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October 12, 2004 at 08:00 PM
NEW YORK (HedgeWorld.com)–Speaking at a recent seminar organized by the group 100 Women in Hedge Funds, Nassim Nicholas Taleb–author, mathematician, trader and chairman of Empirica LLC–argued that success in money management mainly is due to chance and disasters are inevitable for hedge fund investors.
In this view, differences between managers are a lot more random than most of us think, and we tend to find reasons after the event to explain success and failure–reasons that in fact are utterly irrelevant. “We are better at ‘postdicting’ than predicting,” Mr. Taleb quipped.
Thus, one manager may look like a genius after running a profitable fund for years while another with identical skills is in trouble. But if the difference between the two is luck, not ability, investors with the apparent genius may mistakenly believe they are safe.
As Mr. Taleb sees it, the much-used Sharpe ratio figures may provide reassurance but are not really useful in making investment decisions. The two managers described above might have identical Sharpe ratios to begin with, yet end up with widely divergent returns.
The Lottery Factor
He cited findings from cognitive psychologists, in particular from Daniel Kahneman, a recent winner of the Nobel Prize in economics, showing that people are prone to a variety of systematic biases. When confronted with real-life situations, even the statistically sophisticated make simple mistakes such as extrapolating from an inadequate sample.
There is built-in survivorship bias in many explanations. People notice survivors’ attributes and conclude that these make for success, but the failures may have had the same characteristics. Since they have not survived, people do not see them and do not account for why they failed..
