Invest in a monkey, anyone?

If one puts an infinite number of monkeys in front of typewriters, and lets them clap away, there is a certainty that one of them would come out with an exact version of the Iliad… Now that we have found that hero among monkeys, would any reader invest his life’s savings on a bet that the monkey would write the Odyssey next?- Nassim Nicholas Taleb

I read this post about how intelligence and wealth do not go hand in hand. golbguru says that having high IQ does not necessarily mean that you are better at managing your finances and staying out of debt.

I was reminded of Nassim Nicholas Taleb’s thinking about randomness, in which he gives an example of how people can appear to be, and believe that they are good at running funds, although the same results are possible just by luck.

Tossing a coin is an example of something random and based on luck. In any given coin toss, there is a 50% chance of getting heads, and a 50% chance of getting tails. Taleb ran a simulation based on such coin tosses. He took 10,000 investment managers, and gave them a 50% chance of making money and a 50% chance of losing money in any given year. He also added the condition that if they lost money in any single year, they are out of the game.

This is a totally fair game, and based entirely on coin flips. No skill is required on the investment manager’s part. And after 5 consecutive years, there are still 313 managers left. What happens, however, is that everyone gets bowled over by the amazing track record, and start investigating his strategies and what he does. And some may give him all their life savings.

Taleb went on to model a bunch of incompetent managers, giving them a 45% chance of making money, and a 55% chance of losing money. The result: 184 incompetent managers having positive track records for 5 consecutive years.

What Taleb did showed that it is possible for someone to have high (or low) IQ, be a poor fund manager and still have a great track record just by luck. He isn’t saying that skill is totally irrelevant of course, but he warns us of the possible dangers of believing in a method just because the manager has a good track record. Anyone can buy or sell. You have to know how much randomness there is in the system, and the sample size involved at the beginning, not just the survivors.

Its much more logical to put your life savings on the monkey who wrote the Iliad if there were only 5 monkeys to begin with, instead of the investment manager who made record returns out of the tens of thousands out there.