Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets by Nassim Taleb
I recently finished this audio CD, and really enjoyed it. So many things in life are random, yet as humans, we have a hard time realizing what actions cause an event, and what was merely related, or even random. The author intentionally writes in a personal style, foregoing any academic feel, and favoring presenting stories and logical arguments about chance. I recommend it.
Notice how when things are going well in your life, you tend to think that you’re skillful. Yet when things start going bad, you have bad luck? Very little of the book is directly about stock or bond markets, but they do provide an ideal place to study randomness. One thought exercise he presents in the book is to take thousands of money managers, and flip a coin to see if they’ll beat the market in a given year. Luck would have some managers getting long streaks of heads, but that doesn’t mean you should ask them to predict the next flip. How do we know if managers are skillful, or just making lucky calls? The most impactful quote for me was this:
At any given time in the market, the most successful traders are likely to be those that are best fit by the latest cycle.
It seems like the majority of financial news and business press talk about recent performance—The best money manager, the best fund over 3 years, the most successful CEO. However ALL of these are subject to randomness, and all of them potentially just happen to have their system best fit to the prior situation. Well the situation always changes, and those people are likely to keep expecting the past to repeat itself, and thus will blow up in the face of new uncertainty.
Quick quiz: Is it logical to think the market will go up, but still bet against it? It is if you think that it has a 60% chance of rising a few percent, but a 40% chance of falling by a large amount. Taleb doesn’t like the terms bullish or bearish, because risks come with probability and payoffs. As such, he favors a system of judging by process, rather than judging by results. Obviously that’s a much harder task, and the 2008 credit crisis showed us that few people do it despite its importance. Otherwise no one would have rewarded those who piled up the banks with risky CDS contracts, making a little income to accept a huge risk.
He relates a fooled by randomness story from the animal world. Researchers put a lever in a pigeon cage to dispense their food. Later they swapped out the lever, and dispensed food randomly. All of the pigeons ended up having superstitions about how the food arrived, such as dancing or moving in a certain way.
[As an engineering aside, sometimes I watch people use an Xbox user interface under development for the first time, to see if they understand it (usability tests). When there’s a high degree of randomness to whether the product works well or not, such as with early Kinect interfaces or voice recognition, users tend to form misunderstandings, or superstitions about how things work. For awhile we had wave feedback in a circular pattern, and when users struggled, tried to copy the pattern. Sometimes it randomly worked, and they concluded that they should wave in a circle. People also came up with all sorts of theories about how the cursors work best. Clearly, a UI is not successful if it exhibits such uncertainty.]
Taleb berates the media for perpetuating the problem. He mentions how Robert Shiller was on CNBC and the host complained that if people had listened to him a year before when he said the market was overvalued, they’d have lost money. So why should they listen to him now? By definition, if the market is “irrationally high,” as Shiller said, it must be able to make irrational moves even higher. Yet somehow, it’s easier to just conclude that he must be wrong. [Aside, I’m glad I wasn’t investing during the dot-com bubble!].
Taleb concludes the book with what he calls his generator statement:
We favor the visible, the embedded, the personal, the narrated, and the tangible. We scorn the abstract.
This book seriously led me to question any records of past performance. And not just mutual funds. Consider his criticism of The Millionaire Next Door, which commends saving and was published at the end of the biggest bull market in history. Of course they’re going to find that savers in the US did great. But what will they find if they research it again at the end of this secular bear market? I’ve always been skeptical by nature, and now perhaps even more so. Hopefully it will keep me out of trouble. I recommend this book, for all audiences, curious about randomness.
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