Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life / Edition 1

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Overview

This book is about luck -- or more precisely how we perceive and deal with luck in business and life. Set against the backdrop of the most conspicuous forum in which luck is mistaken for skill -- the world of trading -- Fooled by Randomness is a captivating insight into one of the least understood factors in all our lives. Writing in an entertaining and narrative style, the author succeeds in tackling and explaining three major intellectual issues: the problem of induction, the survivorship biases, and our genetic unfitness to the modern world.

The book is populated with an array of characters, some of whom have grasped, in their own way, the significance of chance: Yogi Berra, the baseball legend; Karl Popper, the philosopher of knowledge; Solon, the Ancient World's wisest man; the modern financier George Soros; and the Greek voyager Ulysses. In addition we meet the fictional Nero, who seems to understand the role of randomness in his trading life, but who also falls victim to his own superstitious foolishness.

But the most recognizable character of all remains unnamed -- the lucky fool in the right place at the right time. The embodiment of the "Survival of the Least Fit." Such individuals attract devoted followers who believe in their guru's insights and methods. But no one can replicate what is obtained through chance. A monkey banging on a keyboard may eventually produce the Iliad, but would you sign him to write the sequel? Are we capable of distinguishing the fortunate charlatan from the genuine visionary? Must we always try to uncover non-existent messages in random events? It may be impossible to guard ourselves against the vagaries of the Goddess Fortuna, but after reading Fooled by Randomness we can be a little better prepared.

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Editorial Reviews

Marco Avellaneda
Intelligent, honest, and revealing. There exists a distinct Taleb way of thinking and it is contagious.
Robert J. Shiller
I really liked this book. . . It is fun to read, refreshingly independently-minded and at the same time playful.
Donald Geman
Taleb's book is mathematically sound as well as entertaining and informative for the general public, which is quite an achievement . . .
Victory Niederhoffer
Whether you agree with Mr. Taleb or not, his book will leave you with many suggestive queries.
Paul Wilmott
A blast of common sense. From classical to modern philosophers, via cab drivers, businessmen, and dentists . . .
Peter L. Bernstein
. . . Taleb will grab you. As a non-random consequence, your understanding of life (and your money will expand exponentially.
Publishers Weekly
In this look at financial luck, hedge fund manager Taleb (Dynamic Hedging) addresses the apparently irrational movement of money markets around the world. Using his own investing experience and examples of others' successes and disappointments, he discusses theories like Monte Carlo math (easy; considered cheating by purists) and the concept of Russian roulette. Taleb tells interesting, well-wrought stories about individual behavior: "While Nero has succeeded beyond his wildest dreams, both personally and intellectually, he is starting to consider himself as having missed a chance somewhere." While serious investors and mathematics enthusiasts will be intrigued, readers looking for practical investment strategies will be disappointed by this rambling intellectual discourse. Tables. 40,000-copy first printing; $150,000 marketing budget. (Oct. 30) Copyright 2001 Cahners Business Information.
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Product Details

  • ISBN-13: 9781587990717
  • Publisher: South-Western
  • Publication date: 10/1/2001
  • Edition description: Older Edition
  • Edition number: 1
  • Pages: 220
  • Product dimensions: 6.26 (w) x 9.14 (h) x 0.89 (d)

Read an Excerpt

Prologue

Mosques in the Clouds

This book is about luck disguised and perceived as non-luck (that is, skills) and, more generally, randomness disguised and perceived as non-randomness (that is, determinism). It manifests itself in the shape of the lucky fool, defined as a person who benefited from a disproportionate share of luck but attributes his success to some other, generally very precise, reason. Such confusion crops up in the most unexpected areas, even science, though not in such an accentuated and obvious manner as it does in the world of business. It is endemic in politics, as it can be encountered in the shape of a country's president discoursing on the jobs that "he" created, "his" recovery, and "his predecessor's" inflation.

We are genetically still very close to our ancestors who roamed the savannah. The formation of our beliefs is fraught with superstitions—even today (I might say, especially today). Just as one day some primitive tribesman scratched his nose, saw rain falling, and developed an elaborate method of scratching his nose to bring on the much-needed rain, we link economic prosperity to some rate cut by the Federal Reserve Board, or the success of a company with the appointment of the new president "at the helm". Bookstores are full of biographies of successful men and women presenting their specific explanation on how they made it big in life (we have an expression, "the right time and the right place" to weaken whatever conclusion can be inferred from them).

