Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets by Nassim Taleb

Summary

Through stories about investing, thought experiments, and lessons from history, Nassim Taleb explores the idea of how randomness influences our world more than we think. He argues that the world is not entirely random – there is a role for hard work, skills, and being prepared to help you ascend – but the role of luck is greater than you might imagine. By the end, you’ll walk away with a greater appreciation for how randomness influences our lives and the ways you can avoid common and sometimes costly traps.

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Fooled by Randomness

The central idea of the book is that the world is more random than we think. It is not all random. The world does favor hard work and preparation. These things do not cause you to benefit from randomness, but they can better position you over time and increase your odds of benefiting.
We fail to fully appreciate the randomness of the world for a few reasons, the most important of which is that due to the hindsight bias, past events always look less random than they were. And we craft compelling stories about why things happened, even if those stories are not true.

Probability

Probability is a branch of applied skepticism. It’s the acceptance of uncertainty and the use of methods to deal with our collective ignorance and uncertain world. But probability is not a simple mathematical calculation. Because the future is random, we cannot precisely calculate the probabilities of what might happen.

To think probabilistically, you have to be willing to consider that things could have worked out differently than they did. This means that we have to leave the comforts of determinism, which often leverages stories and oversimplifications to falsely ascribe the “why” behind something occurring. It’s important to remember that we often get the causality arrow wrong. Correlation does not equal causation.

Whereas statistics need logic (or reason) to be valid or meaningful, logic and reason do not need statistics to be valid. We can make observations about the world without having the stats about them.

Courage is not admirable

“Heroes are heroes because they are heroic in behavior, not because they won or lost.”

We often admire and herald the “courageous.” But often courage is not driven by a brave person confronting the difficult and uncertain odds of the world. It’s often born in ignorance. Courageous people are more likely to underestimate the role of randomness, which causes them to act and plan with excessive optimism and confidence. Sometimes, it works out; other times, it doesn’t.

Observed and unobserved events

To think clearly about the world, you must take into account both the observed and unobserved events. Most people don’t account for the unobserved events. They see what happened, and with hindsight, that it was the obvious thing to happen. But it wasn’t. It was one of a series of potential events, and it was the one that happened and was observed.

Playing Russian roulette with wealth

There are many ways to become wealthy. If you’re a dentist, on average, you will become wealthy over time in a predictable way. Alternatively, you could become wealthy via a hypothetical game of Russian roulette whereby you earn a million dollars if you survive. That game can make you as if not more wealthy than the path of a dentist, but it carries a very different risk profile.

In our lives, we’re often unaware that we’re playing a dangerous game of roulette. We often call our paths by some lower-risk name, but the truth is that we often can’t see the barrel of reality. We look at our rich neighbor and assume he is skilled and deserved their winnings. But they may have been lucky and benefited from little more than the graceful side of the randomness equation.

The trouble with insurance

People pay for insurance to protect themselves. When a bad event happens, we think of their decision as a smart one. When it doesn’t, it seems like they wasted money. But even if it doesn’t happen, probabilistically, it may have been the right move to buy the insurance.

People are funny with insurance – they’d rather pay for something specific that’s less likely to happen than something abstract that’s harder to imagine. For example, people would pay more for insurance that protects them financially if they were subject to a terrorist attack on a plane than insurance that protects them from any form of death on an airplane. Rationally, this makes no sense because the terrorist attack is a subset of the general insurance for airplane death. But

we’re not rational with risk calculations and insurance.
Rational thinking has little influence on how we avoid risk. Rather, we often use rational thinking to justify our actions or decisions that were made by emotions or feelings.

Lindy effect

The longer an idea has survived, the great its relative fitness to all types of conditions. This is partially why “new” is not “better.” And often the new things that we cherish are simply the outliers. For example, we herald technology by looking at what Amazon and Google have achieved, but we don’t appropriately consider all of the wasted energy and garbage that has come out of people’s desires to build tech companies.

Variance, returns, and time

If you check your stock portfolio daily, you’re most likely to observe noise, rather than actual returns. The shorter the time period, the more noise you observe. If you were to check quarterly, you would see something closer to the actual returns, or at least less of the noise.

This is partially why something like reading the daily news does little to nothing to increase your predictive power, knowledge about the world, or ability to profit from it. Yet, traders still read the Wall Street Journal.

If you look at your portfolio over the short term, not only do you see mostly noise, but you also induce more negative pangs on your nervous system. You see volatility that provides little to no info, and it hurts you. No one is immune from this, though some people are better than others at controlling the emotional impact.

