Adverse Selection (Selection Bias)
A fund can choose to advertise after a strong run, so advertised performance is a selected sample. Taleb warns that this makes past success harder to interpret: the advertisement alone does not distinguish skill from luck.
THE IDEA
An Interrupted Tennis Game
It is not uncommon for someone watching a tennis game on television to be bombarded by advertisements for funds that did (until that minute) outperform others by some percentage over some period. But, again, why would anybody advertise if he didn’t happen to outperform the market? There is a high probability of the investment coming to you if its success is caused entirely by randomness. This phenomenon is what economists and insurance people call adverse selection. Judging an investment that comes to you requires more stringent standards than judging an investment you seek, owing to such selection bias. For example, by going to a cohort composed of 10,000 managers, I have 2/100 chances of finding a spurious survivor. By staying home and answering my doorbell, the chance of the soliciting party being a spurious survivor is closer to 100%. These percentages belong to Taleb’s illustration; the passage does not derive them as general rates for investment solicitations.
When to use it
Evaluating investment opportunities that are actively marketed to you.
Assessing the credibility of testimonials or reviews that are voluntarily provided.
Understanding why unsolicited advice or offers may be less trustworthy.
Analyzing performance data of funds that are advertised versus those that are not.
FROM THEORY TO EVERYDAY LIFE
In practice
Tennis Game Investment Advertisements
A fund advertises after outperforming the market. Because funds can select favorable periods and successful products for promotion, the advertisement is not a random sample of investment performance. Further evidence is needed to distinguish skill from luck.
Cohort of Managers
Taleb contrasts approaching a cohort of 10,000 managers, with a stated spurious-survivor chance of 2/100, and receiving a solicitation, which he places close to 100%. These are the passage’s illustrative figures; their assumptions and derivation are not supplied.
A MOMENT TO REFLECT
Put it to work.
When you see an advertisement for a high-performing investment, what factors should you consider to determine if the performance is due to skill or luck?
How does the context in which you encounter an opportunity (sought vs. presented) affect its reliability?
Can you think of other areas in life where adverse selection might occur? For example, in job applications or dating?
CONTINUE THE CONVERSATION
Source texts
- Fooled by Randomness The Hidden Role of Chance in the Markets and in Life (Nassim Nicholas Taleb)