Fooled by Randomness

aazg-square-1536I recently finished reading “Fooled by Randomness” by Nassim Taleb – Taleb also wrote “The Black Swan” which is a must-read for anyone with an investment account.  “Fooled by Randomness” is focused on how humans have a difficult time acknowledging the random events that we experience in the financial markets, as well as in our everyday lives.  We are more inclined to believe in our abilities or lack thereof, than to simply acknowledge that a particular outcome was random.

For example: Taleb takes to task traders and money managers who believe that their ability is responsible for their great investment returns.  Let’s say a particular mutual fund manager “called the top” of the 2002 to 2007 bull market and took his fund to an “all cash” position right before the crash.  Taleb would argue that skill had very little to do with the call – the fund manager was lucky at best.  How do we know if that particular fund manager has an actual skill for calling market tops?  We need a much bigger sample size – say, out of 1000 market tops how many does she get right?  Unfortunately, no money manager will see 1000 or even ten market tops in his lifetime, so separating skill and randomness is very difficult.

The other takeaway for investors is Taleb’s discussion of “alternative histories”.  As an example, let’s take a look at Jim who takes his entire (fictional) retirement account and buys a penny stock trading for 10 cents.  Most people would agree that this is not a good idea.  However, this particular penny stock goes to 50 cents and Jim sells.  In this “reality” Jim has a 400% gain – a great return that may have taken him decades to achieve investing in a diversified portfolio.  However, there are a million “alternative histories” or possible outcomes that could have happened.  In very few outcomes, his investment would have made 400% or more.  In very many other outcomes his investment would have stayed at 10 cents for years or decades.  But the most probable outcome for this scenario is that Jim loses ALL of his retirement money over a given period of time.  Jim was rewarded by randomness, but that does not take away from the fact that Jim’s “investment” was a terrible idea and would have lost him his entire savings in a high percentage of scenarios.

The takeaway for investors is to position your portfolio in a way that you benefit in any number of “alternative futures”.  Think about diversification.  We diversify across countries and asset classes because we do not know where the best performing stock markets will be.  By diversifying, we are positioning ourselves to benefit from a high percentage of the “alternative futures” that await our portfolio.  Having all of our eggs in one basket CAN work out in our favor due to randomness, but this is still not a good investment decision due to the large amount of “alternative histories” where it does not work out.  Be wary of advisors making decisions with your money that depend on a narrow set of outcomes (rising US interest rates, higher global inflation, etc…) – what happens to your portfolio when that particular outcome does not come to pass?

Charles Brown is a Portfolio Manager and Financial Advisor at M.Brown and Associates in Naperville, Illinois.

***The above article is informational in nature only and is not a recommendation to buy or sell securities.  All information is gathered from sources believed to be reliable, but neither Charles Brown nor Ausdal Financial Partners, Inc guarantees the accuracy of the information.  All investments carry a degree of risk.  Individuals should consult with their tax and investment professionals before making changes to their investment portfolios.