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Coin-Flipping & Graham-and-Doddsville

     The fictional village of Graham-and-Doddsville was introduced by Warren Buffett in 1984. The edited transcript of a talk given by Buffett at Columbia University is included in the Appendix of a special edition of The Intelligent Investor titled "The Superinvestors of Graham-and-Doddsville." Buffett presents an analogy of a national coin-flipping contest whereby everyone in America wagers one dollar on their ability to call a coin flip. The following is only a summary based on the version presented in the book but it includes current population numbers and additional commentary. Text in quotes are directly from the Appendix of The Intelligent Investor.

     "I would like you to imagine a national coin-flipping contest." Let's imagine all 268 million people in the United States are asked to wager one dollar on their ability to call the flip of a coin. "If they call correctly, they win a dollar from those who called wrong." After each flip the losers drop out, and on the subsequent flip the stakes multiply. Each person has a 50-50 chance of calling each flip and approximately half of the people will lose and drop out each round. After ten flips there would be approximately 260,000 people that had successfully called ten consecutive coin flips. After 20 flips, based purely on chance, there would be approximately 250 people that had called 20 consecutive coin flips - a seemingly miraculous feat.

     The surviving callers would have over one million dollars each at that point. Press coverage and inquiries about their coin calling ability would increase with each successive flip. Several callers might even attempt to profit from their good fortune by writing books on coin calling, setting up 900 phone lines, or by sending mass mailings or spam Email solicitations offering to share their secrets with intrigued members of the public.

     As with winners of the lottery, its obvious that those remaining would have been blessed with good luck. But what if a large percentage of remaining coin flippers had a common characteristic or trait. What if a disproportionate number had came from one town or had been educated by one "patriarch." Would this signify that more than luck was involved in calling coin flips?

     It is at this point when its intriguing to compare the coin flippers to investors. There are literally millions of investors and stock pickers trying to beat the stock market. Clearly, based on the laws of probability, many will be successful in significantly outperforming the market even over long periods of time. The question is: are successful stock pickers effectively equivalent to lucky coin callers or are there some common characteristics, styles or traits among the outperformers that signify that more than just luck is involved? It is in this context that Buffett introduced the fictional land of Graham-and-Doddsville.

"I submit to you that there are ways of defining an origin other that geography. In addition to geographic origins, there can be what I call an intellectual origin. I think you will find that a disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddsville."

     When you look at the performance records of successful long term investors it seems that a disproportionate number have a particular investing style. They list value investing as their style and Ben Graham as their "intellectual patriarch." Buffett goes on to identify a number of successful long term investors that all make use of the principles and themes taught by Graham and Dodd. Buffett concludes that the evidence implies that the concentration of winners cannot be explained by chance but "can be traced to this particular intellectual village."

     The coin-flipping analogy is a common one and useful for many purposes. An important point to realize is that strong performance doesn't necessarily signify skill, especially in the short term. To differentiate skill from luck it is critical to look at the big picture and the coin-flipping analogy can be useful in that perspective. If the experiment continued, odds are only one survivor would remain after 28 flips. Similarly, in every ranking and comparison of investors and money managers there has to be someone at the top of the list. The important issue to address is whether there are any common characteristics among the succesful flippers (or investors) that result in more success than would be expected by pure chance.

     There are thousands of money managers, mutual funds, and other market "players" constantly trying to beat the market. Investors who ignore the odds and mathematical probabilities run the risk of investing based on previous successes that are the result of nothing more than random chance. In fact, when researchers compare the distribution of returns of stock pickers (money managers, mutual funds, etc.) with distributions generated at random, they find that the results are hard to differentiate.

     It's clear that in the past, a larger percentage of investors from Graham-and-Doddsville have beaten the market than can be explained by chance. But its also clear that while Graham-and-Doddsville was once a neglected and little known village, it is now quite popular and a larger percentage of investors classify themselves as natives of the town. Will the village of Graham-and-Doddsville continue to produce a disproportionate number of successful investors in the future? Time will tell, but we know that betting against the villagers certainly hasn't been a market beating strategy in the past.

     The tools and techniques used by the villagers can be found in Graham and Dodd's Security Analysis. Other versions of the coin flipping analogy can be found in other books including Andrew Tobias' The Only Investment Guide You'll Ever Need and Where Are The Customerís Yachts? by Fred Schwed.

     See also

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