely like congress does, by having information that the market is unaware of.
This is what make people move money into venture capital: It's a way to invest into things most of the market is unaware of, and whee the number of players is small enough that it's still possible to get privileged information.
Buffet's current plan is only doable because he has access to more information, and has such a gigantic bundle of money that any effort to get an edge will be multiplies by investment size.
Where does the wealth of the richest people in the world come from? Tremendously risky bets, going heavily into a single, extremely successful venture that they had special access to. But what makes their ventures win, vs those of second players that did badly in the same industry? Non replicable things, distributed in a way you could call luck.
I see no reason to conclude the hyper-winners are more than just luck. Perhaps all the '1% edge' associated with talent is simply avoiding bad mistakes that always deliver a loss. If everyone performs optimally, it becomes entirely and completely luck.
I guess it's a lucky thing that'll never happen? I seriously think the only skill involved in investing is a combination of humility and an admission that you're not smarter than everyone else. It keeps you medium conservative and provides solid returns.
This is exactly the opposite of what he claims in his essays. One quote:
> The other way we differ from some arbitrage operations is that we participate only in transactions that have been publicly announced. We do not trade on rumors or try to guess takeover candidates. We just read the newspapers, think about a few of the big propositions, and go by our own sense of probabilities.
There are several others in "The Essays of Warren Buffett" where he also describes how he just uses public information.
In the former case, Buffett solicits sellers to directly contact him. He makes this solicitation every year in his letter to Berkshire Hathaway shareholders.
In the latter case, Buffett recommends the Financial Times as a source of information.
you just picked one person out of billions of investors. what is more improbable? that he is flipping a coin 40 times and got head all the time or that billions of people cant see what he sees?
also, buffet is the perfect example of why you should not invest, as he beats the market by not investing in the market.
His average returns with the Buffett Partnership were in excess of 35% a year. That's not coin flipping. The odds of a 35% return when the stock market is returning 10% is probably closer to one in a hundred. doing that for a decade straight is insane.
Then follow it with 40+ years where he beat the market every year but a couple, and not barely crushing on average by over 10% year (probably 10-1 against each year), even when handicapped by an enormous portfolio.
(1/100)^10*(1/10)^40=?
Actually, the probability of getting a head 40 times is 1/2^40, which is 1 in about 1.1 trillion. If we assume there are 1 billions investors overall, the probability that at least one wins 40 times (which is the probability that one or several Warren Buffet could appear by luck in this simple model) is about 0.00091.
So yeah, in this particular phrasing of the question, with this model, the less likely option is to flip a coin and get head 40 times and the more likely option is that there is something else, like talent.
I bet that the odds of beating the market 40 times are even worse since it is not a simple binary choice. The better analogy would be to choose the correct face of a 6 sided dice 40 times in a row, or even better a 100 sided dice. Calculate the odds for that! (I'm too lazy to do it myself)
Before concluding "talent" is responsible, you must exclude other possibilities in the "something else" category (e.g., intelligence, insider information, control of upstream/downstream resources, etc.).
Wealth allows access to resources unavailable to those w/o wealth.
It seems a bit hard to believe that this is just confirmation bias. What are the odds that he guesses correctly almost 40 times in a row? It is possible but not likely. If he is not really as good as we think he is then you could also say that he is doing insider trading and he just hasn't been caught.
Honestly I don't buy the theory that he is just extremely lucky.
I know what you're thinking. "The stock market is a random walk! Efficient market hypothesis!" But the market is not a black box. You can legally gain insight that other participants don't have and use that insight to profit.
Other people have done the math in this thread. The human population would need to be orders of magnitude larger than it is now, and every human would need to be an active, failing market participant, in order for the successful traders we see being the result of chance.
The probability of repeatedly beating the market the way Buffett has done it is several orders of magnitude lower than the probability of winning the lottery. That's the point.
More like just world falacy in this case.
It's everywhere in all things social. Some religions even incorporate it (Hinduism, Buddhism and Calvinism come to mind)
No. It's statistically impossible for him to be the NORM, or some sort of aspirational figure. Statistics is exactly how we can measure how much of a fluke he is, and how lucky he's been. Give him 2% for ultra-talent, and another 5% for trading on the fact that he's Warren Buffett, and he's still a fluke. He is just able to put a thumb on the scales for personal/emotional reasons: implying to people like you that he's not a fluke. The odds of him being in that position are very long odds, and he lucked out and has taken advantage of it. If you run a lottery and draw one ticket, that's long odds but by definition one person will have won.
