November 30, 2007

Was Michael Jordan only lucky?


Fascinating article by Michael Lewis of Liar's poker fame pointed out by fellow blogger
Contrary Canary. As far as the efficient market/random walk theory, it's important to remember that randomness is in the eye of the beholder, a point Taleb makes repeatedly in his books. If I recall correctly, Taleb gives the example of a pregnant woman. From a stranger's point of view, her baby being a boy or a girl is a random event with probabilities 1/2 and 1/2 for the 2 possible outcomes. From her point of view, thanks to doppler technology, the sex of her child is not random anymore, she knows for certain that her baby will be a boy or a girl.

Apply this to investing/trading: to a hypothetical master trader, the fact that he or she is in the top 1% of traders is not a random event, because he/she (presumably) knows what he/she's doing. From the hapless scholar's (let's call him Mr. Fama) point of view, that particular trader is just lucky, he or she just happens to be part of the surviving 1% of the initial sample of traders. So as far as Mr. Fama is concerned, whether a particular trader beats the market or not is a random event and has nothing to do with that trader's abilities. Should Mr. Fama sit down with the trader, understand the trader's methodology and test that methodology (provided Mr. Fama has the intellectual curiosity, flexibility and capability to do so and provided the trading methodology is conducive to modelling) against a throw-the-darts methodology, he would discover that the trader's performance is indeed superior and that has nothing to do (or at least not much to do) with luck or survivorship.

I mean, just think about it for a second, has anyone anywhere ever accused Michael Jordan of being "just lucky" or theorized that the only reason he was such a great basketball player is that out of a starting sample of say 10 million basketball players, he was the only one lucky enough to survive all the tests, obstacles and competitions he faced? Obviously, luck had a hand in his success but how important was it compared to his talent, his work ethic and his competitiveness?

November 23, 2007

The unknown knowns

I have a couple of thoughts on the "black swan theory" and Taleb's thesis in general.
Doesn't it simply boil down to a belief in miracles? And isn't it a step backward? Once upon a time, most people did believe in miracles, i.e. very low probability events. A scientific revolution and more than a hundred years later, most people have stopped believing in miracles and are much more rational and sceptical. But on balance, I would say that people still believe in miracles more than they should and more education, more knowledge are needed to make us more realistic, less prone to irrational hopes and magical thinking. Here comes Taleb who would like humanity to go back to the Dark Ages and start believing in miracles again. Isn't a black swan just a fancy new name for what people used to call miracles?

My second (disorganized) thought is less a criticism of Taleb's thesis and more an avenue for further musings. Taleb likes to talk about the known unknowns and the unknown unknowns, the latter being basically the so-called black swans. How about the unknown knowns, in other words, the thinks we don't even know we know? I would think that those unknown knowns are the same thing as intuition or instinct. I guess a book such as Blink by Malcom Gladwell did cover just that.

November 4, 2007

The two-headed monster


As I was telling a technician friend lately, the market is a two-headed beast these days.
On the one hand you have financials, represented in the first chart by XLF, the financial ETF (it's actually the chart of the ratio XLF/SPY), which are in the middle of what could be an epic bear market. On the other hand, you have the technology sector, represented in the second chart by QQQQ, the Nasdaq 100 ETF (again it's the ratio QQQQ/SPY) undergoing a no less impressive bull explosion.
It appears that a good trade would be long QQQQ, short XLF, a gift that could keep on giving for quite a long time as these secular trend changes tend to last.
As far as the market in general (as represented by SPY), given the tug of war going on, it is much harder to trade.