Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets (Incerto, #1)

by Nassim Nicholas Taleb

It certainly takes bravery to remain skeptical; it takes inordinate courage to introspect, to confront oneself, to accept one’s limitations—scientists are seeing more and more evidence that we are specifically designed by mother nature to fool ourselves.

(in the real world one has to guess the problem more than the solution).

Of course chance favors the prepared! Hard work, showing up on time, wearing a clean (preferably white) shirt, using deodorant, and some such conventional things contribute to success—they are certainly necessary but may be insufficient as they do not cause success. The same applies to the conventional values of persistence, doggedness and perseverance: necessary, very necessary.

In my experience (and in the scientific literature), economic “risk takers” are rather the victims of delusions (leading to overoptimism and overconfidence with their underestimation of possible adverse outcomes) than the opposite. Their “risk taking” is frequently randomness foolishness.

this book has two purposes: to defend science (as a light beam across the noise of randomness), and to attack the scientist when he strays from his course (most disasters come from the fact that individual scientists do not have an innate understanding of standard error or a clue about critical thinking,

On the one hand there is your local college English professor; your great-aunt Irma, who never married and liberally delivers sermons; your how-to-reach-happiness-in-twenty-steps and how-to-become-a-better-person-in-a-week book writer.

It is called the Utopian Vision,

conventional normative economists (of the kind to ask you to make rational choices because that is what is deemed good for you), etc. They believe in reason and rationality—that we should overcome cultural impediments on our way to becoming a better human race—thinking we can control our nature at will and transform it by mere edict in order to attain, among other things, happiness and rationality. Basically this cate...

On the other hand there is the Tragic Vision of humankind that believes in the existence of inherent limitations and flaws in the way we think and act and requires an acknowledgment of this fact...

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.

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

Trading forces someone to think hard; those who merely work hard generally lose their focus and intellectual energy. In addition, they end up drowning in randomness; work ethics, Nero believes, draw people to focus on noise rather than the signal

Nero believes that risk-conscious hard work and discipline can lead someone to achieve a comfortable life with a very high probability. Beyond that, it is all randomness: either by taking enormous (and unconscious) risks, or by being extraordinarily lucky. 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,

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

an increase in personal performance (regardless of whether it is caused deterministically or by the agency of Lady Fortuna) induces a rise of serotonin in the subject, itself causing an increase of what is commonly called “leadership” ability. One is “on a roll.” Some imperceptible changes in deportment, like an ability to express oneself with serenity and confidence, make the subject look credible—as if he truly deserved the shekels. Randomness will be ruled out as a possible factor in the performance, until it rears its head once again and delivers the kick that will induce the downward spiral.

Nero can be considered prosperous but not “very rich” by his day’s standards. However, according to some strange accounting measure we will see in the next chapter, he is extremely rich on the average of lives he could have led—he takes so little risk in his trading career that there could have been very few disastrous outcomes. The fact that he did not experience John’s success was the reason he did not suffer his downfall. He would be therefore wealthy according to this unusual (and probabilistic) method of accounting for wealth. Recall that Nero protects himself from the rare event. 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.

The idea of taking into account both the observed and unobserved possible outcomes sounds like lunacy. For most people, probability is about what may happen in the future, not events in the observed past; an event that has already taken place has 100% probability, i.e., certainty.

one cannot judge a performance in any given field (war, politics, medicine, investments) by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories.

10 million earned through Russian roulette does not have the same value as $10 million earned through the diligent and artful practice of dentistry. They are the same, can buy the same goods, except that one’s dependence on randomness is greater than the other. To an accountant, though, they would be identical; to your next-door neighbor too.

(certainty is something that is likely to take place across the highest number of different alternative histories; uncertainty concerns events that should take place in the lowest number of them).

An Even More Vicious Roulette Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands, of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet, under a numbing false sense of security. The point is dubbed in this book the black swan problem,

unlike a well-defined, precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality. Very rarely is the generator visible to the naked eye. One is thus capable of unwittingly playing Russian roulette—and calling it by some alternative “low risk” name. We see the wealth being generated, never the processor,

George Will the representative of so many nightmares in my career; my attempting to prevent someone from playing Russian roulette for $10 million and seeing journalist George Will humiliating me in public by saying that had the person listened to me it would have cost him a considerable fortune.

ask travelers en route to some remote destination how much they would pay for an insurance policy paying, say, a million tugrits (the currency of Mongolia) if they died during the trip (for any reason).Then ask another collection of travelers how much they would pay for insurance that pays the same in the event of death from a terrorist act (and only a terrorist act). Guess which one would command a higher price? Odds are that people would rather pay for the second policy (although the former includes death from terrorism).

people do not like to insure against something abstract; the risk that merits their attention is always something vivid.

risk detection and risk avoidance are not mediated in the “thinking” part of the brain but largely in the emotional one

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.

