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

by Nassim Nicholas Taleb

For a long time we traders were totally ignorant of the behavioral research and saw situations where there was with strange regularity a wedge between the simple probabilistic reasoning and people’s perception of things. We gave them names such as the “I’m as good as my last trade” effect, the “sound-bite effect,” the “Monday morning quarterback” heuristic, and the “It was obvious after the fact” effect. It was both vindicating for traders’ pride and disappointing to discover that they existed in the heuristics literature as the “anchoring,” the “affect heuristic,” and the “hindsight bias” (it makes us feel that trading is true, experimental scientific research).

This dependence on the local rather than the global status (coupled with the effect of the losses hitting harder than the gains) has an impact on your perception of well-being. Say you get a windfall profit of $1 million. The next month you lose $300,000. You adjust to a given wealth (unless of course you are very poor) so the following loss would hurt you emotionally, something that would not have taken place if you received the net amount of $700,000 in one block, or, better, two sums of $350,000 each. In addition, it is easier for your brain to detect differences rather than absolutes, hence rich or poor will be (above the minimum level) in relation to something else

System 1 is effortless, automatic, associative, rapid, parallel process, opaque (i.e., we are not aware of using it), emotional, concrete, specific, social, and personalized. System 2 is effortful, controlled, deductive, slow, serial, self-aware, neutral, abstract, sets, asocial, and depersonalized.

we feel emotions (limbic brain) then find an explanation (neocortex). As we saw with Claparède’s discovery, much of the opinions and assessments that we have concerning risks may be the simple result of emotions.

get mixed up between absence of evidence and evidence of absence,

At birth, your unconditional life expectancy may be seventy-three years. But as you advance in age and do not die, your life expectancy increases along with your life. Why? Because other people, by dying, have taken your spot in the statistics, for expectation means average.

even assuming statistical significance, one has to accept a cause and effect, meaning that the event in the market can be linked to the cause proffered.

I managed to build an instinctive way of knowing if something serious is going on. The trick is to look only at the large percentage changes. Unless something moves by more than its usual daily percentage change, the event is deemed to be noise. Percentage moves are the size of the headlines. In addition, the interpretation is not linear; a 2% move is not twice as significant an event as 1%, it is rather like four to ten times. A 7% move can be several billion times more relevant than a 1% move!

I consider myself as prone to foolishness as anyone I know, in spite of my profession and the time spent building my expertise on the subject. But here is the exception; I know that I am very, very weak on that score. My humanity will try to foil me; I have to stay on my guard. I was born to be fooled by randomness.

I understood that I was not intelligent enough, nor strong enough, to even try to fight my emotions. Besides, I believe that I need my emotions to formulate my ideas and get the energy to execute them. I am just intelligent enough to understand that I have a predisposition to be fooled by randomness—and to accept the fact that I am rather emotional.

On the one hand, I talked like someone with strong scientific standards, a probabilist focused on his craft. On the other, I had closet superstitions just like one of these blue-collar pit traders. Would I have to go buy a horoscope next?

there is a difference between noise and signal, and that noise needs to be ignored while a signal needs to be taken seriously.

For example, after registering a profit of $100,000 on a given strategy, I may assign a 2% probability to the hypothesis of the strategy being profitable and 98% probability to the hypothesis that the performance may be the result of mere noise. A gain of $1 million on the other hand, certifies that the strategy is a profitable one, with a 99% probability. A rational person would act accordingly in the selection of strategies, and set his emotions in accordance with his results. Yet I have experienced leaps of joy over results that I knew were mere noise, and bouts of unhappiness over results that did not carry the slightest degree of statistical significance. I cannot help it, but I am emotional and derive most of my energy from my emotions. So the solution does not reside in taming my heart. Since my heart does not seem to agree with my brain, I need to take serious action to avoid making irrational trading decisions, namely, by denying myself access to my performance report unless it hits a predetermined threshold.

