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

by Nassim Nicholas Taleb

(Why don’t most journalists end up figuring out that they know much less than they think they know? Scientists investigated half a century ago the phenomena of “experts” not learning about their past failings. You can mispredict everything for all your life yet think that you will get it right next time.)

Luck is democratic and hits everyone regardless of original skills. The author notices variations from the general population in a few traits like tenacity and hard work: another confusion of the necessary and the causal. That all millionaires were persistent, hardworking people does not make persistent hard workers become millionaires: Plenty of unsuccessful entrepreneurs were persistent, hardworking people.

Luck is democratic and hits everyone regardless of original skills. The author notices variations from the general population in a few traits like tenacity and hard work: another confusion of the necessary and the causal. That all millionaires were persistent, hardworking people does not make persistent hard workers become millionaires: Plenty of unsuccessful entrepreneurs were persistent, hardworking people.

Most journalists do not take things too seriously: After all, this business of journalism is about pure entertainment, not a search for truth, particularly when it comes to radio and television. The trick is to stay away from those who do not seem to know that they are just entertainers (like George Will, who will appear in Chapter 2) and actually believe that they are thinkers.

This book is about luck disguised and perceived as nonluck (that is, skills) and, more generally, randomness disguised and perceived as non-randomness (that is, determinism).

It manifests itself in the shape of the lucky fool, defined as a person who benefited from a disproportionate share of luck but attributes his success to some other, generally very precise, reason.

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.

it does not matter how frequently something succeeds if failure is too costly to bear.

Nero is allergic to the vocabulary of business talk, not just on plain aesthetic grounds. Phrases like “game plan,” “bottom line,” “how to get there from here,” “we provide our clients with solutions,” “our mission,” and other hackneyed expressions that dominate meetings lack both the precision and the coloration that he prefers to hear.

Mild success can be explainable by skills and labor. Wild success is attributable to variance.

Psychologists have shown that most people prefer to make $70,000 when others around them are making $60,000 than to make $80,000 when others around them are making $90,000. Economics, schmeconomics, it is all pecking order,

These traders use “quantitative tools” that give them the odds—and Nero disagrees with the methods used. This high-yield market resembles a nap on a railway track. One afternoon, the surprise train would run you over. You make money every month for a long time, then lose a multiple of your cumulative performance in a few hours. He has seen it with option sellers in 1987, 1989, 1992, and 1998.

Can we judge the success of people by their raw performance and their personal wealth? Sometimes—but not always. We will see how, at any point in time, a large section of businessmen with outstanding track records will be no better than randomly thrown darts. More curiously, and owing to a peculiar bias, cases will abound of the least-skilled businessmen being the richest. However, they will fail to make an allowance for the role of luck in their performance.

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 (our hormonal system does not know whether our successes depend on randomness).

A word on the display of emotions. Almost no one can conceal his emotions. Behavioral scientists believe that one of the main reasons why people become leaders is not from what skills they seem to possess, but rather from what extremely superficial impression they make on others through hardly perceptible physical signals—what we call today “charisma,” for example.

Likewise, never ask a trader if he is profitable; you can easily see it in his gesture and gait. People in the profession can easily tell if traders are making or losing money; head traders are quick at identifying an employee who is faring poorly. Their face will seldom reveal much, as people consciously attempt to gain control of their facial expressions. But the way they walk, the way they hold the telephone, and the hesitation in their behavior will not fail to reveal their true disposition.

The problem is that only one of the histories is observed in reality; and the winner of $10 million would elicit the admiration and praise of some fatuous journalist (the very same ones who unconditionally admire the Forbes 500 billionaires).

thus view people distributed across two polar categories: On 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. Somehow, tricky products, like exotic options, were introduced and carried counterintuitive payoffs that were too difficult for someone of such culture to handle. They dropped like flies; I do not think that many of the hundreds of MBAs of my generation I met on Wall Street in the 1980s still engage in such forms of professional and disciplined risk taking.

Heroes are heroes because they are heroic in behavior, not because they won or lost.

emotions they elicit or the ease with which they come to mind. In addition to such problems with the perception of risk, it is also a scientific fact, and a shocking one, that both risk detection and risk avoidance are not mediated in the “thinking” part of the brain but largely in the emotional one (the “risk as feelings” theory). The consequences are not trivial: It means that rational thinking has little, very little, to do with risk avoidance. Much of what rational thinking seems to do is rationalize one’s actions by fitting some logic to them.

In addition, volatility seems to be determined not by the actual moves but by the tone of the media. The market movements in the eighteen months after September 11, 2001, were far smaller than the ones that we faced in the eighteen months prior—but somehow in the mind of investors they were very volatile. The discussions in the media of the “terrorist threats” magnified the effect of these market moves in people’s heads.

This is one of the many reasons that 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.