This confusion strikes people of different persuasions; the literature professor invests a deep meaning into a mere coincidental occurrence of wordpatterns, while the financial statistician proudly detects "regularities" and "anomalies" in data that are plain random.

At the cost of appearing biased, I have to say that the literary mind can be intentionally prone to the confusion between noise and meaning, that is, between a randomly constructed arrangement and a precisely intended message. However, this causes little harm; few claim that art is a tool of investigation of the Truth—rather than an attempt to escape it or make it more palatable. Symbolism is the child of our inability and unwillingness to accept randomness; we give meaning to all manner of shapes; we detect human figures in inkblots. I saw mosques in the clouds announced Arthur Rimbaud the 19th-century French symbolic poet. This interpretation took him to "poetic" Abyssinia (in East Africa), where he was brutalized by a Christian Lebanese slave dealer, contracted syphilis, and lost a leg to gangrene. He gave up poetry in disgust at the age of 19, and died anonymously in a Marseilles hospital ward while still in his thirties. But it was too late. European intellectual life developed what seems to be an irreversible taste for symbolism—we are still paying its price, with psychoanalysis and other fads.

Regrettably, some people play the game too seriously; they are paid to read too much into things. All my life I have suffered the conflict between my love of literature and poetry and my profound allergy to most teachers of literature and "critics". The French poet Paul Valery was surprised to listen to a commentary of his poems that found meanings that had until then escaped him (of course, it was pointed out to him that these were intended by his subconscious).

More generally, we underestimate the share of randomness in about anything, a point that may not merit a book—except when it is the specialist who is the fool of all fools. Disturbingly, science has only recently been able to handle randomness (the growth in available information has been exceeded by the expansion of noise). Probability theory is a young arrival in mathematics; probability applied to practice is almost nonexistent as a discipline.

Consider the left and the right columns of Table P. 1. The best way to summarize the major thesis of this book is that it addresses situations (many of them tragicomical) where the left column is mistaken for the right one. The sub-sections also illustrate the key areas of discussion on which this book will be based.

Table P.1 Table of Confusion
Presenting the central distinctions used in the book

GENERAL
Luck—Skills
Randomness—Determinism
Probability—Certainty
Belief, conjecture—Knowledge, certitude
Theory—Reality
Anecdote, coincidence—Causality, law
Forecast—Prophecy

MARKET PERFORMANCE
Lucky idiot—Skilled investor
Survivorship bias—Market outperformance

FINANCE
Volatility—Return (or drift)
Stochastic variable—Deterministic variable

PHYSICS AND ENGINEERING
Noise—Signal

LITERARY CRITICISM
None (literary critics do not seem to have a name for things they do not understand)—Symbol

PHILOSOPHY OF SCIENCE
Epistemic probability—Physical probability
Induction—Deduction
Synthetic proposition—Analytic proposition

The reader may wonder whether the opposite case might not deserve some attention, that is, the situations where non-randomness is mistaken for randomness. Shouldn't we be concerned with situations where patterns and messages may have been ignored? I have two answers. First, I am not overly worried about the existence of undetected patterns. We have been reading lengthy and complex messages in just about any manifestation of nature that presents jaggedness (such as the palm of a hand, the residues at the bottom of Turkish coffee cups, etc.). Armed with home supercomputers and chained processors, and helped by complexity and "chaos" theories, the scientists, semi-scientists, and pseudoscientists will be able to find portents. Second, we need to take into account the costs of mistakes; in my opinion, mistaking the right column for the left one is not as costly as an error in the opposite direction. Even popular opinion warns that bad information is worse than no information at all.

However interesting these areas could be, their discussion would be a tall order. In addition, they are not my current professional specialty. There is one world in which I believe the habit of mistaking luck for skill is most prevalent—and most conspicuous—and that is the world of trading. By luck or misfortune, that is the world in which I operate. It is my profession, and as such it will form the backbone of this book. It is what I know best. In addition, business presents the best (and most entertaining) laboratory for the understanding of these differences. For it is the area of human undertaking where the confusion is greatest and its effects the most pernicious. For instance, we often have the mistaken impression that a strategy is an excellent strategy, or an entrepreneur a person endowed with "vision", or a trader an excellent trader, only to realize that 99.9% of their past performance is attributable to chance, and chance alone. Ask a profitable investor to explain the reasons for his success; he will offer some deep and convincing interpretation of the results. Frequently, these delusions are intentional and deserve to bear the name "charlatanism".

