It is human nature to see order where there is none and to see patterns that do not exist. The reason, it is argued, is that early man would use pattern recognition to see a lion behind trees and thus attempt escape. It was much more important to be wrong sometimes than not see the pattern at all.

Similarly, we have tendency to ascribe skill rather than luck to desired outcomes. Read more on skill vs luck here and on human optimism here.

There are two excellent books (by Nassim Nicholas Taleb and Leonard Mlodinow – details below) on how we are influenced by randomness. Most outcomes in life are the result of many preceding random events. But after the outcome has occurred man typically, and irrationally, shows how the event could have been predicted.

Investment is one particular area of endeavour where randomness or luck are commonly confused with skill and ability. And of course fund managers and the like are remunerated on performance.

Leonard Mlodinow has an excellent example. He plots the performance of 800 funds over a five year period. He then ranks the fund managers by over or under performance compared to the mean performance.

Mlodinow then takes the performance of the same 800 funds over the next five year period and compares it to the first period. The result is random noise. For example the top fund manager in the first period was ranked 360th in the second period. The second in the first was 700th in the second period.

One fund manager has to be the best, but it is random as to whom. Similarly, one fund manager will be the best over a 10 or 20 year period, because someone has to be.

There are many ‘self-help’ books that purport to know something like “The Ten Habits of Successful People”. These authors are of course describing the outcome after it has occurred. Being well-dressed and hardworking, for example, are common to both rich and poor people. They are not required traits for richness. Nonetheless, hard work and skill are likely to take you further after a lucky break than indolence  and incompetence.

Not only does the human brain see order in randomness, it also has a poor grasp of probability and statistics. Leading to the popularity of casinos, among other things. And the birthday problem.

There are variations on this problem, but all with the same result. Imagine that there are 30 people on a room, what are the odds that two people share a birthday. Most people say 30 people, 365 days in the year, 30/365 sounds good. That equals a 0.08% chance of two people sharing a birthday.

In fact the correct answer is a 78% chance. This is because each person in the room must be compared with every other person. That results in 345 pairs to be compared.

Anyway, there is much more to randomness and probability that I have covered here.  I highly recommend you buy and read both books.

Conclusion

Randomness is an issue that the investor must be across. You need to find something that will help improve the odds in you favour. For instance, an improved understanding of the macro economic environment can help improve trading results.

Another possibility is to look for an “in favour” sector. Recently lithium juniors have been all the rage. PLS was the first mover, now with a market cap of AUD270M. This has floated the other boats in the sector such as NMT, GXY, LIT and AJM.

There are also some guidelines that can help combat market randomness. Such as cutting losses early. Don’t average down or turn the trade into a “long term investment”.

 

The Drunkard’s Walk: How Randomness Rules Our Lives
By Leonard Mlodinow
Vintage Books, 2009
Buy it here

Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets
By Nassim Nicholas Taleb
Random House, 2005
Buy it here

14 October 2015 Markets