Fooled by randomness | INSPIRATTIO

Nassim Taleb es un ensayista, filósofo, matemático y ex operador de derivados de origen libanés. Tras abandonar su carrera como trader, dedicó buena parte de su actividad al estudio y reflexión acerca del impacto de la aleatoriedad y la incertidumbre en el devenir de la Historia y los acontecimientos cotidianos. Está considerado uno de los pensadores más influyentes de nuestra época.

Fooled by randomness es el primer volumen de su obra Incerto, compuesta, además, por El Cisne Negro, El lecho de Procusto, Antifrágil y Skin in the game. Las ideas de Taleb, muy influidas por pensadores como Michel de Montaigne, David Hume y Benoit Mandelbrot, entre otros, reflejan su empirismo escéptico.

Publicado en 2001, Fooled by randomness fue considerado uno de los 75 libros más relevantes de todos los tiempos por la revista Fortune.

Nuestras notas están tomadas de la versión original de la obra, que en castellano se tradujo defectuosamente como ¿Existe la suerte?

Preface and prologue

Past events look less random than they were
Courage to introspect, to confront oneself, to accept one’s limitations
Acceptance of the lack of certainty –> methods for dealing with our ignorance
Confusion of the necessary and the causal: preparation (hard work, perseverance, etc.) is necessary but may be insufficient as it does not cause success

One needs to go out and buy a lottery ticket in order to win. Does it mean that the work involved in the trip to the store caused the winning?
Skills count, but they count less in highly random environments than in dentistry

Luck disguised and perceived as non-luck (i.e. skills) – randomness disguised and perceived as non-randomness (i.e. determinism)

Lucky fool: person who benefitted from a high share of luck but attributes his success to some other reason
Confusion between noise and meaning –> unwillingness to accept randomness

We underestimate the share of randomness in about everything
What is called “courage” comes from an underestimation of the share of randomness in things

“Risk takers” are rather the victims of delusions (leading to over optimism and overconfidence with their underestimation of possible adverse outcomes) –> “risk taking” is frequently randomness foolishness

Inability to think critically
The false belief in determinism is also associated with the reduction of the dimensionality of things: it is the simplification that is dangerous.

Part I: Solon’s warning – skewness, asymmetry, induction

That which came with the help of luck could be taken away by luck. Things that come with little help from luck are more resistant to randomness
It does not matter how frequently something succeeds if failure is too costly to bear

If you’re so rich, why aren’t you so smart?

[Trader Nero Tulip] “I love taking small loses; I just need my winners to be large”. In no circumstances does he want to be exposed to those rare events, like panics and sudden crashes, that wipe a trader out in a flash. To the contrary, he wants to benefit from them
His net worth is not a function of the investment of his savings – he does not want to depend on his investments, but on his cash earnings, for his enrichment
Mild success can be explainable by skills and labor. Wild success is attributable to variance
Risk of blow-up, a risk John [high-yield trader] could not see because he had too short an experience of the market (but also because he was not thoughtful enough to study history)
Nero felt proud of his sticking to his strategy for so long, in spite of the pressure to be the alpha male. He would no longer question his trading style when others were getting rich because they misunderstood the structure of randomness and market cycles
Can we judge the success of people by their raw performance and their personal wealth? Not always

A large section of businessmen with outstanding track records will be no better than randomly thrown darts

Lucky fools do not bear the slightest suspicion that they may be lucky fools. They will even fool themselves about their ability to outperform markets
One cannot consider a profession without taking into account the average of the people who enter it, not the sample of those who have succeeded in it –> take into account both the observed and unobserved possible outcomes
For most people, probability is about what may happen in the future, not events in the observed past; an event that has already taken place has 100% probability, i.e., certainty

A bizarre accounting method

One cannot judge a performance by the results but by the costs of the alternative (i.e. if history played out in a different way)

The quality of a decision cannot be solely judged based on its outcome, but those who succeed attribute their success to the quality of their decision

Alternative histories: only one of the histories is observed in reality [Russian roulette example]

$10m earned through Russian roulette do not have the same value as $10m earned through the practice of dentistry

Reality delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands, of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet –> black swan, denigration of history
We do not see the roulette barrel of reality: the generator and risks are rarely visible
Risk detection and risk avoidance are not mediated in the “thinking” part of the brain but largely in the emotional one (the “risk as feelings” theory)

