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

by Nassim Nicholas Taleb

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.

Both Carlos and John belong to the class of people who benefited from a market cycle. It was not merely because they were involved in the right markets. It was because they had a bent in their style that closely fitted the properties of the rallies experienced in their market during the episode. They were dip buyers. That happened, in hindsight, to be the trait that was the most desirable between 1992 and the summer of 1998 in the specific markets in which the two men specialized. Most of those who happened to have that specific trait, over the course of that segment of history, dominated the market. Their score was higher and they replaced people who, perhaps, were better traders.

There is asymmetry. Those who die do so very early in the game, while those who live go on living very long.

Asymmetric odds means that probabilities are not 50% for each event, but that the probability on one side is higher than the probability on the other. Asymmetric outcomes mean that the payoffs are not equal.

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.

history teaches us that things that never happened before do happen.

I started to label a rare event as any behavior where the adage “beware of calm waters” can hold. Popular wisdom often warns of the old neighbor who appears to remain courtly and reserved, the model of an excellent citizen, until you see his picture in the national paper as a deranged killer who went on a rampage. Until then, he was not known to have committed any transgression. There was no way to predict that such pathological behavior could emanate from such a nice person. I associate rare events with any misunderstanding of the risks derived from a narrow interpretation of past time series.

They are generally caused by panics, themselves the results of liquidations (investors rushing to the door simultaneously by dumping anything they can put their hands on as fast as possible).

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.

Where statistics becomes complicated, and fails us, is when we have distributions that are not symmetric,

There is no point searching for patterns that are available to everyone with a brokerage account; once detected, they would be self-canceling.

The practice of “financial engineering” came along with massive doses of pseudoscience. Practitioners of these methods measure risks, using the tool of past history as an indication of the future.

John Stuart Mill):

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.

more severe aspect of naive empiricism. I can use data to disprove a proposition, never to prove one.

(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.

Maximizing the probability of winning does not lead to maximizing the expectation from the game when one’s strategy may include skewness, i.e., a small chance of large loss and a large chance of a small win.

extreme empiricism, competitiveness, and an absence of logical structure to one’s inference can be a quite explosive combination.

One cannot infer much from a single experiment in a random environment—an experiment needs a repeatability showing some causal component.

I was at the age when one felt like one needed to read everything, which prevented one from making contemplative stops.

I was too young and was reading too much then to make a bridge to reality.

Popper’s idea is that science is not to be taken as seriously as it sounds (Popper when meeting Einstein did not take him as the demigod he thought he was). There are only two types of theories: 1. Theories that are known to be wrong, as they were tested and adequately rejected (he calls them falsified). 2. Theories that have not yet been known to be wrong, not falsified yet, but are exposed to be proved wrong. Why is a theory never right? Because we will never know if all the swans are white

the difference between Newtonian physics, which was falsified by Einstein’s relativity, and astrology lies in the following irony. Newtonian physics is scientific because it allowed us to falsify it, as we know that it is wrong, while astrology is not because it does not offer conditions under which we could reject it. Astrology cannot be disproved, owing to the auxiliary hypotheses that come into play. Such point lies at the basis of the demarcation between science and nonsense (called “the problem of demarcation”).

My extreme and obsessive Popperism is carried out as follows. I speculate in all of my activities on theories that represent some vision of the world, but with the following stipulation: No rare event should harm me. In fact, I would like all conceivable rare events to help me. My idea of science diverges with that of the people around me walking around calling themselves scientists. Science is mere speculation, mere formulation of conjecture.

Induction is going from plenty of particulars to the general.

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.

there are situations in which using statistics and econometrics can be useful. But I do not want my life to depend on it.

If the science of statistics can benefit me in anything, I will use it. If it poses a threat, then I will not. I want to take the best of what the past can give me without its dangers. Accordingly, I will use statistics and inductive methods to make aggre...

make sure that the costs of being wrong are limited (and their probability is not derived from past data).

stop loss, a predetermined exit point, a protection from the black swan. I find it rarely practiced.

there is a social treadmill effect: You get rich, move to rich neighborhoods, then become poor again.

