Wednesday, November 21, 2007

Don't be a Fool of Randomness

There is too much noise in the world, and by noise I mean unfiltered meaningless news and data. A higher and higher percentage of what we read, see and hear comes straight from the event to you. Doesn't matter what the event is, we'll hear about it as it happens live and unfiltered and full of unintelligent garbage from the first reporter on the scene. Where am I going with this? What I am getting at is that in a small time frame, a snapshot of recent activity is meaningless, and I'll use the example provided by Nassim Taleb in his excellent book 'fooled by randomness'
Suppose you have a portfolio with an expected annual return of 15% above the risk free rate (very good), 10% volatility (very low). This is a high return, low volatility portfolio. The one we'd all like to have. It should be almost painless as it grinds its way higher with little or no large unexpected deviations, but the results of putting this portfolio through a monte-carlo simulation are very interesting. We'll see that only 1 year in 20 is a down year. The interesting thing is to look at a shorter and shorter time periods and see what the probability of success becomes;
1 year = 93%
1 quarter = 77%
1 month =67%
1 day = 54%
1 hour = 51.3%
1 minute = 50.17%
1 second = 50.02%
in a given day in front of the screen (8 hours) that's 241 happy minutes and 239 sad ones. So the moral of the story is that if the pain of a loss exceeds the joy of a victory (which believe me it does) then don't watch the stocks you own (and plan on owning for a long time) all day. It's an easy way to get stressed and sell too early and miss out on making money.

1 comment:

Anonymous said...

boy, this is insightful stuff rocky