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

by Nassim Nicholas Taleb

A mistake is not something to be determined after the fact, but in the light of the information until that point.

How could traders who made every single mistake in the book become so successful? Because of a simple principle concerning randomness. This is one manifestation of the survivorship bias. We tend to think that traders were successful because they are good. Perhaps we have turned the causality on its head; we consider them good just because they make money. One can make money in the financial markets totally out of randomness.

The philosopher Pascal proclaimed that the optimal strategy for humans is to believe in the existence of God. For if God exists, then the believer would be rewarded. If he does not exist, the believer would have nothing to lose. Accordingly, we need to accept the asymmetry in knowledge; there are situations in which using statistics and econometrics can be useful. But I do not want my life to depend on it.

The Backtester A programmer helped me build a backtester. It is a software program connected to a database of historical prices, which allows me to check the hypothetical past performance of any trading rule of average complexity. I can just apply a mechanical trading rule, like buy NASDAQ stocks if they close more than 1.83% above their average of the previous week, and immediately get an idea of its past performance. The screen will flash my hypothetical track record associated with the trading rule. If I do not like the results, I can change the percentage to, say, 1.2%. I can also make the rule more complex. I will keep trying until I find something that works well. What am I doing? The exact same task of looking for the survivor within the set of rules that can possibly work. I am fitting the rule on the data. This activity is called data snooping. The more I try, the more I am likely, by mere luck, to find a rule that worked on past data. A random series will always present some detectable pattern. I am convinced that there exists a tradable security in the Western world that would be 100% correlated with the changes in temperature in Ulan Bator, Mongolia.

Repetitiveness is key for the revelation of skills because of what I called ergodicity in Chapter 8—the detection of long-term properties, particularly when these exist. If you bang one million dollars at your next visit to Las Vegas at the roulette table in one single shot, you will not be able to ascertain from this single outcome whether the house has the advantage or if you were particularly out of the gods’ favor. If you slice your gamble into a series of one million bets of one dollar each, the amount you recover will systematically show the casino’s advantage. This is the core of sampling theory, traditionally called the law of large numbers. To view it in another way, consider the difference between judging on process and judging on results. Lower-ranking persons in the enterprise are judged on both process and results—in fact, owing to the repetitive aspect of their efforts, their process converges rapidly to results. But top management is only paid on result—no matter the process. There seems to be no such thing as a foolish decision if it results in profits. “Money talks,” we are often told. The rest is supposed to be philosophy. Now take a peek inside the chief executive suite. Clearly, the decisions there are not repeatable. CEOs take a small number of large decisions, more like the person walking into the casino with a single million-dollar bet. External factors, such as the environment, play a considerably larger role than with the cook. The link between the...