In the world of investing, stories of traders achieving extraordinary returns often make headlines. These “market wizards” are celebrated, inspiring many to emulate their strategies. But how much of their success is due to skill, and how much is simply luck? While it’s challenging to answer this question definitively, we conducted an experiment to help readers better understand how the role of luck can create the illusion of exceptional trading prowess.
The Experiment
Imagine that in 1990, we set up a tournament where 1,000 “traders” are required to pick 10 stocks randomly each year. The stocks must be part of the Russell 3000 index at the beginning of that year. Positions are equally weighted and held until year-end. In case of a delisting, a new stock is randomly chosen to replace it.
At the end of each year, we calculated and ranked the returns of all portfolios. We repeated this process over multiple years to analyze not just the market’s performance but also that of the top traders each year.
Results: The Illusion of Exceptional Performance
As depicted in the chart below, the results were striking:
Runners-Up: The second and third best traders also posted impressive average returns of 241% and 196%, respectively.
Top Performer: The best trader each year averaged a whopping 338% annual return, far outpacing the market’s average of 12%. In 2001, 2004, and 2021, the top performer achieved a return of more than 1,000%!
These figures suggest phenomenal success. However, since all stock selections were random, these outstanding returns were purely due to chance.
Our experiment doesn’t claim that all top performers in real-world trading are merely lucky. Many achieve success through skill, strategy, and experience. However, when a large number of participants are involved, probability dictates that some may achieve exceptional results purely by chance. In our case, with 1,000 traders making random picks, it was almost guaranteed that a few would end up with spectacular returns.
Why This Matters
- Misplaced Admiration: Celebrating outliers without context can lead to unrealistic expectations.
- Media Narratives: Sensational success stories often overlook the role of luck, misleading aspiring traders.
- Risky Behavior: Chasing after outlier results can encourage excessive risk-taking based on false assumptions.
- Recency Bias: Recent success is often given undue weight, causing investors to believe that current trends will continue indefinitely. This can lead to poor decision-making based on short-term performance rather than long-term value.
Understanding the Difference Between Skill and Luck
Distinguishing between skill and luck is crucial but often challenging with publicly available information. Here are a few guidelines to help traders avoid following false-positive “market wizards”—traders who achieved extraordinary returns simply due to luck:
- Evaluate Consistency Over Time: Assess the trader’s performance across multiple years. Consistency is a hallmark of skill. Exceptional returns over a short period don’t necessarily indicate expertise, especially if accompanied by significant drawdowns. For instance, having three fantastic triple-digit returns is less impressive if the average drawdown exceeds 50% per year. Always assess returns in relation to the risks taken; extraordinary gains achieved with high risk may not be sustainable.
- Analyze Methodology and Philosophy: Delve into the trader’s methodology and trading philosophy. When possible, try to reverse-engineer their trading rules and test them quantitatively using historical data. Base your trading decisions on empirical evidence rather than anecdotes. We run a similar empirical investigation with Marios Stamatoudis and published the results in SSRN.com
- Leverage Analytical Tools: Utilize publicly available software (like www.r-candles.com) to investigate the profitability of discretionary technical trading strategies. These tools allow you to test and refine your strategies in an unbiased environment.
To succeed in financial markets, it’s important to approach trading with realistic expectations. Recognizing that many success stories may be driven by temporary luck can help prevent falling victim to FOMO (Fear of Missing Out) or recency bias. By maintaining a balanced perspective, you can make more informed decisions that align with your long-term goals.
Conclusion
This experiment reveals a fundamental truth: in large groups, exceptional results may occur purely by chance. While this doesn’t mean all top performers owe their success to luck, it does highlight the danger of attributing extraordinary performance solely to skill without considering the role of randomness.
Stay enthusiastic and motivated, but be cautious about blindly relying on the most successful short-term stories—they may simply be the fortunate outcomes of a large pool of unskilled traders. By focusing on developing robust, evidence-based strategies and maintaining realistic expectations, you can navigate the markets more effectively and enhance your chances of long-term success.
For any further details about this article, feel free to contact me at carlo@concretumgroup.com.
