Fooled by Randomness

 

Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets

 Nassim Nicholas Taleb

Preview

 

Fooled by Randomness deals with the fallibility of human knowledge, and the significance of chance! Do successful fund managers owe their success to their method of picking stocks, or are they just lucky? Taleb distils his experiences and his ideas together into one book and presents the argument that most of the star performers in stock market owe their success to luck than to their own skills. He also highlights that all professions involving significant risk have victors who win mostly by chance and not by skill.

 

About the Author

Nassim Nicholas Taleb is a Lebanese born American writer, statistician, former trader, and a risk analyst. His works deal with the implication of probability and uncertainty in the world. He has written a bestselling trilogy of books on randomess: The Black Swan, Fooled by Randomness, and Antifragile.

 

The Big Idea: It is more random than we think!

 

We adulate the winners and completely ignore the large sample size of failures who were in the game. This kind of skewed thinking causes survivorship bias and results in an improper generalization of results. This book emphasizes the impact of randomness in our lives, and argues that our irrational brain guided by heuristics and emotions, fails to comprehend its importance.

Taking pride in achievements is human nature. We attribute hard work and deliberate efforts to achievement. However, when it comes to our failures, we often hold luck responsible! The stories written by victors in so many domains of life often leave little chance for the narrative of randomness to tell its story. The effect of a phenomenon called randomness is quite prevalent in the stock markets. Here, the star traders can make money for a long period of time and then only with a  few bad calls, lose it all. The world has extreme survivor's bias and the majority totally neglects the sample size. Different professions bear different effect of randomness. In the stock market, the winners and losers all owe their wealth to randomness for the most part. However, in professions like that of a dentist, the effects of randomness are far less. A Dentist's success can be attributed to himself and his choices. As a general rule, the effect of randomness directly proportional to the amount of risk involved. Higher the risk, the more is randomness and lower risk means lower randomness.

In this book you will learn:

 

1)    Why the world is more random than we think it is

2)    Why journalism is more about entertainment and not "news".

3)    Why measuring results may not be the correct way of identifying a good choice.

 

The Survival biases. Focusing on successes can mislead. 

If one follows the right mathematics of statistics, they can understand the influence of randomness. Sadly, many MBAs and traders neglect it completely. Even Scientists sometimes falter in appreciating the influence of randomness. The influence of randomness is measurable and can be studied using principles of statistics. The illustration for Russian roulette games can drive the point easily. If thousands of 25-year-old play Russian roulette where the Victor in each game gets $ 10,000 and the loser obviously dies, then in next 25 years we will see a few lucky winners who are very rich. But, there will also be a huge cemetery for all the dead ones. However, the problem is that the people only see the victors and conveniently ignore the dead, thus skewing the actual description of reality. Scientists are often trained to see through this statistical bias, and thus their actions are more rational. This is one of the reasons why scientists (or academicians) turned traders survive longer than MBA graduates as traders, analysts or fund managers. There are well devised statistical techniques to study randomness and its effects. Monte Carlo simulation is one of the more popular strategies. It simulates models depicting all possible outcomes with different probabilities. The technique is widely used in risk analysis and decision making in the stock market, and also finds significant application in the studies of evolution, economics, and computer science.

 

Evolution is misunderstood. Life is unfair and non-linear: The best do not always win.

 Darwin's theory of evolution is perhaps one of the most misused scientific theories of all times. Eugenicists used it inappropriately in Nazi Germany to justify the genocide of Jews in the guise of racial supremacy. In the corporate world, it translates into another fallacy: The belief that the free markets and competition create the perfect organizations, and that the survivors are or will be uber perfect. Similarly, bankers also believe that the competition between traders will ultimately reveal the best of the lot.

However, randomness can fool evolution itself! The idea that best will always win is wrong in itself. This is because a rare event can still occur and influence the probability of survival. For example, sickle cell anemia is prevalent among countries where malaria is rampant. Though normal cells are superior in most aspects, they can be infected with malaria unlike the mutated sickled cells! This causes a less viable alternative to survive over a more viable one.

 

The stock market, Climate change, and politics; rare events play a significant role everywhere. 

Human beings are not naturally attuned to understand the importance of rare events. Since rare events are "rare" they are often ignored, or their impact underestimated, which totally changes the probabilities of results. People are not the rational beings they believe themselves to be. Most of our decision making comes from heuristics which is simply a patchwork of rules and shortcuts. We only make a logical connection in retrospect and if a similar situation arises, use that logic to deduce the future. This is why the importance of rare events can be missed. Quite simply because they are rare in occurrence, it is hard to gauge their impact.

Climate scientists committed this mistake years ago when they were building a climate model. They ignored the random temperature spikes which occur irregularly, which resulted in the final model being way off the observed reality. Only when they corrected for those rare events did the model match the observed reality. The Stock Markets too can experience the wrath of a rare event. A sudden military coup in an oil-rich nation can change its foreign policy. The investment which would have been secure in the previous regime could suddenly became volatile. This can start a chain reaction of panic which can cause the entire market to plummet.

