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Skill or Luck?

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To illustrate the idea of market predictability–or unpredictability–imagine that you held a national coin-flipping competition, and enlisted exactly 200 million participants. To play the game, four rules must be followed:

1. Everyone begins with a silver dollar.

2. You flip the dollar once a day as long as you’re in the game.

3. If you flip tails, you lose your dollar and are out of the game.

4. If you flip heads, you keep playing and receive a portion of all the silver dollars from the contestants who lost that day.

On day one, all 200 million players flip their coins. Each has a 50% chance of flipping heads. Therefore, 100 million people can reasonably be expected to flip heads, stay in the game and split up the 100 million dollars of those who flipped tails. After continuing for 25 straight days, statistics suggest that six people should have flipped heads 25 times in a row–and collected more than $44 million each. These six would have beaten enormous odds and probably see themselves as possessing some kind of expert talent. The media would certainly pounce, putting the “expert flippers” on talk shows to discuss their strategies and success.

Of course, flipping coins takes no skill–any success is fueled entirely by luck. Likewise, fewer professional money managers beat the market than would be expected simply by random chance. Because there are so many managers out there, a few will succeed. That doesn’t mean, however, that their results can be attributed to skill or distinguished from pure luck. The upshot: Trying to beat the market through active management is a game that–like coin flipping–isn’t worth your clients’ time.


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