Statistics tell you he's an outlier. It tells you nothing about why, however.
Yes, Buffet is incredibly skilled. Buffet actually claimed once that he was born with a preternatural ability to invest in companies. The whole "you can't beat the market" quote is meant more to say that we mere mortals are to Warren Buffet what normal people playing pickup basketball are to Michael Jordan.
I'm curious, do you have any evidence of this? "Statistically impossible" means "zero probability". If that's really your argument then you need to back it up.
Perhaps you mean, "improbable"?
People like Buffet and Einhorn are extreme anomalies. So much so that they are legendary, they are that unusual. There are only a small handful of legendary investors throughout history for a reason.
If you have enough people throwing coins, you're going to get some people who keep getting heads over and over. Those few people who have a superior coin-tossing technique are probably not going to end up anywhere near the top - This is especially true if you believe in the rhetoric that people of high talent are "very rare".
The sheer masses acting out of randomness will always beat out the few "very talented" individuals.
In "Fooled by Randomness", the author alludes to the idea that the top people at any given time in any given field often got there through very little talent - It just happens that their approach was a good fit for their field at that particular time - As soon as some "black swan" event happens (and they always happen, eventually); these people tend to lose everything very, very quickly.
Also, the reason why Buffet gets it right most of the time these days is the same reason why George Soros gets it right most of the time; whenever either of these famous investors buys any stock, it becomes big news then all these other wealthy investors follow suit - Soon enough you have half of humanity rooting for/against that specific company/security so anything they do becomes a self-fulfilling prophecy.
How many people do you need for a "Buffett or better" event to have > 5% probability of happening?
There is a good Euler problem on investing showing that odds based investing can be relatively easy. Of course, many things including granularity of bets, floors, ceilings, and fees complicate matters considerably.
But, a relatively few big wins can give you a lot of slack.
https://projecteuler.net/problem=267
Interesting, I might have a go at it this afternoon.
It depends on what you mean by easy. To maximize the probability of going from $1 -> $1B in 1000 flips, you need to bet almost everything you have every time (the answer to the problem is > 0.99999).
If you do so, you must win at least 917 of the coin flips to get more than $1B. I can't compute the probability of this event, but using the normal approximation to the binomial distribution, the probability of winning at least 615 coin flips is less than 1 in a trillion (10e-12). You can imagine how much lower it is if you need 917 flips.
This is under the favorable betting scenario where you get 2x the value of your bet every time you win.
EDIT: Ignore everything above. Clearly I solved this a while ago and forgot to check what the actual question was. The probability that you become a billionaire is > 0.99999, the optimal fraction is quite small, of course.
Things change drastically if you get the value of your bet when winning instead of 2x (it seems you need 602 coin flips in that case which is about 0.07 in a billion).
Now, yes, that is greatly simplified and lets you always divide your current wealth. And always double. That is what I meant about floors and ceilings.
I recall playing with the code to toy with more realistic situations. Washing fees out of the game makes it a lot easier to not lose everything.
By no means guaranteed. But easier. And it is likely someone could have done really well by the odds.
Edit: Just saw your edit. Yeah, it was easy to think it was asking the other question. And yes, realistic scenarios are vastly different. Otherwise, a lot of us would be billionaires. :). Just pointing out that the odds aren't nil. Just small. And don't forget, in real scenarios you can change games once you have won enough.
In addition to the comment pasted below, others in this thread have shown that the actual odds of someone consistently beating the market for decades becomes 1 in billions or even trillions. Yes, there are very few traders and funds that consistently beat the market, but there are enough that it seems implausible to be due to chance when you do any reasonable math. You would need nearly the entire human population trying and failing at beating the market in order to justify the number of demonstrable winners we can observe as mere chance. It's much simpler to assume that 1) market inefficiencies exist and 2) some individuals have the technical skill, domain knowledge and/or business acumen to repeatedly capitalize on them.
I don't understand why this coin flipping analogy from efficient market hypothesis keeps popping up. We can clearly see that funds like RenTec exist, and average 70% returns year over year for literally decades. It's an attractive idea, but I've never seen anyone who puts it forward do any empirical calculation. The claim is essentially, "Get enough monkeys slinging poop in a room full of typewriters and you'll eventually get Hamlet." If you want to cast doubt on the fundamental possibility of people beating the market, at least least try to claim that these successful funds/traders illegally trade on insider information. Don't use the same analogy that is basically indefensible under real scrutiny.
