Fooled by randomness? You need one of these
Posted by Robin Powell on October 16, 2015
If he were alive today, I suspect Sir Francis Galton would subscribe to the Evidence-Based Investor. Heck, I’d probably hand him the editorship and let him get on with it.
Galton was born in 1822 in Birmingham, England, about a mile from where I’m sitting now, and went on to lead about as full a life as it’s possible to cram into 88 years. A half cousin of Charles Darwin, Galton was, among other things, a statistician, scientist, sociologist, psychologist, eugenicist, inventor and explorer.
The writer of 340 papers and books, he wasn’t afraid if his findings caused offence. For instance, his study on the power of prayer is well worth reading (it concluded that it had nil effect based on the longevity of those who were prayed for). He even devised a beauty map of Britain, charting the physical attractiveness, or lack of it, of women in different cities (female readers in Aberdeen might want to give that one a miss).
Investing was one of the few subjects Galton didn’t write about, and yet he made two significant contributions to our understanding of how financial markets operate.
The first is his work on the wisdom of crowds, which has a direct application to the markets, namely that the collective wisdom of millions of market participants is more reliable than the hunch of an individual stockpicker.
His second contribution concerns probability. Too many investors — and even so-called experts —are fooled by randomness. They see patterns where there are none; the market falls 5% and they think we’re heading for meltdown; or a fund manager produces three years of good returns and they assume he’s a genius. The data shows, overwhelmingly, that fund performance — indeed market performance generally — generally reverts to the mean over the long term. And who was it who first described and explained the phenomenon of reversion to the mean? You’ve guessed it. Sir Francis Galton.
Mark Hebner, a financial adviser in California, was so fascinated in Galton’s work that he commissioned a replica of the “bean machine” that Galton developed to illustrate mean reversion. I recently visited Mark at his office in Irvine and he showed me the machine in action. Nicknamed “Sir Francis”, it demonstrates quite brilliantly the random nature of investment returns and why it pays to stay diversified and take a long-term view.
I think you’re going to enjoy this video!