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NASSIM NICHOLAS TALEB has written a trilogy on the topic of chance: Fooled by Randomness, The Black Swan and Antifragile. I didn’t find these three books to be easy reading, plus Taleb has strong opinions, which may turn off some readers. Still, there’s a host of investment lessons to be culled from his works.
Taleb argues that randomness plays a powerful role in financial markets and, indeed, it influences market outcomes far more than most of us realize. One result: We’re often “fooled by randomness.”
According to Taleb, most active managers who beat the market over a few years are simply lucky—which may explain why persistent outperformance is so rare. He labels those who ascribe their market-beating results to skill as “lucky fools” since, more often than not, randomness—better known as luck—is the probable reason for their success.
Consider this thought experiment: You ask 10 people to flip a coin 10 times. It’s unlikely any one of them will flip, say, eight heads in a row. But if you ask 10,000 people, it’s highly likely that several will achieve this feat. With a large sample size, you should expect there to be several “successful” coin flippers. Such is the nature of randomness. Long streaks of positive and negative events do occur, even though they seem improbable to us.
Globally, there are many thousands of individuals, money managers and institutions investing in stocks. Based on randomness alone, there’ll be some managers with market-beating results in any given period. But you can’t conclude that skill explains this short-term outperformance. Instead, most managers likely beat the market because they were lucky—and luck isn’t a “strategy” we should expect to persist.
It’s common for investors to favor an actively managed fund if it boasts market-beating three-, five- or 10-year performance. Such results seem to demonstrate that the manager is skilled at picking investments and investors assume this outperformance will continue. But rather than skill, we could be looking at the record of a manager who’s simply been lucky.
Bill Miller of Legg Mason Capital Management’s Value Trust beat the S&P 500 for 15 consecutive years and then flamed out. Was he skilled or lucky? It’s worth remembering that with enough investors picking U.S. stocks, even a 15-year market-beating record may be explained by randomness.
Does this mean there’s no one skilled at stock investing? No. Successful investors like Warren Buffett come to mind. But it takes many years to conclude that an investor is truly skilled. Buffett’s investment record spans decades, so we can be confident that his long-term performance isn’t solely due to luck. Still, he didn’t consistently pick winning stocks throughout his career. No one bats a thousand.
You might opt to buy an actively managed fund to get exposure to a specific asset class if its fees are reasonable and there’s no index-fund alternative available. In doing so, it’s understandable if you take into account the fund’s track record. Just be sure you aren’t considering the fund solely because it performed well recently.
While it’s easy to be a buy-and-hold investor with index funds, you have to keep tabs on actively managed funds to make sure you don’t get stuck with sub-par performance. And if you decide to jettison a poor-performing active fund, what then? Do you go back to square one and pick another actively managed fund with a good record?
The lesson: We can’t be sure that a three-, five- or 10-year record of beating the market means we’ve found a manager who’ll continue to produce superior returns. A manager specializing in, say, small-cap stocks may generate market-beating returns when small-cap stocks are in vogue. But should market sentiment shift to another class of stocks, those market-beating returns will likely evaporate. Such shifts in sentiment seemingly occur at random and are hard to predict.
Occasionally, due to social, cultural or demographic trends, one sector of the economy will outperform the broad market for an extended period. One example is the aging of the U.S. population and the outperformance of health care stocks. Does investing in a growing sector of the economy represent skill? Perhaps—if, say, you invested when those stocks were underperforming and later recognized that those same stocks had become overvalued, prompting you to sell the shares near their peak.
I’d be less inclined to consider it skill if you jumped on the bandwagon after the trend had become apparent. The problem: You may not know when the party is over—and your gains could quickly slip away.
“But wait,” some say. “I’ve picked individual stocks most of my life and I’ve beaten the market. Doesn’t that mean I have stock-picking skills?” Perhaps. But often, people who claim outperformance are focusing exclusively on their winning investments. They may conveniently forget about their stock picks that underperformed and were sold at a loss. Without knowing the degree to which your successful picks outnumbered your unsuccessful ones, and over what time frame, it would be hard to conclude that you have investment skill.
The notion that luck plays a greater role than skill in stock investing bolsters the argument for index-fund investing and broad diversification. The global economy is so dynamic, so subject to geopolitical, cultural, social and natural forces, that prudence dictates we spread our investment bets widely—and not depend too heavily on the stock-picking skills of others.
Be passive, stay diversified, keep costs down, rebalance periodically and stay the course over the long term. That’s how small investors can earn returns that beat many professionals.
Philip Stein, currently retired, was a public health microbiologist and later a computer programmer in the aerospace industry. He maintains that he’s worked with bugs, in one form or another, his entire career. Phil and his wife Jeanne live in Las Vegas. His previous article was Saved by Compounding.
