|Learn to recognise the statistical
Do you base the average achievement level of
your school contemporaries on the attendees at the annual reunion?
Wrong! The failures don't show up.
And do you judge the success of a group of funds
by analysing those currently on offer? Think again.
You can test a hypothesis by checking it against a range of past
data, and using statistical tests to see if the data supports the
hypothesis. But suppose you just picked the data that happened to
fit the hypothesis? That would be a) cheating and b) called "data
And do you judge the skill of a fund manager
by an analysis of his past performance over a time period picked
by him? Or the reliability of a fund family based on one fund chosen
by the managers? Think again.
A randomly lucky result is presented as though
it is representative of the system/scheme/fund as a whole.
We are used to this in advertisements - for
tipsheets e.g. But it's very common in journalism (because extremes
make a better story than the boring average)
To decide if something is extraordinary, you need to know the size
of the sample from which it is drawn.The Law of Large Numbers says
that very rare things occur if you try often enough. Or, you can
find very special things if you pick from a large enough sample.
If you meet a fund manager at a party and it
transpires that he has beaten the average fund every year for the
last five, that's quite unusual. In fact the odds are 1 in 32 against.
It would be polite to congratulate him. But out of 800 funds in
the UK it's likely that 25 would have achieved this using the dart-throwing
stock selection technique. Should you congratulate them also?
Paying for randomness
Consider the following proposition. You pay us
£100 and we guarantee you can chose the sex of your next child.
In fact we will refund your money if we get it wrong.
Get it? We send out random answers. Half of
them will be right and we'll keep the money. Half of them will be
wrong but we won't lose.
You should now be able to recognise lots of tipsheet
hidden rare event
If you played roulette without any knowledge of the numbers on the
wheel, you might by observation come to the conclusion that putting
equal amounts of money on red and black for each spin was a pretty
safe strategy. Your money always seemed to come back.
That's when the zero comes up - wiping you out.
It's only once every 37 spins (for a single-zero wheel) but it's
good enough. The zero is the "hidden rare event".
You could devise a tailored financial product
offering 6% annual income with the investor's whole capital at risk
once a year depending on the spin of a roulette wheel. That's 4%
risk free return, just under 3% (1 in 37) for the capital risk,
less 1% for you. That should work. In
fact, that's how "precipice