Sunday, April 30, 2006

Buffett's coin-flipping contest

Investing is not the field for those who do
not have sufficient expertise to evaluate the company's prospects.
For the people who are learning the tricks of the trade, it is better
that they put their money in experienced hands.

However one should note that the historical performance may not be
the indicator of future performance. Even if the fund managers
invest randomly you would find top 10 funds giving superb returns.
Warren Buffett had explained this phenomenon in a characteristic
humor. I'm putting this excerpts here(full text in files/articles

"I would like you to imagine a national coin-flipping contest. Let's
assume we get 225 million Americans up tomorrow morning and we ask
them all to wager a dollar. They go out in the morning at sunrise,
and they all call the flip of a coin. If they call correctly, they
win a dollar from those who called wrong. Each day the losers drop
out, and on the subsequent day the stakes build as all previous
winnings are put on the line. After ten flips on ten mornings, there
will be approximately 220,000 people in the United States who have
correctly called ten flips in a row. They each will have won a little
over $1,000.

Now this group will probably start getting a little puffed up about
this, human nature being what it is. They may try to be modest, but
at cocktail parties they will occasionally admit to attractive
members of the opposite sex what their technique is, and what
marvelous insights they bring to the field of flipping.

Assuming that the winners are getting the appropriate rewards from
the losers, in another ten days we will have 215 people who have
successfully called their coin flips 20 times in a row and who, by
this exercise, each have turned one dollar into a little over $1
million. $225 million would have been lost, $225 million would have
been won.

By then, this group will really lose their heads. They will probably
write books on "How I turned a Dollar into a Million in Twenty Days
Working Thirty Seconds a Morning." Worse yet, they'll probably start
jetting around the country attending seminars on efficient coin-
flipping and tackling skeptical professors with, " If it can't be
done, why are there 215 of us?"

By then some business school professor will probably be rude enough
to bring up the fact that if 225 million orangutans had engaged in a
similar exercise, the results would be much the same - 215
egotistical orangutans with 20 straight winning flips"

The bottom line is that the new investors are still better off with
mutual funds but they should not blindly assume that past
performances would continue.

Posted:Oct 7, 2004

1 comment:

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