Fooled By Randomness

If you have lost a lot of money in the current economic downturn, it is likely because your money was under the direction of superstars such as Bill Miller at Legg Mason. He had a 15 year unbroken winning streak, and this year lost it all. How come?

Nassim Nicholas Taleb has written a book, FOOLED BY RANDOMNESS, that explains among other things, something called "survivorship bias." Taleb is a probability theorist and investment adviser, an unusual combination.

Miller says "Every decision to buy anything has been wrong" Not quite. The word "decision" is really going too far in describing what is just a guess. When so many factors impact the world we live in every decision is just a guess. Miller is not smart or gifted, just lucky. Because his guesses turned out to be right for 15 years straight, Miller is fooled into thinking he is brilliant. So do very many other people, who then begin to turn their savings over to Miller. His fund gets huge, and he ups his fees. Very many people are fooled by his random success, and when the conditions that reward his particular thought processes change, he fails. Spectacularly. A Baltimore city pension fired him from managing their $2.2 billion fund.

Survivorship bias is no secret. Taleb explains how it is a fundamental process to selling Wall Street advice to the public. Did you turn your assets over to a manager based on his investment track record? (If you do not have direct control over your Retirement Account, then be sure the managers of that fund certainly did).

How does Legg Mason and Merrill Lynch and Fidelity recruit such superstar investment advisors? Each starts as a nobody, but each will cold call people and offer free predictions. Say the new hire contacts 1000 people and makes a prediction to half that the market will go up, and to the other half he predicts the market will go down.

In a month the newbie will call the 500 to whom he made an accurate prediction (say the market went up) and tell them 250 of them the market will go up again, and 250 of them the market will go down. In a month, he will yield 250 names of people to who he made accurate predictions on the market. Next month he calls those 250 people, and advises 125 the market will go down, and advises another 125 the market will go up. Say the market goes down, then he has 125 people for who he has been consistently right. In four months the fellow has a following of some 62 people for whom he is always right. Maybe 5 turn their portfolios over to him. Keep in mind he starts the process with a new group every month, so in a year he has dozens of clients.

Did you choose your investment advisor on this basis? The alternative is your investment advisor is simply lucky-for-a-while, like Bill Miller.

Now the reason I have not lost money in this market is because I read Taleb's book (and I handle my own retirement accounts, etc.)

The trick is not to find out who has been right, but to follow the arguments of people who are doing well today, and test their arguments. As I have mentioned, between Mish Shedlock, James Grant, Dr. Gary North, Jim Rogers, and Frank Shostak you can vector in on arguments that can guide you in these turbulent times. None of these people are mainstream of course.

The problem again is concentrating too much power in too few hands. Why do workers agree to pour their retirement savings into such huge pools that relatively few people manage? Even if these managers can avoid being scammed, they cannot avoid being fooled by randomness, at which people very many people suffer for the bad guesses of just a few.

We are all safer if we all do our own investing. In Ecclesiastes King Solomon advises to divide your investments into seven, even eight portions for you have no idea what will happen. Most people have all of their retirement savings in the market, indeed the rules rather force this.

What if we were all free to invest our savings as we thought best?

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