Comment below:
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Yes, that's the classical coin flipping example from the strong position on Fama's Efficient Market Hypothesis. There are several problems with the coin-flipping analogy:
1. As stated, it's not falsifiable. So you start with a conception of the market as entirely random, and you observe that participants are consistently beating this market. Each time you observe someone beating the market, you chalk it up to the probability distribution. "Well, that's just a two-sigma event." Then you see it happen again. "Well, that's just a three-sigma event." Then again, and again, and again. How many sigmas from the average market performance are you willing to accept before you agree that someone is legitimately and purposely beating the market with a skill-based mechanism, not a chance-based mechanism? Furthermore, do you have the numbers to turn this into a falsifiable claim? What is your time interval? Daily, weekly, monthly or annually? How many correct forecasts do they have to make ("how many sigmas from the average"), compared to the chance expectation of coin flipping over the same timescale? If you don't have these numbers handy, then it's purely a thought experiment. Subsequently, the observation that funds like Berkshire Hathaway, Bridgewater, Renaissance Technologies, Baupost Group, Citadel, DE Shaw, etc. consistently beat the market for at least 20% net of fees over 20-30 years suggests that, per Occam's Razor, people can beat the market due to skill.
2. The analogy is not comparable to active trading. You don't need to hit 20 heads in a row to beat the market consistently, you just need to hit a p-value number of x heads correct for y coin flips greater than chance would suggest. We don't assume that basketball is a game of chance if the players can't make all their shots in a row; nor do we assume that baseball players with a 0.3 batting average aren't clearly better than the average high school dugout. If your trading interval is weekly or monthly, and you're consistently up over the market (even net of fees!) for 240 months or 360 months, it doesn't matter if every single month was a winner.
3. Have you ever read Warren Buffet's response to the EMH assertion, as postulated by Fama?[1] He outlined an excellent rebuttal in his 1984 The Superinvestors of Graham and Doddsville. Essentially, if you assume that the coin flipping analogy does map to trading, then you should expect to see a normal distribution of the winners, given that the market is inherently random and no one is achieving superior coin flips through skill. However, if you observe that the winning coin-flippers consistently hail from a small village with standard coin-flipping training, then it is more reasonable to assume that there is something unique about those particular flippers. This is what we see in reality - yes, most amateur traders fail miserably, and yes, most hedge funds underperform the market over time. But there is a relatively small concentration of extremely successful funds and traders in an uneven distribution.
4. Even Fama has walked back on Efficient Market Hypothesis, and no longer espouses the view that the market is inherently random. It is deeply complex, yes, but it is not efficient, nor entirely random. Several studies have been conducted to empirically examine EMH, and the results in favor of the hypothesis are dubious.[2][3][4] A much more charitable retelling of EMH is the weak position, which essentially states that any obvious alpha will be quickly arb'd out of real utility, but that non-obvious alpha, or alpha which is technically public but not easily accessible will retain utility until it becomes obvious. This also maps more cleanly to reality, in which trading on e.g. news reports is mostly unprofitable (everyone can get a news report at around the same time, for the same level of skill) whereas mathematically modeling pricing relationships can be extremely profitable (doing so accurately requires public, but mostly unclean data and a great deal of skill). _______________________________________ 1. The Superinvestors of Graham and Doddsville - http://www8.gsb.columbia.edu/rtfiles/cbs/hermes/Buffett1984..... 2. Investment Performance of Common Stocks in Relation to Their Price-Earning Ratios: A Test of the Efficient Market Hypothesis - http://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1977..... 3. The Cross-Section of Expected Stock Returns - http://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1992..... 4. International Stock Market Efficiency and Integration: A Study of 18 Nations - http://onlinelibrary.wiley.com/doi/10.1111/1468-5957.00134/a....
There are not seven billion traders. At any time in the United States the number of funds is in the thousands. Adding in other countries, and being generous with the term "trader" (or "investor", "fund manager", etc), I would be willing to agree that there have been millions over the past two decades (the same time frame as some of the track records I've mentioned). What does that leave us with? We're still orders of magnitude away from the successes we observe emerging due to chance. The numbers just aren't there.
