Special to AllAboutAlpha.com by: Konstantin Danilov, CAIA
Looking at several excerpts from chapter 25 of Machiavelli’s letter to Lorenzo de’ Medici written in 1513, it is interesting to note that a large portion of this particular chapter is particularly relevant to the hedge fund industry. It seems that ideas that were once known and respected have since been forgotten or largely ignored; modern day investors would be wise to revisit Machiavelli’s prescient observations on the topic of luck and randomness and the implications for hedge fund investing. (As you will see, you might even say that best-selling author Nassim Nicholas Taleb is somewhat of a latter-day Niccolo Machiavelli.)
Chapter 25 begins with the idea one must understand the overwhelming effect of luck on life events, and by extension, the financial markets:
“Nevertheless, since our free will must not be denied, I estimate that even if fortune is the arbiter of half our actions, she still allows us to control the other half, or thereabouts. I compare fortune to one of those torrential rivers which, when enraged, inundates the lowlands, tears down trees and buildings, and washes out the land on one bank to deposit it on the other. Everyone flees before it; everyone yields to its assaults without being able to offer any resistance.”
Machiavelli’s observations are even more relevant today, as the complex world of finance is highly influenced by randomness, yet few people realize the impact of luck on hedge fund performance. Because of the overwhelmingly large sample size (number of fund managers or investors), it is inevitable, based on randomness alone, that during our lifetime we will encounter a fund manager like Michael Steinhardt. With that in mind, it is easy to see that, as Nassim Taleb points out in Fooled By Randomness:
“…the number of managers with great track records in a given market depends far more on the number of people who started in the investment business (in place of going to dental school), rather than on their ability to produce profits”.
In the next line, Machiavelli alludes to some of the phenomena that we often witness in the financial industry; here, we can replace “prince” with “investor” (or hedge fund, etc.), “safely in power” with “outperforming”, and finally, “overthrown” with “blow-up”.
“But limiting myself to particulars, I would like to point out why it is that we see a prince safely in power on one day and overthrown the next, though there has been no change in his character or behavior.”
Some examples that come to mind here are high-flying hedge fund stars like Julian Robertson (who turned $8 million in start-up capital in 1980 into over $22 billion in the late 1990s, and subsequently blew up in 2000) and Victor Neiderhoffer (who after years of superb performance had to mortgage his house after his fund blew up), as well as LTCM. Machiavelli then goes on to explain the reason for this phenomenon:
“This derives first of all, I think, from that fact that a prince who relies entirely upon fortune will fail when his fortune changes. It also derives, I think, from the fact that a prince is successful when he fits his mode of proceeding to the times, and is unsuccessful when his mode of proceeding is no longer in tune with them.”
Performance in financial markets is heavily influenced by factors such as sample size (as mentioned above) survivorship bias (we only look at the successes). Because of the effect these factors, it is impossible to determine (based on performance alone, at least) whether skill or luck is the driving force (a la Taleb’s “The Black Swan”).
The next passage is particularly relevant as it relates to the different methods of investing that are employed by the various market participants:
“We note that men pursue the ends they have in view, that is, glory and wealth, by different ways. One uses caution while another is impetuous, one resorts to violence while another relies on craft, one acts patiently while another does the contrary; and each reaches his goal by a different route. We also note that of two men who employ caution one will gain his objective while the other will not, or that both will gain their objectives by different means, one by being cautious, the other by being impetuous.”
The prior passage alludes to the fact that the outcome (in this case investment performance) does not necessarily validate the methods (investment strategy) employed to arrive at that outcome. The reason for this is as follows:
“The case of this is nothing other than the character of the times to which these modes of conduct may or may not be suited. It is this, as I have said that explains how tow men using different methods will achieve the same results, and two others using similar methods will achieve contrary results – the one succeeding, the other failing.”
or, as Taleb says in “Fooled by Randomness“:
“…never considered that the fact that trading on economic variables has worked in the past may have been merely coincidental, or, perhaps even worse that economic analysis was fit to past events to make the random element in it.”
This generally occurs because the markets produce a vast amount of noise (random, short-term price/level movements that do not contribute to the overall long-term trend) that is often mistaken by market participants for information. Aside from the coincidental benefit of favorable returns, luck can also entail the temporary avoidance of a particular risk. In the case of LTCM (mentioned above), luck was the only reason that the fund did not blow up sooner than it did; many investors reap profits for years by taking on huge unseen risks, and are wiped out when their luck runs out and they experience a “black swan” event. The next passage elaborates upon this idea:
“This also explains the inconsistency of prosperity. If one is cautious and patient in his method of proceeding and the times lend themselves to this kind of policy, he will prosper. But if the times and circumstances change, he will fail, for he will not alter his policy […] because having prospered in pursuing a particular method, he will not be persuaded to depart from it. Hence, when the times require it, the cautious man will not know how to act impetuously and he will be overthrown. If he were able to adapt his nature to changing times and circumstances, however, his fortunes would not change.”
Because the lucky investor does not realize that he is lucky when things are going well, he will be caught off guard and suffer massive losses when his fortuitous circumstances change. (The adjectives cautious and impetuous in this case should not be taken literally, but instead serve as describing any two opposing methods or styles of investing.) Because he is ignorant of his luck (instead, attributing his success to skill), he will not change his methods when it becomes necessary to do so. One example of this is the fate of many internet start-up companies and their owners during the tech bubble; as the bubble pushed the valuations of these essentially worthless companies to their peak, many prudent entrepreneurs, realizing their serendipitous circumstances, sold their companies before their “value” evaporated. Others – attributing the success of their companies to their sheer entrepreneurial skill – continued to own and operate their businesses and were wiped out as their luck suddenly changed when the tech bubble finally burst. Machiavelli makes the point that the impact of luck, or more specifically bad luck, is most severe on the unprepared:
“…The same can be said about fortune, which tends to show her strength where no resources are employed to check her. She turns her course toward those points where she knows there are no levees or dikes to restrain her…”
Finally, Machiavelli offers his advice on how to operate, and perhaps succeed, in this type of randomness-prone environment:
“Therefore, since fortune changes while human beings remain constant in their methods of conduct, I conclude that men will succeed so long as method and fortune are in harmony and they will fail when these are no longer in harmony. But I surely think that it is better to be impetuous that to be cautious, for fortune is a woman and in order to be mastered she must be jogged and beaten. And it may be noted that she submits more readily to boldness than to cold calculation.”
(It should be noted that impetuous is used here as “moving with great force and energy” and not in its more common usage as “done without though as a reaction to an emotion or impulse”. Conversely, cautious is taken to mean “timid” or otherwise weak.) This concluding passage offers timeless advice to market participants: traders must incessantly question their methods and beliefs – especially when things are going well. During periods of strong performance, it is easy to be lulled into a sense of false security, unquestioningly attributing success to an inherent skill. However, unless hedge fund managers continually and aggressively (or impetuously) test their methods and allow for the idea that some (or all) of their success can be the result of luck, they will be setting themselves up for a huge loss if, and when, their fortunes change.
– K. Danilov, March, 2009
The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com.