A mathematical meditation on history

One sees only one realization among a collection of possible ones
Random sample path –> Monte Carlo simulations: create thousands of random sample paths
No longer visualize a realized outcome without reference to the non-realized ones
“Pseudoscientific historicism” draws theories from past events without allowing for the fact that such combinations of events might have arisen from randomness
When you look at the past, the past will always be deterministic, since only one single observation took place
A mistake is not something to be determined after the fact, but in the light of the information until that point
Ergodicity: (under certain conditions) very long sample paths would end up resembling each other
Distilled thinking: thinking based on information around us that is stripped of meaningless clutter

The ratio of undistilled information to distilled is rising
Prominent media journalism is a thoughtless process of providing the noise that can capture people’s attention; smart journalists are often penalized

We only see and count the winners, to the exclusion of the losers
Those who will survive are not necessarily those who appear to be the fittest. Curiously, it will be the oldest, simply because older people have been exposed longer to the rare event and can be more resistant to it
The wise man listens to meaning; the fool only gets the noise
Over a short time increment, one observes the variability of the portfolio, not the returns (i.e., one sees the variance, little else) –> it is emotionally better to deal with monthly statements rather than more frequent ones
The news is full of noise; history is largely stripped of it (though fraught with interpretation problems)
People who look too closely at randomness burn out, their emotions drained by the series of pangs they experience; a negative pang is not offset by a positive

Survival of the least fit – can evolution be fooled by randomness?

Economists are evaluated on how intelligent they sound, not on a scientific measure of their knowledge of reality
The richest traders are often the worst traders. The most successful traders are likely to be those that are best fit to the latest cycle. This does not happen with dentists because this profession is more immune to randomness
Bad traders divorce their spouse sooner than abandon their positions. Loyalty to ideas is not a good thing
They become investors “for the long haul” when they are losing money, switching back and forth between traders and investors
They have no plan ahead of time as to what to do in the event of losses
Absence of critical thinking: middlebrow traders do not like selling when it is “even better value”. They did not consider that perhaps their method of determining value is wrong, rather than the market failing to accommodate their measure of value
We tend to think that traders are successful because they are good. We consider them good just because they make money. One can make money in the financial markets totally out of randomness
Bad traders have a short- and medium-term survival advantage over good traders
Many people believe that companies and organizations are, thanks to competition, heading toward betterment: the strongest will survive; the weakest will become extinct. Things are not as simple as that
We do not live in a world where things “converge” continuously toward betterment. Nor do things in life move continuously at all
Just as an animal could have survived because its sample path was lucky, the “best” operators in a given business can come from a subset of operators who survived because of overfitness to a sample path – a sample path that was free of the evolutionary rare event. The longer these animals can go without encountering the rare event, the more vulnerable they will be to it
Someone who is a pure loser in the long run and correspondingly unfit for survival, presents a high degree of eligibility in the short run and has the propensity to multiply his genes

Skewnsess and asymmetry

Expected and median do not mean the same thing at all
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 means that the payoffs are not equal
People confuse probability and expectation [expected value = probability x payoff]. It is not how likely an event is to happen that matters, it is how much is made/lost when it happens that should be the consideration
Skewed bets: try to benefit from rare events – events that do not tend to repeat themselves frequently, but, accordingly, present a large payoff when they occur

I try to make money infrequently, as infrequently as possible, simply because I believe that rare events are not fairly valued, and that the rarer the event, the more undervalued it will be in price

Attributes of random events –> frequencies do not matter

The statistic that an event occurs 90% of the time (the frequency) is meaningless if we don’t take into account how much is made/lost during the remaining 10%
–> distinguish between probability and expectation

Nero aimed to avoid exposure to rare events. I aim at profiting from the rare event with asymmetric bets
An event, although rare, that brings large consequences cannot just be ignored
I reject a sole time series of the past as an indication of future performance; I need a lot more than data. My major reason is the rare event. History teaches us that things that never happened before do happen
Beware of calm waters
I associate rare events with any misunderstanding of the risks derived from a narrow interpretation of past time series
Peso problem: form of investment that was based on a naive interpretation of the volatility of past time series
He could try and try for years without anything to show for it. Until bingo, one day he comes up with a result. Someone observing the time series of his occupation would see absolutely no gain, while every day would bring him closer in probability to the end result
Where statistics becomes complicated, and fails us, is when we have distributions that are not symmetric
We take past history as a single homogeneous sample and believe that we have considerably increased our knowledge of the future from the observation of the sample of the past. What if vicious children were changing the composition of the urn? In other words, what if things have changed?