Other than that though, sure. Unfortunately it would be really difficult to examine empirically, which is why I use a 20-30 year slice of time.
In its lifetime, your position is going to swing from negative to positive to negative multiple times. Emotions and naivety makes novice traders lose money on their trades while luck make throwing dice a random event.
In my opinion, people are just afraid to admit that someone else has a bigger dick (or tits) than him(or her).
I imagine that's grown harder and harder as time goes on, given the ability of HFT algorithms to spot big purchases in progress. But Buffett has always preferred outright purchases or special one-off deals (eg. the Bank of America deal or individually-negotiated insurance contracts).
Long story short, the less you know, the more "random" events appear to be. As Taleb wrote, "a surprise for the turkey is not a surprise for the butcher." Buffett's strategy is to know/understand as much as possible. Of course you will still be victim of the unexpected, but probably not as frequently.
I can't find the source, but I believe Taleb was misquoted (or misinterpreted) on Buffet. Taleb indeed makes the general argument that most high performers are just lucky. But he doesn't say that all are. He just says: you can't tell.
As for Buffet, he complained he hadn't meant Buffet was unskilled. He meant Buffet was skilled and had luck. Which is a plausible interpretation. You likely need skill to get to Buffet's level. But those with the skill of Buffet don't all end up at Buffet's outcomes: Buffet would be at the high end of the distribution of those that had his level of skill to work with.
At least that's how I interpreted it. I believe Taleb's subsequent commentary on this was in Black Swan or Antifragile. It involved the phrase "for Baal's sake" when complaining about how people had interpreting him as saying "Buffet is pure luck".
His returns come from management giving him their shareholders wealth as much as anything and have done for some time. Someone will now claim he was righteous and a white knight saving salomon's management or saving goldman's from gfc ruin or whatever. Believe that if you like but don't compare it to those who were shut out from making that same buy at the same time and same price. I'd be surprised if in the past 20 years or so if you factored out all the off-market, warren only buys he got if his returns didn't look a lot more like the S&P500 adjusted for statistical risk using standard CAPM beta measures.
Saying so out loud will offend the hell out of a lot of people who really need to believe. But maybe someone will calmly and dispassionately do the calculations and show my suspicion to be wrong.
If you put $1,000 in the fund in 1988, it would've become $13.8 million by 2016.
See: https://www.bloomberg.com/news/articles/2016-11-21/how-renai...
It turns out that it can’t be more than about 1 percent.2 A larger talent differential would produce a wealth distribution that is even more extreme than the real one, and that would not follow a power law."
I thought this article looked like it was going to be very obvious, but that passage got my attention. I'm all for experiments of this nature: one day AI will be doing it as a matter of course, on a massive scale.
Lines up with my observation, too: talent makes a difference, and it's about 1% over time. Kind of like compound interest. You can win out if you're very persistent and very determined and you fail a lot, because you're shooting for that 'luck' moment. There's no telling where it will strike, because it's luck! You have to stay in there and not go broke because it's luck, there's very little correlation between merit and success.
I suspect if you went by tenacity rather than 'talent', the number might be a lot more than 1%. But bozos can be tenacious too, which is a daunting thing to consider.
True. Yet both were extremely lucky at the beginning. We all know the story but Gates' mother knew IBM President John Opel, his father was a prominent contract lawyer, and IBM originally wanted CP/M but Gary Kindall missed the meeting to fly his plane. And Microsoft retaining the rights to the OS was, in hindsight, a very grave mistake.
Jobs had the charisma and drive, but without Woz I'm sure we wouldn't be talking now about Apple.
But given the opportunity that this initial luck gave them, they absolutely maximised it, so good on them.
That's just not how to do statistics, sorry. First of all, one of those is not like the others: IQ is normalized, the others are not. There are so many assumptions about linearity and distributions here that would need to be a lot more rigorous before anything like this could be said.
See http://www.thedailybeast.com/articles/2013/02/06/department-... for an actual interesting point regarding income and bell curves.
I agree there's a lot of details that need to be done to make this more rigorous, and I was hoping that the article would be more thorough.
But this has been on my mind a lot lately.
