Friday, August 24, 2012

An article on the investment industry

Nicholas Taleb, of "Black Swan" fame, reminds us why "Why It is No Longer a Good Idea to Be in The Investment Industry" with his new paper.

In the paper, he puts forward the following "econophysics" equation:

Explains it all doesn't it....if you are a rocket scientist! To me, it's half mumbo and half jumbo. Fortunately, the hieroglyphics are accompanied by normal words. The message is not ground breaking but it is a powerful reminder of the nature of the investment industry:

The “spurious tail” is ... the number of persons who rise to the top for no reasons other than mere luck, with subsequent rationalizations, analyses, explanations, and attributions.  

The performance in the “spurious tail” is only a matter of number of participants, the base population of those who tried. Assuming a symmetric market, if  one has for base population 1 million persons with zero skills and ability to predict starting Year 1, there should be 500K spurious winners Year 2, 250K Year 3, 125K Year 4, etc. One can easily see that the size of the winning population in, say, Year 10 depends on the size of the base population Year 1; doubling the initial population would double the straight winners. Injecting skills in the form of better-than-random abilities to predict does not change the story by much. Because of scalability, the top, say 300, managers get the bulk of the allocations, with the lion’s share going to the top 30.  So it is obvious that the winner-take-all  effect  causes distortion.

"This is quite paradoxical as we are accustomed to the opposite effect, namely that a large increases in sample size reduces the effect of sampling error; here the narrowness of M (fund manager) puts sampling error on steroids."

"To conclude, if you are starting a career, move away from investment management and performance related lotteries as you will be competing with a swelling future spurious tail.  Pick a less commoditized business or a niche where there is a small number of direct competitors. Or, if you stay in trading, become a market-maker."

My interpretation is that it's a difficult gig raising funds even if you are a skilled investor simply because you are drowned out by the random outperformers who take the lion's share of the capital. The problem gets worse as the population of fund managers grows simply because the outperforming noise gets even louder. It's almost inescapable.

My spanner, or supplementing thought, to Taleb's paper and conclusion is that even if you are ready and willing to pitch up against the spurious tail and make a living as an honest fund manager, it is unlikely that you will ever truly know whether you are a genuinely skilled enough to beat the market or whether you are part of the spurious tail. Better just to get a real job and speculate a bit on the side with one's own money, me thinks (why pay 2 and 20 to some other fool when I can be fool enough with my own money with no such vig).

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