Derek Sivers

Fooled by Randomness - by Nassim Nicholas Taleb

Fooled by Randomness - by Nassim Nicholas Taleb

Go to the Amazon page for details and reviews.

Mr Black Swan sure does love the sound of his own voice. Interesting thoughts on investing and misjudging randomness inside lots of blather.

my notes

POSSIBLE WORLDS: (risk and uncertainty)

Consider all possible parallel paths of outside effects : janitor who won the lottery would have had 999,999 lives with unsuccessful lottery tickets, and one possible life winning. Whereas a dentist who followed the dental-school and self-practice path has a smaller range of possibilities : ranging only from a dentist practice for poor people versus a dentist practice for rich people.

Challenge the notion that probability is about what may happen in the future, not events in the observed past - that an event that has already taken place has 100% probability.

$10 million earned playing Russian Roulette does not have the same value as $10 million earned through the diligent and artful practice of dentistry. One's dependence on randomness is greater.

The higher-up the corporate ladder, the lower the evidence of contribution. The degree of randomness in an activity : someone "lower" who does something well repeatedly wrongly gets less credit than the CEO who might have made one or two good decisions. The difference between someone who goes to Vegas, puts a single coin in a machine and wins $1 million. You can be sure if that same person put one million $1 bets, they would not have come out as well. This is the core of sampling theory : "the law of large numbers".


MEDIA INFLUENCE:

The market movements in the 18 months after September 11 were far smaller than the ones in the 18 months prior - but somehow in the minds of investors they were very volatile. Discussions in the media of the "terrorist threats" magnified the effect of the market moves in people's heads. This is one of the many reasons that journalism may be the greatest plague we face today.

Conventional wisdom favors things that can be explained instantly and in a nutshell. Most poetic sounding adages are plain wrong. Einstein said common sense is nothing but a collection of misconceptions acquired by age 18.

What sounds intelligent is suspicious. Almost all the smart things that have been proven by science appeared like lunacies at the time they were first discovered.

A mistake is not something to be determined after the fact, but in the light of the information until that point.


SURVIVAL OF THE LEAST FIT:

At a given time in the market, the most successful traders are likely to be those that are best fit to the latest cycle. This does not happen too often with dentists or pianists because these professions are more immune to randomness.

Regime switch : all attributes of a system change, to the point of becoming unrecognizable. Darwinian fitness applies over a very long time. Time aggregation eliminates much of the effects of randomness/noise. Things balance out over the long run.

We do not live in a world where things "converge" continuously toward betterment. Things in life don't move continuously at all.

The longer animals go without encountering the rare event, the more vulnerable they will be to it.


MARKET FOOLS OF RANDOMNESS CONSTANTS:

* - An overestimation of the accuracy of their beliefs in some measure, either economic or statistical. (Not considering it is coincidence.)
* - A tendency to get married to positions. (Loyalty to ideas is not a good thing for anyone.)
* - The tendency to change their story. (To explain foolish behavior.)
* - No precise game plan ahead of time as to what to do in the event of losses.
* - Absence of critical thinking expressed in absence of revision of their stance with "stop losses". (No allowance for flaws.)
* - Denial. (No clear acceptance of what has happened. Ignoring the message from reality.)


SKEWNESS:

"Skewed bets" : I try to benefit from rare events, events that do not tend to repeat themselves frequently, but present a large payoff when they occur. I try to make money as infrequently as possible, because I believe the rare events are not fairly valued, and that the rarer the event, the more undervalued it will be in price.

We read too much into shallow recent history, with statements like "this has never happened before". (Things that never happened before in one area tend eventually to happen.) History teaches us that things that never happened before do happen.

People tend to be sensitive to the presence or absence of a given stimulus rather than its magnitude. A loss is first perceived as just a loss, with further implications later. Same with profits. The agent would prefer the number of losses to be low and the number of gains to be high, rather than optimizing the total performance.

We take past history as a single homogeneous sample and believe we have considerably increased our knowledge of the future from the observation of the sample of the past. What if things have changed?

If rational traders detect a pattern of stocks rising on Mondays, then immediately such a pattern becomes detectable, it would be ironed out by people buying on Friday. There is no point searching for patterns that are available to everyone. Once detected, they would be self-cancelling.