Basically, most human [behavioral] traits are normally distributed, or something close to it, which is radically different from income distributions. At some point, the shape of an income distribution must become inconsistent with what we know about the shape of human trait distributions and wages under fair labor markets, etc. It should be possible to test whether or not an income distribution is consistent with a given trait and market model, and to compare them statistically.
I appreciate McCardle's writing, and read that in the past, but think it's sort of tangential to the points being raised here. Furthermore, many of her arguments aren't supported by the data. That is, income inequality really exists across a wide range of professions. If anything, I suspect there's some demographic effects involved (for example, older, very well-established individuals with a "lock" in a given labor market, shutting out younger individuals).
They also don't even get into cheating as another factor that's nonrandom and might be construed as a "skill" but is arguably unrelated to "real" market value.
All of this is consistent with arguments that the biggest predictor of returns is length in the market. That is, you're better off putting things in a very diversified index portfolio than anything else.
Someone else mentioned Buffet. Even if things were random, with enough people, you'd still end up with people who look like they're not benefiting randomly.
Anyway, I'm not really trying to question Buffet's investing skill. I'm sure that it's not totally random, but I suspect that there is a big element of randomness also. And income per se is different from investment skill per se.
It means talking about an IQ of 5 million as somehow analogous to linear extrapolations of height or age means the author has no clue what they're talking about. The only way to have an IQ that high is to have a population large enough for it to be meaningful, while the other example are possible statistically (if not physically).
Anyway, having now read through the rest of the article, my critique is much simpler: they're using a simplified model with specific magic constants, and using it to derive exact values for other unknowns (specifically talent).
>Half the time it will come up heads and yield a return of 30 percent, and on the rest of the tosses it will come up tails and yield a loss of 10 percent. The numbers are chosen to give an average annual return of 10 percent, plus or minus 20 percent, which is typical of investments in the real stock market, but the overall conclusions do not depend on these specific numbers.
But then they say
>How big can this “talent differential” be and still stay statistically consistent with the power law wealth distribution we see in the real world?
>It turns out that it can’t be more than about 1 percent.
I haven't dug into the numbers here, but I'm comfortable discounting their conclusion because of the clear signs of unfamiliarity with concepts mentioned, as above. Also, they seem to be assuming that most of these people made their money investing, but that's unrealistic, yet they cite articles about money managers. It may very well be that money managers perform randomly, but that clearly shouldn't extrapolate to other rich people. The whole model is incorrect, people get rich by doing many other things (start a business, invent a product, etc) many (most?) of which are, in fact, related to talent but are completely missed by the model.
They casually throw out the claim that "They cannot possibly be the whole story at the high end, where people’s wealth is primarily determined by capital gains or losses on investments." but with no citation, and, as above, I doubt that. (A quick search turns of up http://www.forbes.com/sites/erincarlyle/2013/09/18/how-self-... which says investing is plurality but not a majority of the top 400's sources of wealth).
They keep on going back to people like Gates and Jobs, further confusing the question.
In the universe where he didn't meet Steve Wozniak, Steve Jobs was probably consistently in the top 3 Mercedes salesmen in California.
Not to mention: merely being born in a wealthy country during a period of relative peace is so much luckier than the lot of humans throughout history that it is almost worthy of bad science fiction.
Despite what some folk might wish to believe, Steve Jobs probably came to exist because his parents had sex.
It's not like the US has this super peaceful culture either, so I'm not even sure about what culture has to do with it at all. But even if that made perfect sense it would change nothing about the original point.
If it wasn't Jobs, it'd be someone else, and we'd be just as sure that the other ubermensch was Destined To Succeed No Matter What.
Without Woz, I'm not sure what Steve Jobs would have done. Probably nothing important. Steve Jobs was definitely a very talented man, but he was also in the right place at the right time.
If Apple didn't exist, we would still have computers and laptops. We would still have smartphones in 2017. I think everyone would just be using Android (or something similar), and no-one would know what they were missing.
Do you think that Woz is unique?
That Jobs wouldn't have found another tech guy to build some other whiz-bang thing with him?
This is all just conjecture, and there's no way of knowing what Steve Jobs would have done if his life had been slightly different. We know that he founded NeXT Computer after leaving Apple, but it's hard to imagine him founding that company if he was never involved with computers.
Without a complete record of all the failures of equivalent intelligence, drive, experience etc, it's not possible to fairly attribute to luck or to personal characteristics.