As I mentioned above, it is not natural for us to learn from history. We have enough clues to believe that our human endowment does not favor transfers of experience in a cultural way but through selection of those who bear some favorable traits. It is a platitude that children learn only from their own mistakes; they will cease to touch a burning stove only when they are themselves burned; no possible warning by others can lead to developing the smallest form of cautiousness. Adults, too, suffer from such a condition. This

Much of the risk avoidance that comes from experiences is part of the second. The only way I developed a respect for history is by making myself aware of the fact that I was not programmed to learn from it in a textbook format.

When you look at the past, the past will always be deterministic, since only one single observation took place.

Our minds are not quite designed to understand how the world works, but, rather, to get out of trouble rapidly and have progeny. If they were made for us to understand things, then we would have a machine in it that would run the past history as in a VCR, with a correct chronology, and it would slow us down so much that we would have trouble operating. Psychologists call this over-estimation of what one knew at the time of the event due to subsequent information the hindsight bias, the “I knew it all along” effect.

Now the civil servant called the trades that ended up as losers “gross mistakes,” just like journalists call decisions that end up costing a candidate his election a “mistake.” I will repeat this point until I get hoarse: A mistake is not something to be determined after the fact, but in the light of the information until that point.

If there is anything better than noise in the mass of “urgent” news pounding us, it would be like a needle in a haystack. People do not realize that the media is paid to get your attention. For a journalist, silence rarely surpasses any word.

Shiller made his mark with his 1981 paper on the volatility of markets, where he determined that if a stock price is the estimated value of “something” (say the discounted cash flows from a corporation), then market prices are way too volatile in relation to tangible manifestations of that “something” (he used dividends as proxy). Prices swing more than the fundamentals they are supposed to reflect, they visibly overreact by being too high at times (when their price overshoots the good news or when they go up without any marked reason) or too low at others. The volatility differential between prices and information meant that something about “rational expectation” did not work. (Prices did not rationally reflect the long-term value of securities and were overshooting in either direction.) Markets had to be wrong.

Curiously, it will be the oldest, simply because older people have been exposed longer to the rare event and can be, convincingly, more resistant to it. I was amused to discover a similar evolutionary argument in mate selection that considers that women prefer (on balance) to mate with healthy older men over healthy younger ones, everything else being equal, as the former provide some evidence of better genes. Gray hair signals an enhanced ability to survive—conditional on having reached the gray hair stage, a man is likely to be more resistant to the vagaries of life.

Curiously, life insurers in renaissance Italy reached the same conclusion, by charging the same insurance for a man in his twenties as they did for a man in his fifties, a sign that they had the same life expectancy; once a man crossed the forty-year mark, he had shown that very few ailments could harm him.

Over a short time increment, one observes the variability of the portfolio, not the returns. In other words, one sees the variance, little else. I always remind myself that what one observes is at best a combination of variance and returns, not just returns (but my emotions do not care about what I tell myself). Our emotions are not designed to understand the point. The dentist did better when he dealt with monthly statements rather than more frequent ones. Perhaps it would be even better for him if he limited himself to yearly statements. (If you think that you can control your emotions, think that some people also believe that they can control their heartbeat or hair growth.) When I see an investor monitoring his portfolio with live prices on his cellular telephone or his handheld, I smile and smile.

The same methodology can explain why the news (the high scale) is full of noise and why history (the low scale) is largely stripped of it (though fraught with interpretation problems). This explains why I prefer not to read the newspaper (outside of the obituary), why I never chitchat about markets, and, when in a trading room, I frequent the mathematicians and the secretaries, not the traders. It explains why it is better to read The New Yorker on Mondays than The Wall Street Journal every morning (from the standpoint of frequency, aside from the massive gap in intellectual class between the two publications).

You select randomly five phrases below, then connect them by adding the minimum required to construct a grammatically sound speech. We look after our customer’s interests / the road ahead / our assets are our people / creation of shareholder value / our vision / our expertise lies in / we provide interactive solutions / we position ourselves in this market / how to serve our customers better / short-term pain for long-term gain / we will be rewarded in the long run / we play from our strength and improve our weaknesses / courage and determination will prevail / we are committed to innovation and technology / a happy employee is a productive employee / commitment to excellence / strategic plan / our work ethics. If this bears too close a resemblance to the speech you just heard from the boss of your company, then I suggest looking for a new job.

Modern life seems to invite us to do the exact opposite; become extremely realistic and intellectual when it comes to such matters as religion and personal behavior, yet as irrational as possible when it comes to matters ruled by randomness (say, portfolio or real estate investments).

Carlos is now out of the market. The possibility that history may prove him right (at some point in the future) has nothing to do with the fact that he is a bad trader. He has all of the traits of a thoughtful gentleman, and would be an ideal son-in-law. But he has most of the attributes of the bad trader. And, 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. This does not happen too often with dentists or pianists—because these professions are more immune to randomness.

