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Chandan Dubey
Chandan Dubey
Articles (150) 

Generating Buffett Randomly

October 19, 2012 | About:

I discovered Nassim Taleb a month or so ago and have already read two of his most famous works: “Fooled by Randomness” and “The Black Swan.” Howard Marks in the introduction of his book, “The Most Important Thing,” says that he would find his purpose served if after reading the book the reader exclaimed, “I never thought of it that way!”

The two books of Taleb together have been able to drag out these words many a time from my lips. I am infinitely grateful to him for writing a book which has obviously been a product of several years of intense introspection.

One of the ideas from “I never thought of it that way!” school was the problem of silent evidence. This problem is best illuminated by a story which Taleb tells in "The Black Swan:"

Diagoras, a nonbeliever in the gods, was shown painted tablets bearing the portraits of some worshippers who prayed, then survived a subsequent shipwreck. The implication was that praying protects you from drowning.[/i][i]Diagoras asked, “Where are the pictures of those who prayed, then drowned?”
What Diagoras was pointing to is called "the problem of silent evidence." The worshiper who drowned did not have any pictures to prove that they prayed and drowned. They are evidence of the fact that “praying does not protect from drowning” but are silent because they are now at the bottom of the ocean.

The problem of silent evidence is prevalent in every conceivable area one can think of. Malcolm Gladwell in his essay, “The Talent Myth,” describes a research done by McKinsey & Company with the aim of documenting how the top companies in the U.S. differed from the way they hired and promoted their talent compared to other, less successful ones. The test concluded that “[The top companies] singled out and segregated their stars, rewarding them disproportionately, and pushing them into ever more senior positions.”

Gladwell goes on to describe the management of Enron and how closely they followed the mantra from McKinsey & Co. Enron went bust at the end of 2001. Enron, a poster child for disproportionately rewarding talent, played by the conclusions of McKinsey’s report. McKinsey conducted 20 different projects at Enron. Its directors regularly attended Enron's board meetings and the CEO Ken Lay was a previous McKinsey partner, and still the company did not survive. It now is the “silent evidence” for the failure of the theory.

The experiment itself was flawed in this sense from the beginning. Granted that all the top companies in the U.S. handled their talent in a pampered way, what about the companies who failed even after doing the same? What about the Enrons of the past? They were not part of the sample because they did not appear on McKinsey’s radar.

Let us take the New York Times bestselling book, “The Millionaire Next Door.” In this book Dr. Thomas J. Stanley aims to “reveal the secrets of building wealth in America.” The methodology of doing so is as follows. Dr. Stanley collects data from several millionaires on how they live, eat, shop and save. He comes up with the conclusion that most of the time the wealth is a result of “hard work, diligent savings and living below your means.”

Again, this methodology runs into the problem of silent evidence. Looking at a set of people and trying to explain their success does not give the complete picture. What about all the people who did everything correctly but their assets declined in value ?

* * *

Yesterday I was reading the essay “Blowing Up” by Malcolm Gladwell on Nassim Taleb. And I was quite surprised by the following passage:

Warren Buffett was known as the "sage of Omaha" because it seemed incontrovertible that if you started with nothing and ended up with billions then you had to be smarter than everyone else: Buffett was successful for a reason. Yet how could you know, Taleb wondered, whether that reason was responsible for someone's success, or simply a rationalization invented after the fact?
It hit me that Gladwell seems to be under the impression that Taleb is implying that Buffett might have been just plain lucky. And sure enough after a few lines on George Soros, Gladwell explains himself:

For Taleb, then, the question why someone was a success in the financial marketplace was vexing. Taleb could do the arithmetic in his head. Suppose that there were ten thousand investment managers out there, which is not an outlandish number, and that every year half of them, entirely by chance, made money and half of them, entirely by chance, lost money. And suppose that every year the losers were tossed out, and the game replayed with those who remained. At the end of five years, there would be three hundred and thirteen people who had made money in every one of those years, and after ten years there would be nine people who had made money every single year in a row, all out of pure luck.
I disagree with that conclusion entirely. It is not supported by any math that Buffett might have been plain lucky.