Path dependence

How we feel about something depends on the path to getting to the end result. And there are many ways to get to the end result.

  • A → B
  • A → C → D → B
  • A → D → F → E → C → B

Imagine that you’re at a casino and start with $100. In one case, you lose $90 and then go on to end up even for the night. In another case, you start winning and are up $90, only to end up even by the end of the night. How you feel about ending up even is determined by the path, despite landing at the same outcome. In the first scenario, you end up feeling pretty good that you fought back to even. In the second, you kick yourself for not walking away while you were up. Same outcome, different feelings.

History as a teacher

History proves to be a terrible teacher because:

  • It rarely accounts for the role of randomness
  • We typically can only learn from experience
  • It can’t be tested against alternative potential paths

Even experience proves to be a terrible teacher for most people. That’s partially because when something good happens, we overestimate our role in it happening. And when something bad happens, we underestimate our role in that happening. In both cases, we fail to appropriately account for randomness.

The big problem with history is that we look at the past deterministically, instead of realizing that what occurred was one of a series of potential outcomes. We cannot determine mistakes or successes by what we learn after we made decisions. You have to assess decision quality based on what you knew at the time.

One good thing that history does teach us is about most of what can happen to you – financial ruin, wars, disease, and the better things of life.

Experiments

For an experiment to be valid, it must be repeatable with causal results. The reality is that you can prove almost anything with a single experiment, thanks to randomness. This means that people make conclusions based on experiments that don’t really tell you anything. Don’t fall victim to this trap.

Remember that theories cannot be “right.” They’re either proven wrong or not yet falsified.

Trading

You don’t need to maximize profits. You need to stay in the game. Don’t blow up your portfolio. Blowing up is taking a level of loss that wrecks you and that you don’t want to take. The challenge of avoiding blow up is that you need to avoid the goal of maximizing returns. Instead, you need to optimize for longevity.

Focusing on longevity often means that you will have to deal with less than sexy returns in periods where others (who are dumber and luckier than you) may have glorious profits. These people will often be pumping with serotonin, which makes their mood, posture, and everything else glow with confidence.

Idiotic bulls and stupid bears rarely survive long term. But an options trader can. Bad trades eventually catch up to you, and skills win out. Things ultimately revert to their longer term properties.

Traits of market fools

  • Overestimation of accuracy of their beliefs in some measure (economic or statistical).
  • Loyalty to positions (tendency to get married to positions). Loyalty to ideas is also not good.
  • Tendency to change the story based on what’s happening. They switch back between traders and investors depending on price movements. They become investors for the long haul when losing money. This is an excuse to postpone accepting that they’re wrong and selling the position.
  • No game plan ahead of time of what to do in the face of losses.
  • Absence of critical thinking expressed in absence of thinking.
  • Denial – no clear acceptance of what happened. Continuously ignore the message from reality.

Bad traders can win in the short-to-medium term based on a strategy that works during that time. But in the long run, they will not win. More often than not, they blow up.

Bullish and bearish

Bullish or bearish are useless terms. What matters is the probability of the direction AND the magnitude. Imagine that you believe the market will go up with 70% probability and go up 1% on average if it does. And imagine that you believe that it has a 30% chance of going down, with an average of 10% down if it does. Despite believing that it’s more likely that the market will go up, you’d short it because the expected return is higher on the downside move due to the magnitude of the move.

It’s not about how likely an event is that matters, it’s how much you make when it happens. How frequent you profit is irrelevant; it’s the magnitude of the outcome that counts.

Rare events

People often don’t reflect accurately on random events. But random events are the few events where asymmetric betting opportunities take place and that drive a lot of what happens in the financial world. Most people miss rare events because they remove the outliers from their analysis. Instead, they focus on the average of what’s happening over time.

Rare events often fuel themselves. Something like an unexpected bankruptcy occurs, which fuels liquidations, which causes panic, and that fuels more chaos. It’s a self-perpetuating mechanism.

Avoid intellectual pollution

There are many people who “sound good,” but who have no idea what they’re talking about. Avoid the trap of falling prey to the nice-sounding words.

Wittgenstein’s Ruler

Unless someone has particularly strong credentials, what they say is more of a reflection of themselves, rather than the event that they’re commenting on. The idea is based on the concept that you wouldn’t measure the length of something with confidence if you didn’t trust that the ruler you were using is accurate. The same should be true of the “gurus” and “experts” you listen to. Don’t trust their thoughts on what they’re commenting on unless you’re confident they’re an appropriately accurate judge.

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