Saturday, March 24, 2007

Just A Lucky Coin Flipper?

While surfing the net the other day, continuing my never-ending search for the Pot of Gold at the end of the rainbow - I came across a book review that peaked my interest. It reminded me of many other books I have read. You see, I seldom pass by any promising rocks without at least giving them a quick flip over to see if "the secret" to getting rich might lie beneath.

Many of the books I have read over the years fall into a category of "How To Get Rich Quick". The titles of these books frequently include powerful, emotional triggering, advertising words or phrases such as:

You, Money, Rich, Riches, Easy, Easy Way, Money, More Money, Quick, Secret, Secrets, Good Luck, How To, How I , Teach, Grow, Best, Freedom, Reward, Powerful, Super, and so on.

Did you feel anything when you read them? Words like these have power over us. They tug at our greed, at our desire to be better off, or our desire to escape from some unpleasant situation.
The stock market has been called a "zero sum game". This is a short way of saying that if one person wins $1,000 someone else must lose $1,000 so the balance is $0 with nothing left over. People try all kinds of strategies to "forecast the future" and thereby beat the market. The goal being to be the one making the $1,000 in the zero sum game. This post is about an interesting aspect of the stock market, some might even refer to it as "an inconvenient truth".

The point is that anyone might make a large amount of money in the market simply by random chance if one just happens to be in the right place at the right time. It gets more interesting if the lucky one happens to strike it rich while he/she was trying to beat the market with a special system, a different philosophy, or some new kind of method that in reality has no forecasting value whatsoever.

Here is an example. A couple inherited $50,000 back in late 2002. Let's say the husband, having studied things at length, applied some sort of prediction method. But, for the sake of this example, let us say that his system was totally worthless. His system convinced him to invest the entire $50,000 in the Canadian Stock Market in January 2003. It was invested in an index mutual fund, one that tracked the S&P TSX Composite Index (see graph).

Three years later, their marriage on the rocks, the couple divorced and the divorce settlement split all of their wealth 50/50. The mutual fund was sold in January of 2006. The $50,000 had doubled to $100,000 over only three years because the index had risen from 6,000 to 12,000. Each of them walked away with $50,000 after only three years. Not bad!

In this case, the husband, believing that he had really found "the secret" to beat the market then wrote a best selling book. The title of the book might have been "My Secret: How I Doubled My Money In The Stock Market In Only Three Years". Now that's a title I would at least pick up for a quick peak if I was browsing the investment shelf in Chapter's.

The long term stock market rate is about 7 percent per year. Money normally takes 10 years to double. In this example, the money doubled in only 3 years. A strong bull period following a down turn is the normal course of events. The challenge is knowing when the down turn has ended. But I'm getting off topic.

By random chance the money became available for investment at that point in time due to the inheritance and the divorce timing took it out of the market. Had the timing been different the story could have been very different.

If the $50,000 had been invested in late 2000 and cashed in late 2002, instead of doubling it would have decreased to about $30,000 because the index declined from 10,000 down to 6,000.

Whenever I see one of these books I always wonder "Was the author just one of the survivors?"
Experts talk about a phenomenon called "survivor ship bias". To one unaware of this phenomenon, a lucky winner might appear to be a genius. Even the lucky winner might be fooled by his own random chance success.

A "coin flipping contest" can be used to illustrate how survivor ship bias works.

The long term odds of coming up with a "heads' by flipping a coin is 50 percent. However, if you sit there and flip a coin enough times you will get runs of heads and tails of various durations. In the imaginary coin flipping contest, 1000 people flip and 500 end up with heads. On the second round of coin flipping about 250 come up with "heads" and survive to stay in the contest. And so it goes 250, 125, 62, 31, until only one person is left. Now to someone who doesn't appreciate the odds (probability) of coin flipping, the winner of the coin flipping contest may look like a genius. The winner might even write a book about how to control the flip.

Even if some day I am wildly successful in the stock market I will always wonder...Was it my skill and knowledge, or was I just a lucky coin flipper?


Mike said...

Wow, great post.

This certainly brings to mind at least one "retire early" book I've read that might have benefitted from the recent Cdn bull market.

the money diva said...

Love this post, CM!

I have heard it said that no one's life is long enough to be "the long run" in probability terms, so it is actually possible to be "lucky" or "unlucky" your whole life without things balancing out. Just hoping I end up on the right side of the coin toss!

S. B. said...

This brings to mind a startling article I read a few years ago.

An unscrupulous broker would take about 1,000 highly volatile stocks and then randomly split them into 200 groups of 5 stocks each. The broker would then spam a whole bunch of potential clients with each of the 5-stock lists. (Each individual only got one 5-stock list.) Then the broker would wait one month.

Invariably, at least a couple of the 200 lists would produce some big gains, even if the entire group of 1,000 stocks was unimpressive or even really bad. Then the broker would ONLY follow up with the people who happened to receive one of the lists that did well. To those people, the broker came across like a genius -- I picked 5 stocks for you a month ago and now they are up an average of 50% in just one month! Trust me with all your money because I obviously know what I am doing!

Most people never suspected that the big gains they saw were merely a carefully chosen slice of the pie after the fact, and that their list was just the lucky one in the random sample. Nonetheless, because they saw the list BEFORE the stocks went up and did not know and see all the others that went down, they tended to believe the broker was an investment sage.

That article really made me think...