What we're seeing is that luck may give some random people a boost at first, but that boost is sufficient to let them take all the winnings over time. The rich get richer. Investing success and wealth building follow a Darwinian rather than a probabilistic model.
Now, are we seeing that the powers that be are finding ways to keep their wealth? Almost certainly. But, consider that the same fact for "top 8 have as much as bottom half" was probably true in the Rockefeller years. Difference is that, in American until recently, we had schemes to prevent a landed gentry, or class based society.
But to claim that this is somehow new or unheralded in history seems to ignore a lot of history.
The rest of the list includes Ingvar Kamprad, Bezos, Zuckerberg and Amancia Ortega, and none of them gained the majority of their wealth through inheritance or investment either. Now, their kids on the other hand... :-)
I think nobody is surprised about the fact that the largest cities are more than million times larger than the smallest settlements. Or that that top 1% of the largest cities includes the sizable proportion of human population.
A Random Walk down Wall Street http://www.forbes.com/sites/rickferri/2012/12/20/any-monkey-... http://www.marketriders.com/investing/why-googles-investment...
For instance, if I look at Zuckerberg or Gates, they had access to an amazing network (happened to both be at Harvard). That network allowed good ideas to explode in value. If Zuckerberg were at a community college in a poor section of the country, I'm not sure his idea would have captured the same value. Similarly, had Gates' mother not been on several boards, Microsoft would never have gone anywhere (clearly the introduction to high-level IBM executives through her board connections was paramount in his success).
I don't discount luck - I think it's very important. But luck comes about from your surroundings, and having access to a network like these two had will tilt the luck in your favor much more than if you have a weak network.
If economists focus on the networks, they will have better solutions to addressing inequality.
One final note - I don't think inequality is necessarily bad - rather, it is the inability to move up (or not evening having the chance to move up) that is the real problem.
Applying 1% on top of that as talent and rerunning it, stayed within power law distribution but making talent larger would break it. The faulty logic to me is what makes the "lucky 30% gain, unlucky 10% loss" fact? It seems much more likely that there is an 8% base (index funds, e.g.) with luck playing a +-10% and talent being another ~7% (as a hypothesis). Also, remember his "game" to prove luck > talent only ran for 20 years. I'm curious if I plugged this into a spreadsheet and ran for 50 years if I couldn't get the same power law distribution with greatly different factors. Mainly, it requires a lot of luck AND talent.
Yes, that's basically the findings of Thomas Pikkety. His tome "Capital in the 21st century" goes through great lengths to find and explain the numbers behind the finding.
Investing is not people playing some made up game - but people playing a heavily complicated game which is also known as: the real world. This makes it fundamentally different. Even if it might be very much based on luck, I would bet on the ship with the more experienced sailor/better crew etc. and would not call that gambling.
I personally don't believe investing in the market is gambling, but even if it were, that doesn't necessarily mean you can't consistently make money from it. Some of it is luck, some of it skill.
Investing in general is about probability. An example: I am working on a deal right now.
If it goes through I put $100k at risk by investing in an asset. Absolute worst case I can resell that asset for $50k, but I can probably sell it on for $100k. Best case if everything pans out I make $3m. The chance of that happening is probably around 50%. Those are odds I like. Lots of upside, almost no downside. Some publicly traded stocks are like that.
In fact, just last night I talked to a woman who does really well at poker because she randomly pretends to be a "dumb broad" on some hands.
>> Some publicly traded stocks are like that.
Can you please give an example?
First - there is tons of 'insider trading' going on. It's easy to do, and hard to prove.
Second - though maybe not 'insider' in the illegal sense - but once you have a lot of wealth, you have access to information and systems that others do not.
Warren Buffet made huge bank of a loan to Goldman during the crises. He was one of the few to have the cash and the reputation. Buffet can take advantage of so many situations that very few others can. So that's a lot of leverage.
I'm not saying anything against them, but big finance is an 'insiders game'.
Thesis: where absolute talent/skill is high, variance in relative talent is low, thus luck > skill.
We'd easily spot the fallacy if it read "engineering correct software Is More Luck Than Talent"
Actual investment is usually called "value investing", you purchase assets at a substantial discount to their intrinsic value and wait for the market to recognize that value. True value investing is rarely practiced on Wall Street because Wall Street is mostly about the latest fad and charging fat fees to the uninformed. And when Wall Street firms tout themselves as "Value" they are typically just buying low PE stocks, which isn't actual value investing at all.