 

To have extreme confidence in any one theory is a road to failure in both Science and the Stock Markets. 

It is impossible to prove any theory. Each new observation can either support or contradict a theory. As much as humans take pride in their decisions, they are equally attached to their theories which result in those decisions. However, the world is dynamic and what holds true yesterday may not be true today. With latest advances in knowledge, the previous theories can be proven wrong. The simplest illustration of this can be given by a classic example given by John Stuart Mill. The example goes as follows: if we see only white swans every day for a long period of time, does it mean that all swans are white? Well, this inductive reasoning can never justify any theory for sure. However, if we see a black swan even only once, then it proves that all swans are NOT white. This means that no theory can ever be proved right but it can be proved wrong by a single observation! 

Many star traders who were once extremely revered for their astute skills, were stripped from their titles once they lost some big bets in the market. The Dotcom bubble, the financial crisis of 2008, were all such times. Those who chose to cling to their well-established game plans saw their lifetime of fortunes vanish. History helps us to not repeat past mistakes, but it is equally useless in giving any reasonable prediction for future.

 

 

 

Emotions influence our so-called rational "judgment" and they can be helpful or disastrous depending on how well we can keep them in check. 

The working of the human mind is not based upon strict rational logic as we may like to believe. It is often a set of collected heuristics derived from experience. They are then generalized into rational explanations using inductive logic. For all sorts of unexpected or logically complicated situations, our brain relies on our emotions to simplify the situation. It does so by creating a bias towards one result or another which then leads to decision making. 

They may seem irrational, but emotions do help us get out of a tough situation. Let's take the example of a famous philosophical paradox, Buridan's ass. Let's say that the donkey is equidistant from a source of food and water. It is also equally hungry and thirsty. If it uses logic to determine which direction it should move in it will die without coming to a rational conclusion. However, the presence of emotions can lead to a result which may be called biased and irrational, but in certain situations of stalemates, leads to a decision! A coin flip so to speak, to rescue our own self from disaster. However, emotional outbursts can also plague our capability to think rationally when the situation demands it. When emotional outbursts dictate behavior, tragedies occur!

 

Random noise is all around us and it needs to be filtered out to separate the good from the bad.

There are random noises in everyday world because it is stochastic and filled with chances. Daily fluctuations can be seen in prices of shares in the stock market. Randomness is also visible in politics where depending upon the situation, politicians act differently than their proclaimed ideology. Having said that, many of these movements and fluctuations do not reflect any actual trends. Even so, they are highlighted by the media for self-serving reasons. It is because sensational news sells better than rational news. 

If you become an investor with a stock portfolio, which hypothetically has 10% volatility and 15% expected returns. Upon checking your portfolio every minute, you will largely only see the small variance inherent to the portfolio, i.e. the natural ups and downs that are not related to the stock's performance. If you rejoice at every profit and agonizes over every loss than it would amount to experiencing 60,688 minutes of pleasure versus 60,271 minutes of pain annually. While on the other hand by checking portfolio annually you can expect to feel pleasure 19 out of 20 years. It is prudent to remember that both in the media and the stock markets, random noise is not worth investing into.

Not all randomness is bad, sometimes randomness can create beautiful art, or great music.

To free oneself of biases created by insignificant events requires patience as well as skilled computation. Even when life hits hard with unexpected and random occurrences, deal with the situation in a stoic manner and  remember that it is always more random than you think! 

 

 

Final Summary 

We hope you enjoyed this quid on "Fooled by Randomness". Randomness exists everywhere, and it hides in plain sight. One can assess the effects of randomness only through statistical analysis of the situation with reliable information and no biases. Our world is probabilistic, and we keep getting fooled by randomness. The world is dynamic, and we can never be sure any theory is right as things constantly change. The next observation may prove us wrong. Life is unfair and nonlinear: The best do not always win! Despite all the impact randomness makes in our lives we fail to appreciate it! One reason is that our reasoning is context-dependent and based on simple heuristics. In complex logical conundrums emotions help us to make decisions. But, if emotions are let loose, they can also overwhelm our capacity for rational reasoning. In retrospect, we always find patterns, causes, and explanations in past events. Still, they are mostly useless for predicting the future. Enjoy harmless randomness and use stoicism to handle the harmful kind. Both in the media and stock markets, random noise is not worth listening to.

 

Stand out sections 

Chapter 11, which discusses how probabilities are miscalculated, is fascinating. Overall the entire book is extremely well written. The chapters on Nero and John, two traders with a different background, lifestyle and ultimately different fate are enjoyable. Sections talking about the capabilities of Monte Carlo simulations in varied fields of biology, economics, and physics is also very interesting.