They examined a collection of currently wealthy people and found out that these are unlikely to lead lavish lives. They call such people the accumulators; persons ready to postpone consumption in order to amass funds. Most of the appeal of the book comes from the simple but counterintuitive fact that these are less likely to look like very rich people—it clearly costs money to look and behave rich, not to count the time demands of spending money.

those who act and look wealthy subject their net worth to such a drain that they inflict considerable and irreversible damage to their brokerage account.

The mistake of ignoring the survivorship bias is chronic, even (or perhaps especially) among professionals. How? Because we are trained to take advantage of the information that is lying in front of our eyes, ignoring the information that we do not see.

the survivorship bias implies that the highest performing realization will be the most visible. Why? Because the losers do not show up.

Optimism, it is said, is predictive of success. Predictive? It can also be predictive of failure. Optimistic people certainly take more risks as they are overconfident about the odds; those who win show up among the rich and famous, others fail and disappear from the analyses. Sadly.

The first counterintuitive point is that a population entirely composed of bad managers will produce a small amount of great track records. As a matter of fact, assuming the manager shows up unsolicited at your door, it will be practically impossible to figure out whether he is good or bad.

in real life, the larger the deviation from the norm, the larger the probability of it coming from luck rather than skills:

nobody accepts randomness in his own success, only his failure.

why would anybody advertise if he didn’t happen to outperform the market? There is a high probability of the investment coming to you if its success is caused entirely by randomness. This phenomenon is what economists and insurance people call adverse selection. Judging an investment that comes to you requires more stringent standards than judging an investment you seek, owing to such selection bias.

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.

Historically, medicine has operated by trial and error—in other words, statistically. We know by now that there can be entirely fortuitous connections between symptoms and treatment, and that some medications succeed in medical trials for mere random reasons.

nonscientific methods are gathered under what is called “alternative medicine,” that is, unproven therapies, and the medical community has difficulties convincing the press that there is only one medicine and that alternative medicine is not medicine).

The late astronomer Carl Sagan, a devoted promoter of scientific thinking and an obsessive enemy of nonscience, examined the cures from cancer that resulted from a visit to Lourdes in France, where people were healed by simple contact with the holy waters, and found out the interesting fact that, of the total cancer patients who visited the place, the cure rate was, if anything, lower than the statistical one for spontaneous remissions.

While it is hard to deny that Gates is a man of high personal standards, work ethics, and above-average intelligence, is he the best? Does he deserve it? Clearly not. Most people are equipped with his software (like myself ) because other people are equipped with his software, a purely circular effect (economists call that “network externalities”). Nobody ever claimed that it was the best software product.

“flipping a coin” to break some of the minor stalemates in life where one lets randomness help with the decision process. Let Lady Fortuna make the decision and gladly submit.

there has to be in us an approximation process that stops somewhere.

“Satisficing” was his idea (the melding together of satisfy and suffice): 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.” He believed that our brains were a large optimizing machine that had built-in rules to stop somewhere.

Since the Kahneman and Tversky results, an entire discipline called behavioral finance and economics has flourished. It is in open contradiction with the orthodox so-called neoclassical economics taught in business schools and economics departments under the normative names of efficient markets, rational expectations, and other such concepts.

A normative science (clearly a self-contradictory concept) offers prescriptive teachings; it studies how things should be. Some economists, for example those of the efficient-market religion, believe that our studies should be based on the hypothesis that humans are rational and act rationally because it is the best thing for them to do (it is mathematically “optimal”). The opposite is a positive science, which is based on how people actually are observed to behave. In spite of economists’ envy of physicists, physics is an inherently positive science while economics, particularly microeconomics and financial economics, is predominantly a normative one. Normative economics is like religion without the aesthetics.