Fooled by Randomness – by Nassim Nicholas Taleb
Date read: 8/28/17. Recommendation 8/10.
Deep dive into the role of luck in the financial markets and life. Taleb emphasizes how we tend to only accept randomness in our failures, never in our successes. He discusses concepts like Monte Carlo math, Russian roulette, the Pólya process, nonlinearity and the human brain, and Buridan's donkey. Our tendency to favor the visible, narrated, and neat models, leads us to being fooled by randomness. He summarizes best by suggesting we are all idiots who are mistake prone, but only a handful of us have the rare privilege of knowing it.
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That which came with the help of luck could be taken away by luck (and often rapidly and unexpectedly at that). The flipside, which deserves to be considered as well (in fact it is even more of our concern), is that things that come with little help from luck are more resistant to randomness.
Lucky fools do not bear the slightest suspicion that they may be lucky fools–by definition, they do not know that they belong to such a category. They will act as if they deserved the money. Their strings of successes will inject them with so much serotonin (or some similar substance) that they will even fool themselves about their ability to outperform markets.
Had Nero had to relive his professional life a few million times, very few sample paths would be marred by bad luck– but, owing to his conservatism, very few as well would be affected by extreme good luck.
I thus view people distributed across two polar categories: One one extreme, those who never accept the notion of randomness; on the other, those who are tortured by it.
When I started on Wall Street in the 1980s, trading rooms were populated with people with a "business orientation," that is, generally devoid of any introspection, flat as a pancake, and likely to be fooled by randomness. Their failure rate was extremely high, particularly when financial instruments gained in complexity.
Such a tendency to make and unmake prophets based on the fate of the roulette wheel is symptomatic of our ingrained inability to cope with the complex structure of randomness prevailing in the modern world.
We are not wired in a way to understand probability.
MBAs tend to blow up in financial markets, as they are trained to simplify matters a couple of steps beyond their requirement. (I beg the MBA reader not to take offense; I am myself the unhappy holder of the degree.)
Journalism may be the greatest plague we face today–as the world becomes more and more complicated and our minds are trained for more and more simplification.
I remind myself of Einstein's remark that common sense is nothing but a collection of misconceptions acquired by age eighteen.
Any reading of the history of science would show that almost all the smart things that have been proven by science appeared like lunacies at the time they were first discovered.
Learning from history does not come naturally to us humans, a fact that is so visible in the endless repetitions of identically configured booms and busts in modern markets. By history I refer to the anecdotes, not the historical theorizing...
For me, history is of use merely at the level of my desired sensibility, affecting the way I would wish to think by reference to past events, by being able to better steal ideas of others and leverage them, correct the mental defect that seems to block my ability to learn from others.
In some respects we do not learn from our own history...For example, people fail to learn that their emotional reactions to past experiences (positive or negative) were short lived–yet they continuously retain the bias of thinking that the purchase of an object will bring long-lasting, possibly permanent, happiness or that a setback will cause severe and prolonged distress.
Our minds are not quite designed to understand how the world works, but, rather to get out of trouble rapidly and have progeny.
A mistake is not something to be determined after the fact, but in the light of the information until that point.
It takes a huge investment in introspection to learn that the thirty or more hours spent "studying" the news last month neither had any predictive ability during your activities of that month nor did it impact your current knowledge of the world.
A preference for distilled thinking implies favoring old investors and traders, that is, investors who have been exposed to markets the longest.
Over a short time increment, one observes the variability of the portfolio, not the returns.
Our emotions are not designed to understand the point. The dentist did better when he dealt with monthly statements rather than more frequent ones.
My problem is that I am not rational and I am extremely prone to drown in randomness and to incur emotional torture. I am aware of my need to ruminate on park benches and in cafes away from information, but I can only do so if I am somewhat deprived of it.
At any point in time, the richest traders are often the worst traders. This, I will call the cross-sectional problem: At a given time in the market, the most successful traders are likely to be those that are best fit to the latest cycle.
Recall that someone with only casual knowledge about the problems of randomness would believe that an animal is at the maximum fitness for the conditions of its time. This is not what evolution means; on average, animals will be fit, but not every single one of them, and not at all times.
One vicious attribute is that the longer these animals can go without encountering the rare event, the more vulnerable they will be to it.
Studying the European markets of the 1990s will certainly be of great help to a historian; but what kind of inference can we make now that the structure of the institutions and the markets has changed so much?
There is no point searching for patterns that are available to everyone with a brokerage account; once detected, they would be self-canceling.
Economics: you can disguise charlatanism under the weight of equations, and nobody can catch you since there is no such thing as a controlled experiment.
Nowhere is the problem of induction more relevant than in the world of trading–and nowhere has it been as ignored!
No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion.
Markets (and life) are not simple win/lose types of situations, as the cost of the losses can be markedly different from that of the wins.
The virtue of capitalism is that society can take advantage of people's greed rather than their benevolence, but there is not need to, in addition, extol such greed as a moral (or intellectual) accomplishment.
