Fooled by Randomness

William Bernstein, co-founder of Efficient Frontier Advisors and author of several books, was interviewed in the September 2016 issue of the AAII Journal. He made an interesting point that reminded me of Nassim Taleb’s book Fooled by Randomness:

     > …never confuse outcome with process. By that
     > I mean that there is a lot of noise in investing,
     > and it is perfectly possible to have a bad
     > strategy or be a stupid investor… and do very
     > well. People who buy lottery tickets occasionally
     > win. Having a good strategy and not having a good
     > result happens all too frequently as well. The
     > essential thing people really don’t understand
     > about finance is that there is an enormous
     > amount of noise, particularly over the short term.

The take-home message for me is the first line: never confuse outcome with process. The stock market goes up most of the time. It may even go up for years. When it corrects, large sums of money can be lost in short periods of time. One must be careful not to lose all that has been gained or more.

While the market is going up, people are happy with their strategies and impressed with themselves. Many think they have skills and have attained a level of expertise. Remember the old saying “a rising tide lifts all boats,” though, which suggests most stocks rally when the market moves higher. Anyone participating during these bull market periods is likely to make money regardless of strategy. Ego can really come into play when people dramatically increase position size. This inconveniently happens all too often just in time for the next market correction or crash.

Trading system development methodology is designed to determine whether a profitable system is attributable to an effective strategy or simply a matter of luck. The process is designed to screen out the luck factor by studying large sample sizes, maximum drawdowns, employing Monte Carlo simulation, and walk-forward analysis. This is challenging work because it requires coding skills and software know-how in addition to theoretical understanding.

The cost of mistaking random luck for skill worthy of confidence is an increased likelihood of catastrophic loss when the next bear market rears its ugly head: something none of us look forward to.