One of the most irritating conversations I’ve had is with people who lecture me on how I should behave. Most of us know pretty much how we should behave. It is the execution that is the problem, not the absence of knowledge. I am tired of the moralizing slow-thinkers who pound me with platitudes like I should floss daily, eat my regular apple, and visit the gym outside of the New Year’s resolution. In the markets the recommendation would be to ignore the noise component in the performance. We need tricks to get us there but before that we need to accept the fact that we are mere animals in need of lower forms of tricks, not lectures.

He had just forgotten. One forgets rather quickly what one has not thought about with depth, what has been dictated to you by imitation, by the passions surrounding you. These change, and with them so do your memories.

Path Dependence of Beliefs There is a simple test to define path dependence of beliefs (economists have a manifestation of it called the endowment effect). Say you own a painting you bought for $20,000, and owing to rosy conditions in the art market, it is now worth $40,000. If you owned no painting, would you still acquire it at the current price? If you would not, then you are said to be married to your position. There is no rational reason to keep a painting you would not buy at its current market rate—only an emotional investment. Many people get married to their ideas all the way to the grave. Beliefs are said to be path dependent if the sequence of ideas is such that the first one dominates. There are reasons to believe that, for evolutionary purposes, we may be programmed to build a loyalty to ideas in which we have invested time.

My lesson from Soros is to start every meeting at my boutique by convincing everyone that we are a bunch of idiots who know nothing and are mistake-prone, but happen to be endowed with the rare privilege of knowing it.

attribution bias. You attribute your successes to skills, but your failures to randomness. This explains why these scientists attributed their failures to the “ten sigma” rare event, indicative of the thought that they were right but that luck played against them. Why? It is a human heuristic that makes us actually believe so in order not to kill our self-esteem and keep us going against adversity.

People confuse science and scientists. Science is great, but individual scientists are dangerous. They are human; they are marred by the biases humans have.

There is nothing wrong and undignified with emotions—we are cut to have them. What is wrong is not following the heroic or, at least, the dignified path. That is what stoicism truly means. It is the attempt by man to get even with probability.

The interesting thing about stoicism is that it plays on dignity and personal aesthetics, which are part of our genes. Start stressing personal elegance at your next misfortune. Exhibit sapere vivere (“know how to live”) in all circumstances.

the higher up the corporate ladder, the lower the evidence of such contribution. I call this the inverse rule.

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.

A slightly random schedule prevents us from optimizing and being exceedingly efficient, particularly in the wrong things.

research on happiness shows that those who live under a self-imposed pressure to be optimal in their enjoyment of things suffer a measure of distress.

The difference between satisficers and optimizers raises a few questions. We know that people of a happy disposition tend to be of the satisficing kind, with a set idea of what they want in life and an ability to stop upon gaining satisfaction. Their goals and desires do not move along with the experiences. They do not tend to experience the internal treadmill effects of constantly trying to improve on their consumption of goods by seeking higher and higher levels of sophistication. In other words, they are neither avaricious nor insatiable. An optimizer, by comparison, is the kind of person who will uproot himself and change his official residence just to reduce his tax bill by a few percentage points. (You would think that the entire point of a higher income is to be free to choose where to live; in fact it seems, for these people, wealth causes them to increase their dependence!) Getting rich results in his seeing flaws in the goods and services he buys.

when he was asked by someone particularly lazy if Hillel could teach him the Torah while the student was standing on one leg. Rabbi Hillel’s genius is that he did not summarize; instead, he provided the core generator of the idea, the axiomatic framework, which I paraphrase as follows: Don’t do to others what you don’t want them to do to you; the rest is just commentary. It took me an entire lifetime to find out what my generator is. It is: We favor the visible, the embedded, the personal, the narrated, and the tangible; we scorn the abstract. Everything good (aesthetics, ethics) and wrong (Fooled by Randomness) with us seems to flow from it.