If you expect Arizona weather to be 60 degrees -+ 10, that's quite different than Chicago weather being 60 degrees -+ 30.

My activity in the market depends far less on where I think the market or the random variable is going so much as it does on the degree of error I allow around such a confidence level.


THE PROBLEM OF INDUCTION:

George Soros knew how to handle randomness by keeping a critical open mind and changing his opinions with minimal shame. (Which carries the side effect of making him treat people like napkins.)

Karl Popper says science is not to be taken as seriously as it sounds. There are only two types of theories:
1. Theories that are known to be wrong, as they were tested and adequately rejected.
2. Theories that have not yet been known to be wrong, not falsified yet, but are exposed to be proved wrong.
Why is a theory never right? Because we will never know if all the swans are white.
(Story of how it was believed as fact that all swans are white, until a black swan was discovered hundreds of years later.)

I speculate in all of my activites on theories that represent some vision of the world, but with the following stipulation: no rare event should harm me. In fact, I would like all conceivable rare events to help me.


LOSER TAKES ALL:

The larger the deviation from the norm, the larger the probability of it coming from luck rather than skills.

I wonder if those "experts" who make foolish and self-serving statements like "markets will always go up in any 20-year period" are aware of this problem of randomness.

Real randomness does not look random.

Like actors into stardom, people patronize whatother people like to do. Forcing rational dynamics on the process would be impossible. This is called a "path dependent outcome" and has thwarted many mathematical attempts at modeling behavior.

Imagine practicing piano every day, barely able to perform "Chopsticks", then suddenly finding yourself capable of playing Rachmaninov. People cannot comprehend the nonlinear 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. In trading, one may own a security that benefits from lower market prices, but may not react at all until some critical point. Most people give up before the rewards.

Too much success is the enemy (think of the punishment delt to the rich and famous) - and too much failure is demoralizing. I would like the option of having neither.


THE GOOD SIDE OF RANDOMNESS:

Imagine a donkey equally hungry and thirsty, standing exactly between sources of food and water. He would die of both thirst and hunger, unable to decide which to get first.
Now inject some randomness by randomly nudging the donkey closer to one source, no matter which. The impasse is broken, and our happy donkey will be both fed and hydrated.

"Flipping a coin" breaks some of the minor stalemates in life where one lets randomness help with the decision process.

A slightly random schedule prevents us from optimizing and being exceedingly efficient in the wrong things. A little bit of uncertainty (taking the subway home after dinner) can make you relax at dinner instead of hurrying to catch a scheduled train. Helps you be a satisficer instead of maximizer.


RANDOMNESS AND OUR MIND:

Daniel Kahneman and Amos Tversky : behavioral finance and economics. Heuristics.

Example : the inability to accept anything abstract as risk.

Normative science = how things should be.
Positive science = how people are actually observed to behave.
(Normative economics is like religion without the aesthetics.)

Biases do not disappear when there are incentives.

Russian legal system has conflicting and contradictory laws : sometimes you have to violate a law to comply with another. This legal system came from the piecewise development of the rules. You add a law here and there and there is no central system consulted every time to ensure compatibility.
Napoleon had a similar situation in France, so he remedied it by setting up a top-down code of law for a full legal consistency.
Our brains are like the Russian system.

Your brain reacts differently to the same situation depending on which chapter you open to.

"I'm as good as my last trade" = Prospect Theory = Looking at differences, not absolutes, and resetting to a specific reference point.
"Sound-bite effect" or "Fade the fears" = Affect heuristic, Risk-as-Feeling Theory = People react to concrete and visible risks, not abstract ones.
"It was so obvious" = Hindsight Bias = Things appear to be more predictable after the fact.
"You were wrong" = Belief in the law of small numbers = Inductive fallacies; jumping to general conclusions too quickly.
"Brooklyn smarts / MIT intelligence" = Two systems of reasoning = The working brain is not quite the reasoning one.
"It will never go there" = Overconfidence = Risk-taking out of an underestimation of the odds.

You do not have everything you know in your mind at all times, so you retrieve the knowledge in a piecemeal fashion, which puts these retrieved knowledge chunks in their local context. You have an arbitrary reference point and react to differences from that point, forgetting that you are only looking at the differences from that particular perspective of the local context, not the absolutes.