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Thank you, Philip, for your thoughtful comments.
By BENellist
Phillip Stein’s article on Taleb’s books on chance has shaken up my thinking. I withdrew funds on retirement which, invested, then tripled in value over 18 years. But they lost value substantially beginning in 2022 and have only slightly recovered. As Stein points out, I may have been “fooled by randomness” into thinking that my funds were invested well.
I don’t follow the markets and don’t know if my recent returns are subpar or not. But Stein, along with many other Humble Dollar writers, might suggest that having only 1/3 of the portfolio in index funds is a major factor in poor performance. (Yet my indexed 1/3 has performed as poorly as my 2/3 non-indexed portfolio).
However the specter of random performance having controlled both my successful and unsuccessful years concerns me greatly.
Stein says, “you have to keep tabs on actively managed funds to be sure you aren’t getting subpar results.” Of course, but does keeping track necessarily mean tracking and comparing indices to the portfolio? How frequently? And what keeps the indices from performing extra well or extra poorly? If Taleb offers a methodology, in which book?
In short, the article produces more questions that deserve discussion.
Beth, the quote “fooled by randomness” is meant to convey the idea that if you’re fortunate to own an actively-managed fund that has performed well over the last few years, you can’t assume that the outperformance will inevitably continue. That doesn’t mean that your investment was a poor choice. It just means that with a three- to five-year record, you can’t really be certain that your manager is skillful.
In a bad market year like 2022, its to be expected that both actively-managed and index stock funds will perform badly, so that’s no reflection on your non-indexed funds.
Keeping tabs on actively-managed funds doesn’t need to be a frequent exercise. It may mean monitoring your funds see if there have been manager changes or if your manager’s investment style has shifted suddenly.
You can compare the return of your non-indexed stock portfolio with the return of, say, Vanguard’s S&P 500 index fund or Vanguard’s Total US Stock Market fund to get a feeling for how the non-indexed portion of your portfolio is doing compared with the market as a whole. You may find that your actively-managed funds are doing just fine.
Indices don’t perform extra well or extra poorly. They track the performance of the market and its the market that performs well or poorly.
Taleb offers no methodology for tracking fund performance that I’m aware of.
I hope this addresses some of your concerns.
Even Buffett knows he can no longer beat the mkt and has not done recently
He told his wife to put 90% in S&P 500
most investors are financially illiterate but its starting to be taught in high schools
If you believe Taleb was writing about “Luck”, you may have missed about 95% of what he was saying.
Your example of flipping 10 coins and getting 8 heads in a row is a perfect example of what he was not talking about. Out of 10,000 flippers, you can closely approximate how many will achieve 8 heads in a row. In the stock market, like many other complex systems, they are far too chaotic, and many events far too rare, to even begin to calculate the odds.
But even that isn’t the important part. The important part are the consequences. What is the upside potential and what is the downside? Hence Taleb’s stories about traders that lost more in a week than their bank made in its entire history. The point was, they had no idea what they were doing was insanely risky. Because they couldn’t calculate the risk. But that risk isn’t just the odds, but also the cost if you’re wrong.
COVID-19 is a modern example. If things work out, they may save millions of people. If they don’t, they may kill millions of people. Seems like not the best place for “lowest bidder”…
Steven, the coin flipping example was meant to illustrate that favorable results in the stock market can often be attributable to randomness rather than investing skill. It wasn’t meant to imply that you can calculate the odds of making a successful stock investment.
Taleb himself uses the term “lucky fools” for those who attribute their winning stock investments to skill when randomness was more likely the reason for their good fortune.
The traders losing huge sums were often those who previously enjoyed a long string of successes. They earned huge bonuses and lived lavishly. The few setbacks they encountered previously were relatively minor. They may have felt that they had the skill to navigate the market and avoid huge losses. If they attempted to determine the odds of failure, they didn’t seem to appreciate that Donald Rumsfeld’s “unknown unknowns” lurked in the shadows.
You’re right. Focusing mainly on the upside without sufficient concern for the downside can lead to ruin. Those who blew-up and lost their jobs were likely those who didn’t appreciate the degree to which randomness contributed to their prior success and which ultimately contributed to their downfall.
It’s obvious that luck plays a big part in investing success or failure, just as it has a role in so many of life’s endeavors. Luck in finding the right partner, luck in being hired by a great company or boss, luck in having your children stay alive and thrive in a dangerous world.
