One More Random Shot
May 22nd, 2009 by jeffbrodyWarning: constant() [function.constant]: Couldn't find constant TT_TH8US_LEN in /home/psblogs/public_html/wp-content/plugins/tweet-this/tweet-this.php on line 1821
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I’m now finishing up “The Drunkard’s Walk: How Randomness Rules Our Lives” by Leonard Mlodinow.
One of the most interesting things about the book is not it’s
discussion of how random some things are, but it’s discussion of
how we as humans want to insist that there are patterns in random
occurrences. That often leads us to falsely believe that random
events are actually things we control.
He uses a great
example from the world of finance and mutual funds.
Wall Street, he notes, is always crowning “superstars” who in turn are interviewed by every financial publication and asked to recommend the best stock buys. Studies routinely find that if you actually were to invest in the stocks these gurus pick, you would often lag far behind the return of the market index. Let’s look at one example, though, of how randomness is seen as a pattern of successful stock picking by a mutual fund manager.
Bill Miller, the manager of the Legg Mason Value Trust Fund, was named the “greatest money manager of the 1990s” by Money magazine, “Fund Manager of the Decade” by Morningstar and was listed as one of the 30 most influential people in investing in 2001, 2003, 2004, 2005 and 2006 by SmartMoney magazine (I’m not sure what his problem was in 2002). Why? Because for 15 years in a row, the performance of his mutual fund beat the Standard &Poors 500 index. One analyst was quoted as putting the odds of having a 14-year streak besting the S&P 500 purely by chance as 372,529 to 1.
Actually, that analyst must have flunked his statistics course. Here’s why.
It’s correct that if you were to ask what the chances were, at the beginning of his streak, that Bill Miller would best the S&P 500 for 15 consecutive years, the odds against that happening by chance might indeed have been 372,529 to 1. But that’s not what really happened. What really happened is that there are more than 6,000 fund managers, and there are many different sets of 15-year periods where one of them could have beaten the S&P 500. As Mlodinow writes, “So the relevant question is, if thousands of people are tossing coins once a year and have been doing so for decades, what are the chances that one of them, for some period of 15 years or longer, will toss all heads?” In fact, that probability is far, far higher than the chance of a particular individual tossing 15 heads in a row.
Given the number of funds being managed, the odds are almost three in four, 75 percent likely, that one of them would have a 15-year winning streak against the S&P 500.
“So rather than being surprised by Miller’s streak [and I would add, casting accolades as if he were a stock picking god]” Mlodinow concludes, “I would say that if no one had achieved a streak like Miller’s, you could have legitimately complained that all those highly paid managers were performing worse than they would have by blind chance!”
It’s human nature to see patterns where randomness exists. It’s also in our nature to want to believe we control things when events are being dictated instead by pure chance. That tends to skew our perception in ways that can get us in trouble.
Interesting book. I recommend it.
Scripps Interactive Newspapers Group
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