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Can A Thousand PhDs Be Wrong?

June 16, 2017

“It seemed to me that most of what I was learning at Wharton could only help you fail in the investment business.” -Peter Lynch


They say if you torture numbers long enough, they will tell you anything you want to hear. I submit, if you studied the patterns of ants scurrying around long enough, you could surely find some correlation to timing the market! Of course, only a fool would risk his money on such a conclusion.

Mathematics and theories is seldom a match for experience and expertise. Nothing against professors and mathematicians, but in the stock market, the real world works quite differently than in the textbooks.

Keep in mind that it was highly intelligent people who, for a long time, argued whether or not a baseball could really curve or if it is just an optical illusion. The argument was finally settled with the advent of fast photography. Using cameras, it was determined that, indeed, a curveball does curve. This of course came as no surprise to the pro ball players who stood in the batter’s box over home plate and had to face a major league pitcher day after day.

Don’t be too impressed with what looks good on paper until you can verify it with your own trading in the real world. Those who think they have it all figured out on paper can blow themselves to smithereens in the market. Strategies that are back-tested utilize curve fitting to find the best formula that beats the market, but only in hindsight. The futility of trying to forecast markets with static statistical models has not prevented armies of the greatest minds from trying to invent the next mathematical money-making machine.

But why do so many fail?

The reason is the human element. People learn and people change, and it is people who make buy and sell decisions. Do you think a computer could be programmed to drive a race car and beat NASCAR’s Jimmy Johnson, given all the nuances of a race that require split-second decision making? Sure, his racing team utilizes technology to figure out the best aerodynamic design and how to optimize engine and tire performance, but Jimmy is still at the wheel.

Or what about a 747 with all its advanced computer power in the cockpit? Even so, autopilot is only used mid-air, never on takeoffs and landings, which are the most challenging parts of flying. When it comes to the market, science and technology can be deployed to analyze data and point you in the right direction. Trading, however, is not purely science; it’s also an art.

In the late 1990s, Long Term Capital Management found out the hard way that educational pedigree and mathematical genius (even with a Nobel Prize) is no match for the market—demonstrating that theories and the real world can decouple in a very ugly way. Throw in some mammoth-sized egos, and you have the makings of a financial tsunami.

Long Term Capital’s brainpower claimed that the fund was perfectly hedged. In other words, they thought they had figured out a way to beat the market and truly believed nothing could go wrong. Unfortunately; they did not expect the unexpected, which at some point always happens in the market. When dealing with probabilities, the devil is in the details—or should I say in the tails, meaning the outliers.

In the case of Long Term Capital, the unexpected was Russia’s default on its domestic debt. This had never happened before and, therefore, was thought to be impossible. What was touted as perfectly hedged began to unravel to the tune of $1 trillion in exposure, and leverage that was rumored to be as much as 100-to-1. The Federal Reserve had to step in to save the day.

Long Term Capital Management (LTCM) was managed by a team of some of the brightest financial minds in the industry. In the end, you would have gotten better results investing in T-Bills or even throwing darts.

No one likes to be wrong, but in trading and in life, everyone is wrong at least some of the time. Some people are unwilling to face that fundamental fact of life. In the stock market, those who can't admit mistakes end up going broke.

Marilyn vos Savant, a national columnist and author, earned a listing in the Guinness Book of Records for five years for having the highest IQ for both childhood and adult scores. Marilyn is perhaps best remembered for a brain teaser she published in her column in Parade magazine. The puzzle was based on the game show “Let’s Make a Deal,” hosted by Monty Hall, and therefore became known as Monty Hall Theory.

In short, the scenario presented three closed doors. Behind two are goats, and behind one is a new car. Monty Hall knows what’s behind each of the doors but you—the contestant—do not. Let’s say, you pick Door Number 3. Monty Hall opens Door Number 2, revealing a goat. Now there are two doors left: 1 and 3. One has a goat and one has a new car. When Monty Hall asks if you want to change your door selection, do the odds favor you making a new selection?

Most people would say, no. They think, at the outset, the odds were 1-in-3. Now, the odds are 1-in-2, or 50%. Wrong! As Marilyn wrote, the odds are actually 2-in-3, or 66% if you change doors. Her explanation was based on six games that exhaust all the possibilities. Switching resulted in winning two-thirds of the time, and losing one-third of the time.

What was most interesting about Marilyn’s exercise was the outrage that it provoked. She received more than 10,000 responses from people telling her she was completely wrong (she wasn’t, and proved it)¬—including 1,000 responses from PhDs. How could so many smart people be wrong about a math equation? I mean, math is math.

This plays out countless times in the market. Many people (even highly intelligent individuals) overlook the obvious. As Sam L. Savage points out in The Flaw of Averages “A degree in physics might help you understand how a wing generates lift, but it won’t necessarily make you a good pilot.”

Many of the books out there on stock trading and investing are written by intelligent authors; however, many of them either don’t trade for a living or have never experienced really big success in their own trading account.

The stock market does not care how educated you are or whether you have a PhD. In the stock market, we all start at kindergarten and have to learn and earn our way to the top. 

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