The Curious Case Of Fat Joe And Lessons For Investing In The Stock Markets
Understanding the role of chance in life and its application in investing
Fat Joe is a 35-year-old resident of a sleepy town in Canacon, South Goa. He enjoys simple things in his life, as getting drunk on a Friday, Saturday, and most other days. He owns a modest seafood restaurant in the town.
During the peak season, the town gets flocked by tourists from across the world. So he makes a killer from his restaurant business. But, his income gets offset during the off-season of monsoon. Hence, he saves up his earnings without indulging in any extravagance.
Tall Tim is an old friend of Fat Joe. He has a nasty reputation in the town for being a drunkard and a compulsive gambler. Fat Joe’s mother has already warned him a dozen times to maintain distance from Tall Tim. But, Fat Joe occasionally shares a drink with him without a hint to his mother.
One fine Day, Tall Tim wins a lot of money at a roulette table in one of the local casinos at Panjim. He goes straight to Fat Joe, jumping with joy, and tells about his exploits of gambling episode.
Now, Roulette is a game where you can place different types of bets, and the payout will vary accordingly. Let us assume a simple bet, where you choose a number and place a bet. If you place a bet of $10 and win, your payout will be 50 times the bet, i.e. $500.
After listening to his friend Tall Tim’s winning story, Fat Joe gets all charged up and decides to go to the same casino so that he could gain some cash like Tall Tim.
He dresses up in a tux and shows up at the casino with a bag full of money. As per Tall Tim, there’s a problem with the roulette wheel, it somehow stops only at number 31. Fat Joe places a bet and loses for the first time. Then he places a bet for the second time, losing again. By the fifth time, he bets big to compensate for the lost bets. He loses the bet along with his savings for the dry season.
What went wrong?
Why Fat Joe was not able to replicate Tall Tim’s success?
Fat Joe was nothing but a victim of Survivorship Bias.
“We tend to mistake one realization among all possible random histories as the most representative one, forgetting that there may be others. In a nutshell, the survivorship bias implies that the highest peforming realization will be the most visible. Why? Because the losers do not show up.”
In simple words, Fat Joe was so consumed by Tall Tim’s winning story, that he forgot to take notice of the 7 other people who consistently lost money at the roulette table.
The Media Syndrome
The media is in the business of entertainment. They have no incentive to show the mundane, run of the mill lives of the ordinary population. Until they get bombed by a terrorist group or suffer a state inflicted atrocity.
They have expertise in picking up a winner and finding the causes that lead to his or her rise in the brutal world. A successful fund manager (till then) will appear on the TV show and explain the strategies that he followed for a decade that lead to such a humongous return in his portfolio. He will be labelled as the master stock picker, the Man with the Midas touch and a series of other names celebrating his success.
Hoards of new entrants in the Industry will look at him as their Guru. A case study will be made out of his career spanning a decade, till he has a year of poor performance and goes bust. Then, case studies are conducted on ‘What went wrong with ‘the Man with the Midas touch?’.
As Taleb says, A person will never accept the role of chance in his success but he addresses his failure as misfortune.
In the case of Fat Joe, what he saw was an extreme event in the life of Tall Tim. Like the media, he ignored the fact that for one winner at the table there were 7 losers. He did not take into consideration the role of variance in Tall Tim’s string of wins. To add to this, Tall Tim even justified his win by telling the number he frequently bet.
I would like to call this phenomenon, the Media Syndrome — Highlighting the extreme and finding the causes.
A business news channel will have a special feature for the top 5 winners and losers every day. They will find the causality behind such a drastic movement in these stocks. Who wants to watch about the stocks that didn’t move? Ever heard of a show — Analyzing stocks that didn’t move?
The Variance in Earnings
Fat Joe made the same amount of money at the restaurant in 3 months as Tall Tim made in one night at the casino. Now, if we consider the value, it is absolutely the same. But the amount earned by Fat Joe was the outcome of serving delicious dishes whereas Tall Tim’s success at the casino is by pure chance or luck.
“Mild success can be explainable by skills and labor. Wild success is attributable to variance.”
Fat Joe earning, say $10,000, in a span of 3 months can be attributed to his management and customer service at his seafood restaurant. But Tall Tim’s wild run at the casino that made him the same amount in a matter of hours, will always have casualties.
It’s like playing Russian roulette with thousands of slots in the barrels. You might point the gun to your head and pull the trigger ten times in a row, and still be alive. And Voila! You win a price of $10,000.
Imagine your success at the Russian roulette is imitated by hundred others. Their probability of survival will go down to 1 in 10. But, the ten people who win $10,000 by copying you will regard you as their Guru whereas the 90 people who shoot themselves to death are, well dead.
For every Tall Tim, there will be hundreds of Fat Joe.
The variance in income will always be high in professions such as actors, painters, sportsperson, pop singers, etc. On the other hand, professors, dentists, accountants will have less variance in their incomes in their respective profession.
The Luck Factor
Does this mean that all the sportspersons and actors are all Tall Tims?
Is their success just a stroke of luck?
Read the following statement carefully,
Fortune favours the brave, but bravery isn’t the cause behind the fortune
In extreme success stories, there is no doubt that there is hard work, consistency and persistence involved. But it is not necessarily the cause behind the success.
“It’s more random than we think, not it is all random.”
Similarly, a series of profits in the stock market does not mean it’s all about the strategy and intelligence of the trader. But, it’s not always about it because the role of chance cannot be quantified.
What should Fat Joe do?
After getting to know the role of chance in a bet, he can do the following things,
- Do not take Tall Tim’s advice of betting and listen to his mother. In that way, he doesn’t incur a loss or earns a profit.
Stay away from the stock markets!
- In a hypothetical casino, he should convince 7 friends to accompany him and make them sit at the same table. Let each one of them place small bets several times. This increases the probability of winning (Although the odds are still in favour of the casino as the roulette wheel has 37 numbers). So, even if they win 2 bets out of 10, it would be a profitable venture. On the flip side, if they lose all the bets, the losses will be divided.
Having a concentrated portfolio is risky. Hence, diversification is essential to reduce the risk in the portfolio. Even 2 stocks can cover the losses incurred by 8 others, in the long term. However, seeking professional advice is recommended unless you are an expert in stock analysis.
- Fat Joe should not bet his three-month savings on a risky venture. But, let’s say he wants to experience the thrill of gambling, he should bet the amount that he might be comfortable losing. That is, it should not make such a big dent in his savings.
No matter how enticing an opportunity might be in the stock market. One should never leverage to the extent of getting completely wiped out that there is no coming back. Cutting out losses is one of the essential aspects of long term profitability.
Key Takeaways
- Although hard work matters, the role of chance in success cannot be ignored
- Don’t get inspired by extreme examples of success
- Keep limited exposure to high-risk assets
- Diversification is essential to mitigate the risk
This article was inspired by Nassim Nichols Taleb’s bestseller — Fooled by Randomness
