Steve's Reviews > Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets

Fooled by Randomness by Nassim Nicholas Taleb
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's review
Oct 02, 07

Renowned statistician George Box once said, “All models are wrong, but some are useful.” The author of Fooled by Randomness is all over the first part of this statement, but apparently doesn’t consider it part of his job as an iconoclast to say anything about the second. Taleb goes to great lengths to point out how some of the original assumptions made in investments and finance have blown up in people’s faces. Yes, unusual events do happen more often than a normal distribution suggests. Yes, relationships among securities can change in meltdown scenarios. And yes, people are regularly fooled into thinking luck is skill. However, some market participants are clear-sighted enough to see those shrouded risks for what they are and make better assumptions about how they should be traded off against expected returns. These more enlightened investors don’t get the print, though, since they’re not the straw men Taleb can knock down.

Don’t get me wrong. We all like debunking stodgy, established wisdom when we see the holes. If you’re like Taleb, though, and see only holes, what you’re left with is nothing. What might there be in its place? Some models, when tweaked, are still useful.

In a brief moment of modesty, Taleb confesses to psychological weaknesses that can lead him to mistake noise for signal. He seems rather smug about it all, though. It’s like he figures his ability to recognize himself as a fool puts him on a higher plane. For the most part, his ego is openly displayed. It’s also coupled with an axe to grind – an aggressive combination. His fund has consistently underperformed (though he would counter that he’s positioned just right for the coming holocaust). His investment strategy boils down to buying lots and lots of insurance contracts against rare occurrences that he thinks will be slightly less rare. (In actuality, he buys stock options, but the insurance metaphor illustrates the point.) The problem is he’s so firm in his belief that the insurance companies have underestimated risks that he thinks all premiums are too low. However, those selling options, armed with models that account for rare events appropriately, will charge more than enough to cover those risks.

Who will be fortune’s fool? Time will tell, but a provocateur like Taleb will in all probability be better known for his quasi-epistemological exposition on unanticipated variability than for any true investment success.
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Comments (showing 1-3)

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Xiaosen Xie Well, he just made a small fortune off of the latest economic collapse (so did the hedge fund company he advised)...guess he got sort of vindicated eh?

James Moughan Yes, given that the financial crisis was caused in large part by faulty risk modelling based on assuming a Gaussian distribution where that was known to be incorrect, Taleb seems completely vindicated and this review seems quite funny.

Steve I guess I would have worded things differently had I written my review after the late '08 meltdown in the market. At the same time, I still stand by much of what I said. My central point was that plenty of other investment professionals know that fat-tailed distributions are the norm in financial markets and that the added risk inherent in that should be priced into asset values. Implied vols of options in the put wing are almost invariably higher than at the higher strikes, reflecting this knowledge of greater risk to the downside. This has been the case at least as long ago as the '87 crash.

As for Taleb's vindication, I hear he did do well for himself in late '08. However, he had already sold out of the fund he'd been running at that point. Up until the crash, the fund consistently lost money. Whenever you buy out-of-the-money puts, the payoffs are bound to be like that -- slow bleeding for extended periods and spurts that may or may not make up for it. In order to really tell if the market consistently misprices the tail events Taleb has familiarized everyone with (though he was hardly the first to recognize them), you'd need to evaluate an out-of-the-money put purchase strategy for extended periods, not just after the big downturns.

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