Fooled by Randomness

Nassim Nicholas Taleb

"Successful people are alike (they’re lucky); every unsuccessful person is unsuccessful in his (her) own way."
That's what Tolstoy would have said had he read this book.

Nassim Nicholas Taleb says he’s smarter than we are because he knows that he knows nothing. We, on the other hand, labor under the delusion that we do know something. He invests to profit from the inevitable train wreck somewhere down the tracks (1987, 1998, 2000), while our ignorance will destroy us because we don’t see the calamity coming. And we don’t see it coming because we mistakenly think we saw a pattern of clear vistas ahead.

This work is one in a long line that looks out at the world and sees only chaos. Since there are no patterns and no repetitive behavior, there cannot be any predictions based on past events or probable behavior.

He would have us believe that hard work, drive, creativity, etc. all play second fiddle to luck when it comes to life’s successes. He bases his philosophy on Karl Popper who postulated that there were only two kinds of theories: those which are known to be wrong and those that have not yet been known to be wrong. Thus, no investment theories can hold water and no one can make sense of our uncertain world. And with this as his starting point, Taleb launches into the argument that no matter how long a trader might experience success, he will eventually “blow up,” and that blow-up will be proof that no skill was ever involved – just dumb luck. Perhaps the trader simply happened to ride the right trend for as long as it went. Thus, Taleb’s corollary is that since nothing works, why waste time trying to find a “system?” It’s all random anyway.

Although I would argue many of his suppositions, he does make excellent observations as to why traders blow up: (1) a tendency to get married to their positions, (2) a tendency to change their story as needed so as to justify their long-term investments, (3) no precise game plan ahead of time as to what to do in the event of losses, (4) an absence of critical thinking – they don’t learn from their losses, (5) denial – refusal to stare reality in the face. But his best insight is into the failings of professional money management - “the firehouse effect” where mutual fund managers only converse with others in the industry, thereby accepting as common wisdom what an ordinary outsider would see as sheer bunk.

Taleb’s chosen investment strategy appears to be as a hunter of crises with a game plan designed to profit from that rare, “ten-sigma” event (sigma = 1 standard deviation). He gives little insight into his own success, based on randomness, but he does favor buying out-of-the-money options. His passing remark that the Crash of ’87 made him as a trader could well mean that he was long puts.

A thorough reading of the book leaves us caught between Fama, Merton, and Malkiel’s randomness based on an efficient market being rational, and Taleb’s randomness based on the market reflecting human irrationality (based on our ignorance of probability and statistics). Both sides believe that the future, for investment purposes, is unpredictable. And how did we get into this fix of playing against a stacked deck? The mathematician and probability expert in Taleb gives us his most revealing statement near the end of the book: “We (mankind)  have not had the incentive to develop an ability to understand probability (to make decisions) because we did not have to do so (because we lived in a deterministic world) – but the more profound reason is that we are not designed to understand things. We are built only to survive and procreate.” Ugh!

After debunking any and all who make claims on the future, Taleb signs off with his main piece of advice: “Good luck.”

So what do we have for this effort? Or in Taleb’s words, as he would peruse a bookstore’s shelves, “Is this book worth my time?”  We get a reminder that life is the taking of chances since nothing can be assured for tomorrow. But don’t we already know that? Is that not why we do study patterns and make assumptions on what has and has not worked in the past, and build on what we learn? Is that not the basis of Kuhn’s “The Structure of Scientific Revolutions?” Perhaps Taleb’s randomness (chaos) is merely the interval between paradigm shifts – the confusing time when one set of patterns is discredited while a new set of patterns is being validated. And what of traders blowing up, supposedly proving Taleb’s contention that any previous success was luck? Were they merely unlucky, or were they foolish not to heed obvious increased risk. Abundant evidence exists that there is always sufficient warning for this long-awaited ten-sigma event that does (unlucky) traders in. Greenspan issued his warning of “irrational exuberance” at the end of 1996. And there certainly was enough financial media proclaiming “it’s different this time” to remind everybody that there has been a “previous time”  that was different. Surely there was enough “preparation” or patterns to warn anyone who wanted to consider risk. Mathematicians may dominate the derivatives trade, but the stock market is as much about investor psychology and real economic progress as it is about probability distribution theory. But yes, the book is worth your time. It makes you question what you believe and gives you an opportunity to confirm what you know (a statement that Taleb would certainly never accept).