Much of what we believe is not based on direct evidence, but on what other people say. We believe it because somebody else said it, and we trust him. This works fine most of the times. But is also fraught with unnoticed danger. You realize it, for example, when you read a newspaper article about something you know well. Every so often what you read is imprecise, misleading, if not downright wrong. You shake your head, but keep reading, somehow forgetting that the rest of the paper may also contain the same kind of deficiencies. Michael Crichton talked about this in a speech entitled Why Speculate. He called it the “Murray Gell-Mann Amnesia Effect”, after the US physicist who first pointed it out.
The effect becomes particularly treacherous when it occurs in books, especially those that are otherwise interesting, well researched and well written. I wrote about Daniel Kahneman. The same thing happens in a book written a few years ago by the physicist Leonard Mlodinow, entitled The Drunkard’s Walk. How Randomness Rules Our Lives.
I was really enjoying the book, when all of a sudden I read:
Academics and writers have devoted much effort to studying patterns of random success in the financial markets. There is much evidence, for instance, that the performance of stocks is random – or so close to being random that in the absence of insider information and in the presence of a cost to make trades or manage your portfolio, you can’t profit from any deviations from randomness. (p. 175)
Burton Malkiel’s canonical reference follows, as well as the usual references to the average mutual fund performance, the Super Bowl effect and the Hot Hand Fallacy. But then Mlodinow moves on to Bill Miller and his 15-year S&P 500 beating streak, and puts it in the context of another well trodden example: if you ask 1000 people to toss a coin, the probability that one of them will toss 15 heads in a row is 1/215 i.e. 1 in 32,768. Hence the probability that any of 1000 people will do that is 1/32,768×1000, which is a less than exceptional 3%. Moreover:
I calculated the odds that by chance some manager in the last four decades would beat the market each year for some fifteen-year period. That latitude increases the odds again, to almost 3 out of 4. (p. 181)
He doesn’t say how he calculated this. Dulcis in fundo, a quote from Merton Miller (no relation to Bill!):
If there are 10,000 people looking at the stocks and trying to pick winners, one in 10,000 is going to score, by chance alone, and that’s all that’s going on. It’s a game, it’s a chance operation, and people think they are doing something purposeful but they are really not. (p. 182)
Amazing. The line of reasoning is similar to Kahneman’s: 1) Markets are efficient, as all educated people know. Therefore 2) It is impossible to beat the market. Therefore 3) If somebody did manage to beat the market, he must have been blessed by a random stroke of luck.
There is a lot of evidence that markets are not efficient, as educated people would know if they had taken the trouble to read less out-of-date academic literature.
Therefore it is not impossible (though it is difficult) to beat the market, as proven by the long term track record of many successful investors.
Luck helps, but to regard long term successful investors as just a bunch of lucky bastards is plain silly and a sign of typical academic conceit, with more than a touch of spite.
Consider that the book came out in 2008, when Bill Miller was less than half way through his troubles. A couple of years later Mlodinow would have simply gloated in the spectacle of Lady Luck slamming Miller back onto his fatally mediocre path. But Miller’s problems had nothing to do with destiny. To think otherwise is an ex post rationalization, typical of the many instances of fallacious interpretations of randomness that Mlodinow so effectively exposes in his otherwise excellent text.
Upon turning the last page one is left with the good feeling of having read an interesting and instructive book. Still, the bitter taste of the Gell-Mann effect lingers on: were there other slip-ups in areas that I am not so familiar with?