Let us humor Gladwell and take his argument to its inevitable conclusion. The most recent performance tally of Berkshire is given in Buffett’s 2011 letter to shareholders. Let us forget the amount Buffett has beaten the S&P over the last 46 years (which is 10.6% cumulative each year). Let us assume that each coin toss represents a year and winning the coin toss means that you beat the S&P that year. The following table gives the odds of winning as the number of years progresses.

No. of coin tosses (no. of years)Odds
101 in 1024
181 in 262,144
221 in 4,194,304
261 in 67,108,864
301 in 1,073,741,824
341 in 17,179,869,184

The population of the world in 1975 (10 years after Buffett started in 1965) touched 4 billion. The odds for winning 34 years in a row is around 1 in 17 billion.

Following is the table of the Buffett partnership performance from this article.

YearOverall Results From DowPartnership ResultsLimited Partners' Results

Following is the table of the years in which Buffett was beaten by S&P.

YearRelative performance with S&P

Let us take Buffett’s performance during 1957 to 2011. And because the partnership intersects with Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), we will take the worst of the situations, i.e. in 1967 we assume that Buffett lost the toss.

Over the 54 years Buffett then has had 8 down years and 46 up years. In coin-tossing terms that means 46 heads and 8 tails. If a coin is tossed 54 times (assuming that it is equally likely to result in a head or a tail), getting 46 heads and 8 tails has odds of 1 in 17,313,782. The population of the entire U.S. in 1957 was 172 million. To get a track record of Buffett by sheer luck, one needs to start with 17 million managers in 1957! I don’t think that 1 out of 10 people in the U.S. were managers in 1957.

Furthermore, to actually match Buffett one needs to beat the S&P by a significant margin (10.6% cumulatively between 1965 and 2011). The probability of doing this will be significantly smaller but sadly, I do not have the necessary data to run that calculation.

In either case, Warren Buffett cannot be generated randomly.

About the author:

Chandan Dubey
I invest because I want to be free by the time I reach 40 years of age i.e., 2025. My investment style is to find a small number of bets with large margins of safety. I pay a lot of attention to management and their incentive. Ideally, I like to buy owner operator businesses. I am fortunate to have a strong inclination towards studying. I aid my financial understanding by extensive reading in psychology, economic, social sciences etc.

Rating: 4.4/5 (30 votes)


Marcolanaro - 5 years ago    Report SPAM
Quite interesting.
LwC - 5 years ago    Report SPAM
IMO it's ironic that you would refer to Gladwell's "coin flipping" example to illustrate his interpretation of Taleb as implying that Buffett has just been lucky. In fact Buffett used this example in his speech "The Superinvestors of Graham-and-Doddsvile" given at Columbia University in 1984 and published in edited form in the Appendix of the 1986 edition of The Intelligent Investor.

Also FWIW I disagree with your assertion that Stanley, in his book The Millionaire Next Door, concluded "that if you want to be a millionaire you need to do what the people in the book did is plainly wrong." Though it's been years since I read that book, I remember that my takeaway was simply that most millionaires in the USA are not the obvious and usually very public stars, heirs/heiresses, or founders and managers of very large corporations, but rather as you quoted from the book 'a result of “hard work, diligent savings and living below your means” ', and they very often are not obviously "millionaires" to the casual observer. Thus the title of his book.

In fact AFAIK his book was based on his academic research, and AFAIK Stanley didn't intend that it be a "recipe" book or to present a "methodology". Rather IMO it was intended to be informative about what he concluded his research revealed about the reality of most millionaires, which he apparently thought was not known by most people. If you want to dispute Stanley's conclusions, IMO you will be more credible if you point out the deficiencies that you see in his research and show how he erred in reaching his conclusions, rather than twist his conclusions to suit your own POV.

Good Luck.