Corporations and financial institutions have recently created the strange position of risk manager, someone who is supposed to monitor the institution and verify that it is not too deeply involved in the business of playing Russian roulette. Clearly, having been burned a few times, the incentive is there to have someone take a look at the generator, the roulette that produces the profits and losses. Although it is more fun to trade, many extremely smart people among my friends (including Jean-Patrice) felt attracted by such positions. It is an important and attractive fact that the average risk manager earns more than the average trader

Monte Carlo methods, in brief, consist of creating artificial history using the following concepts. First, consider the sample path. The invisible histories have a scientific name, alternative sample paths,

The notion of path, as opposed to outcome, indicates that it is not a mere MBA-style scenario analysis, but the examination of a sequence of scenarios along the course of time. We are not just concerned with where a bird can end up tomorrow night, but rather with all the various places it can possibly visit during the time interval. We are not concerned with what the investor’s worth would be in, say, a year, but rather of the heart-wrenching rides he may experience during that period.

A random sample path, also called a random run, is the mathematical name for such a succession of virtual historical events, starting at a given date and ending at another, except that they are subjected to some varying level of uncertainty. However, the word random should not be mistaken for equiprobable (i.e., having the same probability). Some outcomes will give a higher probability than others.

Stochastic is a fancy Greek name for random.

Computer programs can be written to simulate just about anything. They are even better (and cheaper) than the roulette wheel built by your carpenter, as this physical version may be inclined to favor one number more than others owing to a possible slant in its build or the floor of your attic. These are called the biases.

My models showed that ultimately almost nobody really survived; bears dropped out like flies in the rally and bulls ended up being slaughtered, as paper profits vanished when the music stopped. But there was one exception; some of those who traded options (I called them option buyers) had remarkable staying power and I wanted to be one of those. How? Because they could buy the insurance against blowup; they could get anxiety-free sleep at night, thanks to the knowledge that if their careers were threatened, it would not be owing to the outcome of a single day.

playing with a Monte Carlo engine for years I can no longer visualize a realized outcome without reference to the nonrealized ones.

the way our mind handles historical information. When you look at the past, the past will always be deterministic, since only one single observation took place. Our mind will interpret most events not with the preceding ones in mind, but the following ones.

Psychologists call this overestimation of what one knew at the time of the event due to subsequent information the hindsight bias, the “I knew it all along” effect.

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

Unlike many “hard” sciences, history cannot lend itself to experimentation. But somehow, overall, history is potent enough to deliver, on time, in the medium to long run, most of the possible scenarios, and to eventually bury the bad guy. Bad trades catch up with you, it is frequently said in the markets. Mathematicians of probability give that a fancy name: ergodicity.

People tend to infer that because some inventions have revolutionized our lives that inventions are good to endorse and we should favor the new over the old. I hold the opposite view. The opportunity cost of missing a “new new thing” like the airplane and the automobile is minuscule compared to the toxicity of all the garbage one has to go through to get to these jewels

People do not realize that the media is paid to get your attention. For a journalist, silence rarely surpasses any word.

(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.

1. 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). 2. 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.) 3. When I see an investor monitoring his portfolio with live prices on his cellular telephone or his handheld, I smile and smile. Finally, I reckon that I am not immune to such an emotional defect. But I deal with it by having no access to information, except in rare circumstances.

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.

a negative pang is not offset by a positive one (some psychologists estimate the negative effect for an average loss to be up to 2.5 the magnitude of a positive one); it will lead to an emotional deficit.

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.

An overestimation of the accuracy of their beliefs in some measure, either economic (Carlos) or statistical (John). They never considered that the fact that trading on economic variables has worked in the past may have been merely coincidental, or, perhaps even worse, that economic analysis was fit to past events to mask the random element in it. Consider that of all the possible economic theories available, one can find a plausible one that explains the past, or a portion of it.

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 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.