Risk and Randomness in the Market[Fool on the Hill] May 8, 2000

An Investment Opinion

Risk and Randomness in the Market

By Paul Commins (TMF Buster)
May 8, 2000

Broad market index funds are truly a gift to the individual investor. We all tend to take them for granted (just as we sometimes fail to recognize our mothers), since, nowadays, they are so readily accessible. But index funds accomplish something special. They allow us all to share in the long-term wealth created, as a whole, by our capitalist economy. In the olden days, if you wanted a piece of this action, you had to pick stocks, and picking stocks just isn't for everyone.

In fact, some folks will tell you that picking stocks is wholly equivalent to a random game of chance. They will state, categorically, that your best odds for long-term success are with index fund shares. In other words, they will advise you to stop when you get to Step 4 in our Foolish 13 Steps.

And to tell you the truth, unless somebody can tell me how to draw a representative sample from future market events, I don't think that this index-only strategy (or any strategy for that matter) can ever be proven or disproven with mathematical certainty, regardless how fancy the statistical mumbo-jumbo. There will always be a little faith behind picking stocks.

"Great," you're saying. "I tuned into Fool on the Hill for an index fund sermon? Thanks, but no thanks. I'm arrogant enough to buy stocks."

"Me, too," I quickly reply. "Good thing, too, or this job would get dull in a hurry, eh? Anybody want to volunteer for a daily column on the S&P 500 index?"

On a more serious note, while I'm not suggesting that every individual investor should buy only index funds, I do think that every individual should have a clear understanding of this argument, so they can Foolishly accept or reject it, based on their own reckoning. To this end, let's talk little about randomness.

What do we mean when we say that someone got "lucky" or that an event is "random"? Looking backward, into the past, it is certainly true that the proof is in the pudding. I can jump up and down and foam at the mouth about how lucky my neighbor has been, but this won't take away the ten grand he just earned by acting on a vapid water-cooler stock tip. What happened is what happened. Money is money.

On the other hand, what can I learn from my neighbor's experience? If the answer is a resounding nada, well, this pretty much defines his windfall as a random event. In this forward-looking context, then, the proof is clearly not in the pudding (unless, of course, our neighbor decides to share his pudding with us, but here we're getting a little beyond our typical Fool investing sphere).

I can't emphasize this enough: It's all about the future. After the fact, for example, we can attribute, with some certainty, a Packers loss to Brett Favre's knee injury (no doubt an honest-to-gosh injury if it forced this gladiator from the turf). We just had no way of predicting, before the game, that the injury would occur and this makes the event random and not too useful for prognosticators.

Randomness is, essentially, stuff that we witness but could not have explained before the fact, even with all the available information. As we learn more and more, knowledge grows and randomness shrinks, but fortunately, the pool of randomness is as vast as space itself. There will always be some noise left over, unexplained. And unlike Albert Einstein, I'm dumb enough to welcome this, to believe that God does indeed "play dice with the universe, " by design. For without the existence of faith, in my opinion, life would lose some meaning. But I leave the Fool sphere again.

Watch pundits carefully when they look back at events that have already occurred. If any attempt to attribute a cause to these events smacks of 20/20 hindsight (best case) or sheer nonsense (worst case) consider the strong possibility that the event was truly random.

Indeed, in my more cynical moments, I've been caught proclaiming that life, as we know it, is nothing more than a giant misattribution festival, teeming with doubtful explanations of random events. They are everywhere, from explanations of daily market moves to call-in sports radio shows that feature last week's most successful NFL prognosticator, from a list of top-performing mutual funds to the "hot dealer" at the casino, from the successful CEO to the U.S. president who takes all the credit or receives all the blame for our collective economic fortunes.

"Who cares about attributing causes to events?" you might say. Well, like it or not, we all do. Successful attribution is the fundamental purpose of all scientific inquiry. Until we can explain what caused an event and then reliably reproduce the event by activating this known cause, then can't say that we "know" anything, at least in the scientific sense. All of our technological progress, then, is predicated on successful attribution.

Of course, in science, things aren't always so cut and dried either, as anyone following recommendations on dietary fiber intake can attest. But investing studies are even harder to control than public health studies. Those who carry out public health studies have to control for or randomize across all the unknown causes lurking in their experimental subjects, a tough task to be sure. But definitive investment studies, if possible, would have to draw randomly from future events (a truly Einsteinian feat), since stock markets will certainly evolve and change more rapidly than the human species.

Hardly anyone in this country wants to hear this, and I am, no doubt, a pinko for even discussing it. After all, we are the world's beacon for the concept of self-determination. We love nothing more than a good "pull yourself up by your bootstraps" story. Any hint of fatalism in this country is met with strong resistance. In fact, if you've never lived anywhere else, it might even surprise you that our fellow capitalists are not all so hostile to limitations imposed by fate (for an interesting discussion of Brits vs. Americans on this subject, check out this book).

Now, at this point, I'm sure I've prodded some readers into rage. I will get plenty of letters supporting [insert your counter-example here]. I'll hear about Warren Buffet, or strategies that have been proven via "out of sample" testing, or uncle Myron's foolproof system. Just to head off this rage, then, let me be the first to congratulate these people and their strategies for their past success. They have beaten the market. Of this there can be no doubt. Huzinga!

But these anecdotal stories can't take away my right to be skeptical -- to insist that no strategy is proven for future markets. Rule Breakers is not proven. Rule Makers is not proven. The Bore port is not proven. Drip investing is not proven. Even the venerable Buffet is no lock for the future.

So what's my point? You say that you already knew that no investing strategy is a lock?

Sure, you knew it, but did you really take it in? Have you considered that all this talk of stock-picking strategies might be just another dimension to the misattribution festival? If this turned out to be true, would you still be comfortable with the stock picking strategy you currently employ?

I certainly don't want to dissuade anyone from stock picking. No sir. I'm squarely on the Fool bandwagon (as laid out in Foolish Steps 5 through 13). But I do think that a healthy understanding of randomness -- and a respect for its power to cloud the truth -- fits nicely in any investor's toolbox.

Once randomness is digested and respected, stock pickers can think more clearly about their strategies and the risk they entail, and can deal more calmly with results in the market, fraught as they are with the unknown. In the end, I think this understanding can only make stock picking less stressful, more educational, safer, and a lot more fun.

Good luck!