In the past, mathematicians coined the phrase “Monkey Typing Shakespeare”, which meant that in the long run, everything will happen. Even if you put a monkey and let it type whatever he wants, eventually, all the greatest novels would be written by that monkey. Not only the greatest novels, even all the greatest but not yet written novels.
Note: No real monkeys were involved in developing the proof.
The monkey typing idea, while exaggerated on purpose, makes a point. Over a long period of time, everything can, and will happen. How does this have to do with investing? The persistent question of whether investment managers outperform the market by sheer luck or by skills. Isn’t it plausible that with such a vast amount of managers, a few would outperform the market by luck?
Let’s look at a little exercise. Consider 100,000 investment managers who invest in the markets. Let’s assume that each year 50% outperform the market. After 5 years, 3125 would have outperformed the market. Those 3125 would be considered stars by their peers. This is a classic example of what is known as the “survivorship bias”, which means, when applied in this context, that when analyzing successful hedge funds, you would only see those who made it and not those who went bankrupt. This may seriously skew your judgment, as seen in our little exercise.
The issue of luck versus skills is strongly connected to the idea of the Efficient Market hypothesis. It all comes down to the question of consistently beating the market. A good example is the legendary speculator, Victor Niederhoffer. For years, he has outperformed the market and was considered one of the top notch hedge fund manager. At September 11, Niederhoffer was betting the market would be quiet. Niederhoffer’s fund blew up and he went bankrupt in one day!
What are the implications for the small investor? Simple. While it may be impossible to beat the market, the market, over the long run, is still the best place to put your money, as seen below when compared to other risk free investments.
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