The survivorship bias implies that the highest performing realization will be the most visible. Why? Because the losers do not show up.
Remember that nobody accepts randomness in his own success, only in his failures.
Medical researchers are rarely statisticians; statisticians are rarely medical researchers. Many medical researchers are not even remotely aware of this data mining bias.
Assume you are standing in 1900 with hundreds of investments to look at. There are stock markets of Argentina, Imperial Russia, the United Kingdom, Unified Germany, and plenty of others to consider. A rational person would have bought not just the emerging country of the United States, but those of Russia and Argentina as well. The rest of the story is well-known; while many of the stock markets like those of the United Kingdom and the United States fared extremely well, the investor in Imperial Russia would have no better than medium-quality wallpaper in his hands. The countries that fared well are not a large segment of the initial cohort; randomness would be expected to allow a few investment classes to fare extremely well. I wonder if those "experts" who make foolish (and self-serving) statements like "markets will always go up in a any twenty-year period" are aware of this problem.
This chapter is about how a small advantage in life can translate into a highly disproportionate payoff, or, more viciously, how no advantage at all, but a very, very small help from randomness, can lead to a bonanza.
Nonlinearities = straw that broke the camel's back, drop that caused the water to spill.
These nonlinear dynamics has a bookstore name, "chaos theory," which is a misnomer because it has nothing to do with chaos. Chaos theory concerns itself primarily with functions in which a small input can lead to a disproportionate response.
Say you played roulette and won. Would this increase your chances of winning again? No. In a Polya process case, it does (probability of winning increases after past wins, and vice versa). Why is this so mathematically hard to work with? Because the notion of independence (i.e., when the next draw does depend on past outcomes) is violated. Independence is a requirement for working with the (known) math of probability.
Our brain is not cut out for nonlinearities. People think that if, say, two variables are casually linked, then a steady input in one variable should always yield a result in the other one...But reality rarely gives us the privilege of a satisfying linear positive progression: You may have to study for a year and learn nothing, then, unless you are disheartened by the empty results and give up, something will come to you in a flash...Most people give up before the rewards.
There are routes to success that are nonrandom, but few, very few people have the mental stamina to follow them.
Buridan's Donkey: Nonlinearity in random outcomes is sometimes used as a tool to break stalemates. *Randomness is not always unwelcome.
You stop when you get a near-satisfactory solution. Otherwise it may take you an eternity to reach the smallest conclusion or perform the smallest act. We are therefore rational, but in a limited way: "boundedly rational." [Herbert Simon] believed that our brains were a large optimizing machine that had built-in rules to stop somewhere.
There are two possible ways for us to reason:
Heuristics: effortless, automatic, associative, rapid, parallel process, opaque (i.e. we are not aware of using it), emotional, concrete, specific, social, and personalized.
Rationality: effortful, controlled, deductive, slow, serial, self-aware, neutral, abstract, sets, asocial, and depersonalized.
1) We do not think when making choices but use heuristics. 2) We make serious probabilistic mistakes in today's world.
Causality can be very complex. It is very difficult to isolate a single cause when there are plenty around. This is called multivriate analysis.
Unless something moves by more than its usual daily percentage change, the event is deemed to be noise. Percentage moves are the size of the headlines. In addition, the interpretation is not linear; a 2% move is not twice as significant as an event as 1%, it is rather like four to ten times. A 7% move can be several billion times more relevant than a 1% move!
My lesson from Soros is to start every meeting at my boutique by convincing everyone that we are a bunch of idiots who know nothing and are mistake-prone, but happen to be endowed with the rare privilege of knowing it.
People confuse science and scientists. Science is great, but individual scientists are dangerous. They are human; they are marred by the biases humans have.
Recall that epic heroes were judged by their actions, not by the results. No matter how sophisticated our choices, how good we are at dominating the odds, randomness will have the last word.
There is nothing wrong and undignified with emotions–we are cut to have them. What is wrong is not following the heroic or, at least, the dignified path. That is what stoicism truly means. It is the attempt by man to get even with probability.
Our attribution of heroism to those who took crazy decisions but were lucky enough to win shows the aberration–we continue to worship those who won battles and despise those who lost, no matter the reason.
Some degree of unpredictability (or lack of knowledge) can be beneficial to our defective species. A slightly random schedule prevents us from optimizing and being exceedingly efficient, particularly in the wrong things.
We know that people of a happy disposition tend to be of the satisficing (blend of satisfying and maximizing) kind, with a set idea of what they want in life and an ability to stop upon gaining satisfaction...They do not tend to experience the internal treadmill effects of constantly trying to improve on their consumption of goods by seeking higher and higher levels of sophistication. In other words, they are neither avaricious nor insatiable. *Optimizers = unhappy and always seeking a better deal.
We favor the visible, the embedded, the personal, the narrated, and the tangible; we scorn the abstract. Everything good (aesthetics, ethics) and wrong (Fooled by Randomness) with us seems to flow from it.