The speculation-investing definitions where "investing" is defined as "value investing" is specific to the Graham-Dodd school of thought. These are not generally-accepted economic definitions. For example, Index investing isn't "investing" per Graham-Dodd.
> Study most successful speculators of or times and
> you will see certain patterns and common traits.
There's no one way to invest -- you have to find a way that works for you.
Last I checked, Renaissance Technologies and Vista Equity Partners outperform Buffett. RenTech is the opposite of a value investor and Vista does technology LBOs.
Having said that, I agree my comment was a bit hyperbolic. The truth is probably a bit less bleak.
Nothing about investing in stocks is speculation, at least in the theoretical sense. Businesses earn profits. If you buy shares in a business, you are entitled to a share of those profits. Obviously, this gains you money, and this money will (usually) not come at the cost of the business. So, you'll gain money due to dividends, and your investment won't lose money.
Investing in stocks is going to be, on average, a net gain for you. In theory. And mostly in practice, see for example the massive exponential gains in the S&P 500.
There's a lot more to things. For example, sometimes businesses fail and you'll have lost all your money. And on the flip side, maybe a business will grow enormously. But this just adds noise to the data, it doesn't change the fact that, on average, you should make money on stocks in the long-term.
If you just buy a total market index fund, you're making a bet with a high expected value. That's not "speculation" in the same sense of going to a casino and playing blackjack or buying an asset which has no fundamental reason to rise in value (like precious metals).
So, I think it's misleading to call investing "speculation". It gives off the wrong vibes, since the way most people understand the word it makes it sounds like investing is super risky. (And yes, there's some risk, don't get me wrong, but not in the sense that it's a coin flip like many people think.)
I think bonds are considered investment although to the price sell them before term fluctuates.
Correlation!=causation
There absolutely is investment, consider the rise of socially-motivated ETFs. You can buy an index in:
- green power ($ICLN)
- smallcap biotech ($PSCH) (admittedly this is also used for speculation)
- boardroom diversity ($SHE)
- LGBT workforce ($EQLT)There's no guarantee your investment will yield a reward but there's a better probability than gambling (let's just say better than 50/50 for that matter). An investment is putting money towards something that has a good probability of yielding a return, be it your education, renovating your house, a new car, shares in Coca Cola, or US government bonds.
"I would like you to imagine a national coin-flipping contest. Let’s assume we get 225 million Americans up tomorrow morning and we ask them all to wager a dollar. They go out in the morning at sunrise, and they all call the flip of a coin. If they call correctly, they win a dollar from those who called wrong. Each day the losers drop out, and on the subsequent day the stakes build as all previous winnings are put on the line. After ten flips on ten mornings, there will be approximately 220,000 people in the United States who have correctly called ten flips in a row. They each will have won a little over $1,000.
Now this group will probably start getting a little puffed up about this, human nature being what it is. 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.
Assuming that the winners are getting the appropriate rewards from the losers, in another ten days we will have 215 people who have successfully called their coin flips 20 times in a row and who, by this exercise, each have turned one dollar into a little over $1 million. $225 million would have been lost, $225 million would have been won.
By then, this group will really lose their heads. They will probably write books on “How I turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning.” Worse yet, they’ll probably start jetting around the country attending seminars on efficient coin-flipping and tackling skeptical professors with, “If it can’t be done, why are there 215 of us?”
By then some business school professor will probably be rude enough to bring up the fact that if 225 million orangutans had engaged in a similar exercise, the results would be much the same — 215 egotistical orangutans with 20 straight winning flips.
I would argue, however, that there are some important differences in the examples I am going to present. For one thing, if (a) you had taken 225 million orangutans distributed roughly as the U.S. population is; if (b) 215 winners were left after 20 days; and if (c) you found that 40 came from a particular zoo in Omaha, you would be pretty sure you were on to something. So you would probably go out and ask the zookeeper about what he’s feeding them, whether they had special exercises, what books they read, and who knows what else. That is, if you found any really extraordinary concentrations of success, you might want to see if you could identify concentrations of unusual characteristics that might be causal factors.
Scientific inquiry naturally follows such a pattern. If you were trying to analyze possible causes of a rare type of cancer — with, say, 1,500 cases a year in the United States — and you found that 400 of them occurred in some little mining town in Montana, you would get very interested in the water there, or the occupation of those afflicted, or other variables. You know it’s not random chance that 400 come from a small area. You would not necessarily know the causal factors, but you would know where to search.