When you take a gamble, do you say "My net worth will end up at $99k or $101.5k after the gamble" or do you say, "I lose $1000 or make $1500?" Your attitude toward the risks and rewards of the gamble will vary according to whether you look at your net worth or changes in it.

Because of this resetting, wealth itself does not really make one happy, but positive changes in wealth may, especially if they come as "steady" increases.

This anchoring to a number is the reason people do not react to their total accumulated wealth, but to differences of wealth from whatever number they are currently anchored to.

We do not *think* when making choices, but use heuristics.
We make serious probabilistic mistakes in today's world.

QUIZ:
A test of a disease presents a rate of 5% false positives.
The disease strikes 1/1000 of the population.
People are tested at random, regardless of whether they are suspected of having the disease.
A patient's test is positive.
What is the probability of the patient having the disease?

Most doctors say 95%! True answer is 1/50. (2%).
The positive reading just made it 20 times more likely the patient has it. Now 1/1000 chance is increased to 1/50 chance.


Very few option traders can maintain a "long volatility" position : a position that will most likely lose a small quantity of money, but is expected to make money in the long run because of occasional spurts. Very few people can lose $1 for most expirations and make $10 once in a while, even if the game were fair.

We think with our emotions, and there is no way around it.


JOURNALISTS:

People get mixed up between absence of evidence and evidence of absence.

When news says "Dow up 1.3 on lower interest rates", it's less than a 0.01% move, which requires no explanation, nothing to explain, no reasons to adduce. But journalists being paid to provide explanations will gladly provide them.

Unless something moves by more than its usual daily percentage, it's noise. A 2% move is 4-10 times more significant than a 1% move. A 7% move can be several billion times more relevant than a 1% move.

Too many people read explanations. We cannot instinctively understand the nonlinear aspect of probability.

Unless the source of a statement has extremely high qualifications, the statement will be more revealing of the author than the information judged.

Unless you have confidence in the ruler's reliability, if you use a ruler to measure a table, you may also be using the table to measure the ruler.

Put wax in your ears and ignore the news.


EMOTIONS:

I cannot help it, but I am emotional and derive most of my energy from emotions. So the solution is not to tame my heart. Since my heart does not agree with my brain, I need to take serious action to avoid making irrational trading decisions.

Most of us know how we should behave. It's the execution that's the problem, not the absence of knowledge.

Ignore the noise component in market performance. We need tricks to get us there, but we need to accept the fact that we are mere animals in need of lower forms of tricks, not lectures.


STOICS / SKEPTICS / CHANGING YOUR MIND:

The skeptics' main teaching was that nothing could be accepted with certainty, conclusions of various degrees of probability could be formed, and these supplied a guide to conduct.

We learned from Popper how to remain self-critical, to respect him more, as he did not hew stubbornly to an opinion for the mere fact that he had voiced it in the past. Your average literature professor would fault him for his contradictions and his change of mind.

Proust did not consider that the diplomat might have changed his mind. We are supposed to be faithful to our opinions. One becomes a traitor otherwise.

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.

Say you own a painting you bought for $20k, and is now worth $40k. If you owned no painting, would you buy it at the current price? If 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 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.

Researchers found that purely rational behavior can come from a defect in the amygdala that blocks the emotions of attachment, meaning that the subject is literally a psychopath.

You attribute your successes to skills, but your failures to randomness. Scientists attributed their failures to an "extremely rare" event : they thought they were right but luck played against them. Why? It is a human heuristic that makes us actually believe so in order to not kill our self-esteem and keep us going against adversity.

Science is great, but scientists are dangerous. They are human, and often forced to act like a cheap defense lawyer rather than a pure seeker of the truth.


PERSONAL ELEGANCE:

No matter how sophisticated our choices, how good we are at dominating the odds, randomness will have the last word. We are left only with dignity as a solution : dignity defined as the execution of a protocol of behavior that does not depend on the immediate circumstance. It may not be the optimal one, but it is certainly the one that makes us feel best.

Start stressing personal elegance at your next misfortune. Try not to blame others for your fate, even if they deserve blame. Never exhibit self-pity. Do not complain.

The only article Lady Fortuna has no control over is your behavior.