Cdubey - 5 years ago    Report SPAM
@LwC: I apologize about the misrepresentation. I have not read the book (it was on my to-read list until I read the Black Swan). The critique of the book is based on the criticism by Taleb. Here is what wikipedia has to say:

Nassim Nicholas Taleb criticised the premise of the book on the basis of two instances of survivorship bias: that there is no mention of the accumulators who have accumulated underperforming assets, and that the United States had just gone through the greatest bull market in its history at the time of the book's publication. He suggested that the authors should lower the net worth of the observed millionaires to compensate for the effect of the unobserved losers, and to consider the fate of accumulators following prolonged periods of recession such as in 1982 or 1935.

I see now that the line "that if you want to be a millionaire you need to do what the people in the book did is plainly wrong" was clearly a misunderstanding of the premise of the book. I have edited the corresponding paragraph to incorporate the new information. Thank you about that !

On coin flipping example: It is ironic ! I was thinking the same thing. So Taleb's example was inspired by Buffett.

Ry.zamora - 5 years ago    Report SPAM

Reading introspective articles like yours makes me smile. Keep on going, man.
Traderatwork - 5 years ago    Report SPAM
I've read both the fool by randomness and the black swan. Steal a word from Mr Munger - Twaddle.

Taleb and Malcom books are waste of my time.
Cdubey - 5 years ago    Report SPAM
@Traderatwork: For me, Taleb has been quite revelatory. Sometimes knowledge is just in the knowing even if there is no application. Gladwell, I am a bit ambivalent about. But he is more of an entertainer. And his books entertain me. I have read only one of his books though (What the dog saw). I planning to read Outliers soon.

I don't think Taleb is Twaddle. Far from it. If you read Howard Marks you will realize that he is a fan too. But even without the stamp of Marks I learned enough to call him anti-Twaddle.
Varunfriend premium member - 5 years ago
Thanks for your article ... thoroughly enjoyed reading it.

IMHO, another way of interpreting the silent evidence as applied to Buffett is the number of times he chose NOT to invest. Technology stocks during the tech bubble would be an example. All of those were good decisions that contributed to a good performance but there is technically no evidence of that either.

Cdubey - 5 years ago    Report SPAM
@Varunfriend: Aah ... nice observation. I was not thinking about it that way. Thanks for pointing it out.
Kreshel47 - 5 years ago    Report SPAM
@LwC Precisely!
Tkervin - 5 years ago    Report SPAM
Buffett was not random or lucky. Neither was da Vinci.

What that means for the rest of us is clear.

Don't get your hopes up...:-)

Cdubey - 5 years ago    Report SPAM
>It is not Warren Buffet's Success that you want to generate automatically/ randomly but the success

> of the underlying companies.

@Ufo: That is a more difficult task then "tossing the coin" example I talked about. The argument was to show that Gladwell's "Is Warren just lucky ?" question does not have an affirmative answer. Buffett's success cannot be explained by only luck because to create a much simpler version of him (who only wins coin tosses with S&P) will need a set of 17 million managers !

Warren has averaged a much better return than simply beating the S&P. What you say is true but I don't think anyone will have a reasonable idea to model and measure the probability of the success of the "underlying companies".

>Never buy a goldmine because no one with a real goldmine is going to sell it.

I don't think this is true. Often times people do sell great businesses for *other* reasons. Are you claiming that Lindt & Sprungli is a worse business than Mars because you can buy shares of Lindt ?

Sometimes people may sell a business because they go in debt, they have no succession plans, they mistakenly think that the idea has run its course or they don't realize the potential. From wikipedia:

By May 1, 1889, Candler was now claiming full ownership of the Coca-Cola beverage, with a total investment outlay by Candler for the drink enterprise over the years amounting to $2,300.inflation adjusted $56,685.42, in 2011).

The list is endless: Swatch, Inditex, Walmart, L'oreal, Roche are some examples.
Bruns premium member - 5 years ago
There's a very rough approximation of Buffett that you can use for the coin toss. he's outperformed the S&P by a wide enough margin for fifty years so that you can give him credit for fifty tosses. if you do a future value on one hundred thousand people randomly doing that at a probability of 50% each year the chances are about one in ten billion that someone will come out the other end of that streak. not bloody likely as our english friends say.

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