The problem of induction

“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” (John Stuart Mill)
David Hume was an obsessive sceptic and never believed that a link between two items could be truly established as being causal
Victor Niederhoffer: any “testable” statement should be tested, as our minds make plenty of empirical mistakes when relying on vague impressions. How many effects we take for granted might not be there?
I can use data to disprove a proposition, never to prove one. I can use history to refute a conjecture, never to affirm it. Samples can be greatly insufficient; we may not know much from historical information
Close to a couple of decades of performance were overshadowed by a single event that only lasted a few minutes
The cost of the losses can be markedly different from that of the wins. 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
There are only two types of theories: (i) theories that are known to be wrong; (ii) theories that have not yet been known to be wrong

A theory is never right because we will never know if all the swans are white
A theory cannot be verified, it can only be provisionally accepted

The matter of knowledge and discovery is not so much in dealing with what we know as in dealing with what we do not know
Open society: one in which no permanent truth is held to exist –> open vs. closed mind
Induction is going from plenty of particulars to the general. It is very handy, as the general takes much less room in one’s memory than a collection of particulars. The effect of such compression is the reduction in the degree of detected randomness
I will use statistics and inductive methods to make aggressive bets, but I will not use them to manage my risks and exposure –> make sure that the costs of being wrong are limited: stop loss, a predetermined exit point, a protection from the black swan
I needed the backing of my bank account so I could buy time to think and enjoy life –> contemplative stops

The matter of knowledge and discovery is not so much in dealing with what we know as in dealing with what we do not know

Part II: monkeys on typewriters – survivorship and other biases

How much can past performance be relevant in forecasting future performance?
If someone performed better than the crowd in the past, there is a presumption of his ability to do better in the future. But the presumption might be weak, because it all depends on two factors: the randomness content of his profession and the number of monkeys in operation
The initial sample size matters greatly. The higher the number of businessmen, the greater the likelihood of one of them performing in a stellar manner just by luck
In real life the other monkeys are not countable, let alone visible. They are hidden away, as one sees only the winners. One sees the survivors, and only the survivors

Too many millionaires next door

Social treadmill effect
The virtue of capitalism is that society can take advantage of people’s greed rather than their benevolence
Survivorship bias is chronic 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
We tend to mistake one realization among all possible random histories as the most representative one, forgetting that there may be others

It is easier to buy and sell than fry an egg

Performance is exaggerated by the observer due to a misperception of the importance of randomness
A population entirely composed of bad managers will produce a small amount of great track records
People believe that they can figure out the properties of the distribution from the sample they are witnessing
The survivorship bias depends on the size of the initial population. The information that a person derived some profits in the past is neither meaningful nor relevant. We need to know the size of the population from which he came. Without knowing how many managers out there have tried and failed, we will not be able to assess the validity of the track record

If the initial population includes 10 managers, I would give the performer half my savings without a blink; if it is composed of 10,000 managers, I would ignore the results

Nobody accepts randomness in his own success, only his failure

Losers take all – nonlinearities of life

A small advantage in life can translate into a highly disproportionate payoff. No advantage at all, but a very, very small help from randomness, can lead to a bonanza (e.g. actors in an audition)
The final outcome is more than frequently the undeserved one – lucky success (e.g. Microsoft, network externalities)
The important fact is knowing the existence of these nonlinearities, not trying to model them
Our brain is designed for linear causality, not for nonlinearities. Owing to nonlinearity, people cannot comprehend the nature of the rare event
There are routes to success that are nonrandom, but very few people have the mental stamina to follow them. Those who go the extra mile are rewarded. Most people give up before the rewards
Buridan’s donkey –> let randomness help with a minor decision process (e.g. flipping a coin)
World’s bipolarity: either one succeeds wildly, by attracting all the cash, or fails to draw a single penny

It is better to have a handful of enthusiastic advocates than hordes of people who appreciate your work – better to be loved by a dozen than liked by the hundreds.

