Saturday, September 23, 2006

In fooled by randomness: The hidden role of risk in the market and in life

To gain an advantage in the stock market or investing in general, it is important to understand the experience in life is generally intertwine with the workings and behaviour of an investor.

Imagine an eccentric and bored billionaire who offers you $10 million to play a game of Russian roulette. He gives you a revolver with 6 chambers, a bullet in one of the 6 chambers, and challenges you to hold it to your head and pull the trigger. Chances are 5 in 6 that you'll get away with $10 million; chances are one in six you won't come away at all. That is, there're six possible paths that your story will take - but after the fact, we'll see one one of them. And if you survive, you may be used as a role model by others, including the media. If this roulette player is a mutual fund player, he'll perhaps end up on the cover of a magazine showing "Savvy investor beating the Index."

Of course, if the roulette-betting fool kept on playing, the chances of failing will catch up with him. From the first round of 5 in 6 chances to survive, it reduces to 4 in 5 chances, then 3 in 4, then 2 in 3, then finally, a 50% chance.

So when you look at the stock market's darling we're looking at the survivors from a very large pool of players. Imagine now there're a large pool of 25 -year-olds willing to play the russian roulette, playing on the first day of each year. With each passing year, there'll be less players, eventually after 20 years, we can expect to see a handful of players left. And this remaining few will be extremely rich and celebrated by the media - and a very large cemetary for those who had fallen. Most likely, they'll be thought by others to have the skills and ways around on how to survive in a roulette game.

These group of players would be hailed as winners - the alternative possibilities of what could have happened to them would be ignored and forgotten.

For every game, someone have to wind up in the top percentile. In a game of luck, it is the same and the important fact here is that none of these players can claim to be an expertise in a game of luck. But still, somebody must always be in the top 10, some in the middle, others trip at the first hurdle.

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