The reader needs to be warned that not all of the emerging-market and high-yield traders talk and behave like Carlos and John. Only the most successful ones, alas, or perhaps those who were the most successful during the 1992-1998 bull cycle. At their age, both John and Carlos still have the chance to make a career. It would be wise for them to look outside of their current profession. The odds are that they will not survive the incident. Why? Because by discussing the situation with each of them, one can rapidly see that they share the traits of the acute successful randomness fool who, in addition, operates in the most random of environments. What is more worrisome is that their bosses and employers shared the same trait. They, too, are permanently out of the market. We will see throughout this book what characterizes the trait. Again, there may not be a clear definition for it, but you can recognize it when you see it. No matter what John and Carlos do, they will remain fools of randomness.

REVIEW OF MARKET FOOLS OF RANDOMNESS CONSTANTS

A tendency to get married to positions. There is a saying that bad traders divorce their spouse sooner than abandon their positions. Loyalty to ideas is not a good thing for traders, scientists–or anyone.

The tendency to change their story. They become investors “for the long haul” when they are losing money, switching back and forth between traders and investors to fit recent reversals of fortune. The difference between a trader and an investor lies in the duration of the bet, and the corresponding size. There is absolutely nothing wrong with investing “for the long haul,” provided one does not mix it with short-term trading–it is just that many people become long-term investors after they lose money, postponing their decision to sell as part of their denial.

No precise game plan ahead of time as to what to do in the event of losses. They simply were not aware of such a possibility. Both bought more bonds after the market declined sharply, but not in response to a predetermined plan.

Absence of critical thinking expressed in absence of revision of their stance with “stop losses.” Middlebrow traders do not like selling when it is “even better value.” They did not consider that perhaps their method of determining value is wrong, rather than the market failing to accommodate their measure of value. They may be right, but, perhaps, some allowance for the possibility of their methods being flawed was not made. For all his flaws, we will see that Soros seems rarely to examine an unfavorable outcome without testing his own framework of analysis.

Denial. When the losses occurred there was no clear acceptance of what had happened. The price on the screen lost its reality in favor of some abstract “value.” In classic denial mode, the usual “this is only the result of liquidation, distress sales” was proffered. They continuously ignored the message from reality.

software for under $999 and run it yourself during the next rainy weekend. But we are not sure that the world we live in is well charted. We will see that the judgment derived from the analysis of these past attributes may on occasion be relevant. But it may be meaningless; it could on occasion mislead you and take you in the opposite direction. Sometimes market data becomes a simple trap; it shows you the opposite of its nature, simply to get you to invest in the security or mismanage your risks. Currencies that exhibit the largest historical stability, for example, are the most prone to crashes. This was bitterly discovered in the summer of 1997 by investors who chose the safety of the pegged currencies of Malaysia, Indonesia, and Thailand (they were pegged to the U.S. dollar in a manner to exhibit no volatility, until their sharp, sudden, and brutal devaluations).

On the surface, my statement here may seem to contradict earlier discussions, where I blame people for not learning enough from history. The problem is that we read too much into shallow recent history, with statements like “this has never happened before,” but not from history in general (things that never happened before in one area tend eventually to happen). In other words, history teaches us that things that never happened before do happen. It can teach us a lot outside of the narrowly defined time series; the broader the look, the better the lesson. In other words, history teaches us to avoid the brand of naive empiricism that consists of learning from casual historical facts.

In the markets, there is a category of traders who have inverse rare events, for whom volatility is often a bearer of good news. These traders lose money frequently, but in small amounts, and make money rarely, but in large amounts. I call them crisis hunters. I am happy to be one of them.

Note that the economist Robert Lucas dealt a blow to econometrics by arguing that if people were rational then their rationality would cause them to figure out predictable patterns from the past and adapt, so that past information would be completely useless for predicting the future (the argument, phrased in a very mathematical form, earned him the Swedish Central Bank Prize in honor of Alfred Nobel). We are human and act according to our knowledge, which integrates past data. I can translate his point with the following analogy. If rational traders detect a pattern of stocks rising on Mondays, then, immediately such a pattern becomes detectable, it would be ironed out by people buying on Friday in anticipation of such an effect. There is no point searching for patterns that are available to everyone with a brokerage account; once detected, they would be self-canceling.

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.

But there is a more severe aspect of naive empiricism. I can use data to disprove a proposition, never to prove one. I can use history to refute a conjecture, never to affirm it. For instance, the statement The market never goes down 20% in a given three-month period can be tested but is completely meaningless if verified. I can quantitatively reject the proposition by finding counterexamples, but it is not possible for me to accept it simply because, in the past, the market never went down 20% in any three-month period (you cannot easily make the logical leap from “has never gone down” to “never goes down”). Samples can be greatly insufficient; markets may change; we may not know much about the market from historical information.

I said that people rarely test testable statements; this may be better for those who cannot handle the consequence of the inference. The following inductive statement illustrates the problem of interpreting past data literally, without methodology or logic: I have just completed a thorough statistical examination of the life of President Bush. For fifty-eight years, close to 21,000 observations, he did not die once. I can hence pronounce him as immortal, with a high degree of statistical significance.