Randomness and our mind: we are probability blind

Others who just ran away at the smallest presumption and were not slowed down by the smallest amount of thinking ended up either outchasing the tiger or outchasing their cousin who ended up being eaten by it
Herbert Simon: satisficing: satisfy + suffice –> stop when you get a near-satisfactory solution
Daniel Kahneman and Amos Tversky –> uncover areas where human beings are not endowed with rational probabilistic thinking and optimal behavior under uncertainty

Divide the activities of our mind into System 1 and System 2

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 –> normative science (how things should be) vs. positive science (how people are observed to behave)
People have difficulties with standard probabilistic reasoning. They confuse the expected value and the most likely scenario
It requires some strength of character to accept the expectation of bleeding a little, losing pennies on a steady basis even if the strategy is bound to be profitable over longer periods
–> “long volatility”: position that will most likely lose a small quantity of money at expiration, but is expected to make money in the long run because of occasional spurts (e.g. call option: accept losing $1 for most expirations and making $10 once in a while)
Option traders: premium sellers sell options, and generally make steady money until eventually they blow up. Premium buyers do the reverse
It is not the estimate or the forecast that matters so much as the degree of confidence with the opinion – it is the variance that matters

Part III: wax in my ears – living with randomitis

Ulises y las sirenas
Unless the source of the statement has extremely high qualifications, the statement will be more revealing of the author than the information intended by him – Wittgentstein’s ruler

Gambler’s ticks and pigeons in a box

We are not made to view things as independent from each other. When viewing two events A and B, it is hard not to assume that A causes B, B causes A, or both cause each other.We establish a causal link
It is the execution that is the problem, not the absence of knowledge

Carneades comes to Rome: on probability and skepticism

The sceptics’ (e.g. Hume, Kant) main teaching was that nothing could be accepted with certainty
During the Middle Ages, Arabs were critical thinkers (through their postclassical philosophical tradition) when Christian thought was dogmatic; then, after the Renaissance, the roles mysteriously reversed
One forgets rather quickly what one has not thought about with depth
What characterizes real speculators like Soros from the rest is that their activities are devoid of path dependence. They are totally free from their past actions. Every day is a clean slate
Path dependence of beliefs / endowment effect –> being married to one’s position. Absence of marriage to ideas is rare:

We may be programmed to build a loyalty to ideas in which we have invested time
Purely rational behavior can come from a defect in the amygdala that blocks the emotions of attachment

An academic who became famous for espousing an opinion is not going to voice anything that can possibly devalue his own past work and kill years of investment. People who switch parties become traitors, renegades, or, worst of all, apostates
The odds in games where the rules are clearly and explicitly defined are computable and the risks consequently measured. But not in the real world. For mother nature did not endow us with clear rules
Long Term Capital Management: they thought they could scientifically “measure” their risks. They made absolutely no allowance for the possibility of their not understanding markets and their methods being wrong
Accepting what has happened, clearly the courageous thing to do, would invalidate the ideas they have built throughout an entire academic career
Attribution bias: you attribute your successes to skills, but your failures to randomness

Bacchus abandons Antony

Epic heroes were judged by their actions, not by the results
No matter how sophisticated our choices, how good we are at dominating the odds, randomness will have the last word
Dignity: execution of a protocol of behavior that does not depend on the immediate circumstance

“Listen, I have a crush on you; I am obsessed with you, but I will not do a thing to compromise my dignity. Accordingly, the slightest snub and you will never see me again”

Manner in which a man of virtue and dignity deals with randomness
“Just listen while shaken by emotion but not with the coward’s imploration and complaints” (Greek poet Cavafy on Marc Antony’s defeat to Octavius) –> following the heroic or, at least, the dignified path – that is what stoicism truly means
Ideas do not truly sink in when emotions come into play; we do not use our rational brain outside of classrooms. Enlightened, friendly advice and eloquent sermons do not register for more than a few moments when they go against our wiring
Show personal elegance at your next misfortune. Exhibit sapere vivere (“know how to live”) in all circumstances. Don’t play victim nor exhibit self-pity. Do not complain. Maintain a dignified attitude –> the only article Lady Fortuna has no control over is your behavior

No matter how sophisticated our choices, how good we are at dominating the odds, randomness will have the last word

Epilogue

Inverse skills problem

The higher the corporate ladder, the lower the evidence of individual’s contribution
Distinction between those skills that are visible (like the abilities of a dentist) and those that present more difficulty in nailing down, especially when the subject belongs to a randomness-laden profession

Judging on process vs. 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
Attribution of heroism to those who took crazy decisions but were lucky enough to win – we continue to worship those who won battles and despise those who lost, no matter the reason –> difference between process and result

Some degree of unpredictability (or lack of knowledge) can be beneficial. A slightly random schedule prevents us from optimizing and being exceedingly efficient, particularly in the wrong things –> act as a satisficer instead of a maximizer
We favor the visible, the embedded, the personal, the narrated and the tangible; we scorn the abstract

Basado en Nassim N. Taleb. Fooled by randomness. Editorial Penguin Books (2007)