This being said, an investor can improve his /her odds by exploiting certain anomalies in the markets. The one that has worked for me is the “stock split advantage”. By maintaining a portfolio of 30 companies bought shortly after a stock split announcement I have achieved an annualized market beating return of +/-11.5% over the last almost 27 years. It can be done.
Neil Macneale III, while you seem like a trustworthy guy, can you provide even the most basic documentation that backs up your claim? Just throw me a bone man. . . anything. Also what does +/-11.5% mean?
See my reply to Philip Stein below
Neil Macneale III, the two Ikenberry studies that I found were published in 1996 and 2003 . . . which I would have found far more interesting (and useful) if it was . . . 1996 or 2003. I did find a 2019 study though that stated “Using the standard risk adjusted event study
methodology, it is apparent that investors are unable to gain an above average return by reacting to a forward or reverse stock split announcement.”
(https://articlegateway.com/index.php/JABE/article/view/2264/2152)
I did review the CSV file on your website, but it is just rows of dates and numbers, which didn’t help me understand if or why stock splits offer above-average returns.
Neil, I congratulate you on enjoying market-beating returns by exploiting the “stock split advantage.”
But as this anomaly becomes more widely known, won’t more investors attempting to exploit it result in the advantage eventually being arbitraged away?
Philip, I agree that market beating “systems” usually lose their advantage as they become known and widely followed. The interesting thing I’ve learned over 27 years, is that both retail investors and “experts” poo-poo the idea that stock splits are a meaningful signal of outperformance. However, academic studies (look up David Ikenberry) and my own track record (see 2-for-1.com) prove otherwise. Even the Stock Split Index Fund following my Index (TOFR – NYSE 2014 through 2017), sponsored by USCF found it hard to attract investors because folks thought it was just a gimmick. My point is that the market is not always a perfect “random walk” and the anomalies can be exploited.
I have read most of Taleb’s books, and while I don’t agree with all his opinions, I have learned from him. The debate between investing in low cost index funds versus trying to beat the market by picking stocks yourself and investing in actively managed funds will never end. Some advocates of the latter approach deride those who favor the former as “settling for average”. Notice they don’t define “average” in this particular context, and let the reader incorrectly infer that “settling for average” means their investment performance will be average compared with all investors. This sounds like a sales pitch. Settling for market averages by investing in index funds has historically produced better investment returns than those received by most active investors.
This means that even those who lack any business expertise or stock picking skills, like me, can easily outperform most actively managed funds long term.
Most are aware that Buffett’s answer to those who asked for investment advice was to invest in an index based on the S&P 500. When asked why most neglected to follow this advice, he reportedly said “Most people don’t wish to get rich slowly”. I never read where he advised anyone to invest in his company. I started reading his annual letters and began investing in Berkshire a long time ago, when typical brokers warned it was “overpriced”. I did not start nearly as early as many of my fellow Omahans did, but I am satisfied and grateful.
I have no idea which company will be “The Next Berkshire”, if any. But I do think young people working and investing today cannot go wrong with following the man’s advice. Settling for long term stock market averages will likely mean outperforming 85% or more of actively managed investments over the long haul. For other amateur investors like myself, it’s competing with that upper 15% (some say 10%) that may likely introduce significant risks.
I think you wrote a useful article Philip.
Jack, I’ve never considered index returns as average, but analogous to shooting par in golf. I’m not a golfer, but I’ve heard that shooting par is difficult. Likewise, the fact that many managers fail to match their benchmarks in any given year, i.e., fail to shoot par, tells me that the index return is above average. I agree with you that the term “settling for average” is not an appropriate way to describe index investing.
I feel that your successful investment in Berkshire Hathaway stock is the exception that proves the rule. You invested alongside a man with a long track record that demonstrates investment skill. We certainly can’t attribute Warren Buffet’s success to luck.
I’m glad you found the article useful.
Many money managers become victims of their success. They may be good at investing $100M or $500M but if they are successful for a few years, a lot of new money will flow in. They discover managing $1B or $10B is much harder and they flame out. Of course, they could have closed the fund once it got to a certain level, but few do that.
Thanks for confirming that my money is mostly in the right place – Vanguard index funds. One item you didn’t really mention was fees – Vanguard tells me I’m paying 0.10% a year. Also, I once briefly belonged to an investment club (for social reasons) and I found the necessary research extremely boring.
Is it safe to assume that you might have stayed with the club longer if that boring research led to market-beating investments?
I doubt it. I hope I would have thought it unlikely that the market beating would continue.
It’s so tempting to claim credit when things are going our way. We humans like to imagine we have more control than we actually do. Your article is a good reminder to stay humble.
I’ve always preferred humility to hubris. I guess it’s my nature to favor the tortoise (passive investors) over the hare (active investors).