I submit to you that there are ways of defining an origin other than geography. In addition to geographical origins, there can be what I call an intellectual origin. I think you will find that a disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddsville. A concentration of winners that simply cannot be explained by chance can be traced to this particular intellectual village."
[1] https://www8.gsb.columbia.edu/articles/columbia-business/sup...
That's true (or nearly true) of good HFT shops in general. The type of trading that HFTs do (market making, short term predictions) is generally less risky than long term investments. Also, the risk/reward of this trading is realized over minutes, not over weeks/years. So just as a hedge fund might have an unprofitable week but a good year, an HFT has a bad 20 minutes but over the whole day comes out on top.
For Renaissance, maybe they are truly smarter than the rest of the market or at least able to act on good trades before anyone else. I wouldn't discount foul play though.
So either RenTech is somehow consistently wildly smarter than the rest of the industry through some completely unknown secret, or something else is up. They might be using insider information, they might have a deal with someone news firms* to get news early, they might use illegal order execution techniques. There's a whole slew of things they might be doing to get an advantage. Maybe they use funds other than Medallion (the super good one) as a testbed for strategies and deploy the really good ones to their best fund. FWIW, I don't think funds started by anybody who left there are as successful so the secrets aren't leaving.
* A friend of mine in the hft industry told an interesting story to me. A high-speed news wire was very predictive of when orders relevant to the news would get run over - except backwards in time. The news was consistently a few minutes late. So either the high-speed news wire was laughably worse than the competition or somebody was getting news early through illicit means.
Do you happen to have a reference for this? This does not seem to match my personal observations, but I could be missing something.
Edit: If you want a high level overview, there's this article: https://origin-www.bloombergview.com/articles/2016-02-25/-fl...
Or just go find spread sizes in say 1990 or 1995, notice that they are far larger.
Edit 2: Also, HFTs can't see your orders before they hit the market, despite what everyone seems to think after reading flash boys. And the idea that HFTs mostly do latency arbitrage is flat out wrong as well.
Not true: https://www.sec.gov/news/pressrelease/2015-164.html
Also, this is a dark pool literally operated by an HFT - I'm referring to the lit market under SEC regulation. This pool isn't even available to retail traders, not to say that excuses frontrunning. Their punishment was fairly light as well, unfortunately.
Edit: It looks like ITG is a tech provider that illicitly used info from the dark pool to run a trading desk. If you look at their disclosures on prop trading, it seems their trading was minor and linked to their frontrunning operation. I think most if not all of the prop trading they do is shut down.
I've also edited my parent post to be more clear.
By "arbitrating broken market rules" I meant that these HFT firms are exploiting our dysfunctional market system at no risk to themselves (like Virtu's single-day loss in a 6 year period). They engage in things like quote stuffing which incidentally increases volatility, decreases liquidity and leads to higher trading costs.
For quote stuffing in particular the SEC investigated and decided to do nothing. The SEC is fully incompetent as the ITG and Citadel slap-on-the-wrist fines for outright illegal activity further demonstrate.
My point about HFT firms being frontrunning scams is basically true.
It's also grossly mis-titiled.
'Wealth' is mostly not generated by speculative investing.
And yes - most 'investing' is luck, but investors already know that.
But declare that some kid who worked his pants off through school, got into a half-decent Uni, and went on to get a high paying job - to his brother, who didn't do much in school, and took a job at their fathers auto-shop earning a respectable but relatively small salary - in terms of 'luck' is just unfair.
I'm nit saying talent per se is a signifixant factor, but this view suffers frim the sane nakady that a lot if wconomic theories do... an idealized situation/world where everyone plays by the rules. To some individuals, life is not a game, but a winner take all conflict and they will Kobayashi Maru the situation whille others are still playing a game of chance
Articles like this seem like a cop-out for failed investors, and perhaps an argument for using index funds. If it's all luck, then your own failings aren't your fault. But that view doesn't apply to most areas of life, including and perhaps especially when it comes to investing decisions.
> In 2006, Warren Buffett posed a challenge. He bet that the smartest hedge fund managers out there couldn't beat the world's simplest, most brainless investment. In this show, we tell you who's winning.
(index funds)