If there is one cause for this confusion between the left and the right sides of our table, it is our inability to think critically—we may enjoy presenting conjectures as truth. We are wired to be like that. We will see that our mind is not equipped with the adequate hardware to handle probabilities; such infirmity even strikes the expert, sometimes just the expert. A critical mind, on the other hand, is someone who has the guts, when confronting a given set of information, to attribute a large share of its possible cause to the left column.

The 19th-century cartoon character, pot-bellied bourgeois Monsieur Prudhomme, carried around a large sword with a double intent: primarily to defend the Republic against its enemies, and secondarily to attack it should it stray from its course. In the same manner, this book has two purposes: to defend science (as a light beam across the noise of randomness), and to attack the scientist when he strays from his course (most disasters come from the fact that individual scientists do not have an innate understanding of standard error or a clue about critical thinking). As a practitioner of uncertainty I have seen more than my share of snake-oil salesmen dressed in the garb of scientists. The greatest fools of randomness will be found among these.

This author hates books that can be easily guessed from the table of contents—but a hint of what comes next seems in order. The book is composed of three parts. The first is an introspection into Solon's warning, as his outburst on rare events became my lifelong motto. In it we meditate on visible and invisible histories. The second presents a collection of probability biases I encountered (and suffered from) in my career in randomness—ones that continue to fool me. The third concludes the book with the revelation that perhaps ridding ourselves of our humanity is not in the works; we need tricks, not some grandiose moralizing help. Again the elders can help us with some of their ruses.

Copyright © 2001 Nassim Nicholas Taleb

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Table of Contents

Preface and Acknowledgments
Chapter Summaries
Prologue 1
Pt. I Solon's Warning - Skewness, Asymmetry, Induction 7
1 If You're So Rich Why Aren't You So Smart? 11
2 A Bizarre Accounting Method 26
3 A Mathematical Meditation on History 40
4 Randomness, Nonsense, and the Scientific Intellectual 60
5 Survival of the Least Fit - Can Evolution Be Fooled by Randomness? 68
6 Skewness and Asymmetry 84
7 The Problem of Induction 99
Pt. II Monkeys on Typewriters - Survivorship and Other Biases 111
8 Too Many Millionaires Next Door 117
9 It Is Easier To Buy and Sell Than Fry an Egg 125
10 Loser Takes All - On the Nonlinearities of Life 142
11 Randomness and Our Brain: We Are Probability Blind 149
Pt. III Wax in my Ears - Living With Randomitis 169
12 Gamblers' Ticks and Pigeons in a Box 175
13 Carneades Comes to Rome: On Probability and Skepticism 182
14 Bacchus Abandons Antony 191
Epilogue: Solon Told You So 196
Notes 197
Index 198
About Texere 204
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Sort by: Showing all of 4 Customer Reviews
  • Anonymous

    Posted May 29, 2004

    Waste of Time

    This book is a complete waste to read. The analysis and arguments are extremely dull and elementary and are written in a very pedantic style. It is more one man's personal insults to all those who have far exceeded him in trading the markets. There is nothing of value in this book.

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  • Anonymous

    Posted January 14, 2004

    Fantastic

    Taleb doesn't put as much math in the book as I'd like, or expected, but the point he gets across is awesome. Seemingly anecdotal, at times, he incorporates lots of stories which range from Roman rulers to traders on the exchange floor. Absolutely excellent.

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  • Anonymous

    Posted October 27, 2001

    Charming

    The narrator may come across as having a big ego, but he is absolutely charming. He lulls you into his world with a totally different logic. He sees randomness where you suspect none and convinces you.

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  • Anonymous

    Posted September 19, 2001

    Managing Unpredictable Variations in Order to Prosper!

    Every person who is interested in investing should read this book! In investing, few can tell the difference between being lucky and smart. Being successful in the short term can come from either source. If it is coming from unrecognized sources of luck, however, the behavior that the investor associates with success can sink the ship. The cautionary tale of Long-Term Capital Management is cited in the book as an example of this point. ¿If you¿re so rich, why aren¿t you smart?¿ is the wonderful reversal here on the old saw. I see this effect all the time in my consulting practice with helping companies understand how their decisions affect their stock price. A large percentage of people feel that they know all the answers when their stock price is rising. They keep doing the same things when the stocks are falling. Few survive to still have top jobs when the cycle shifts again. Then a new group of self-confident people take over who often don¿t know any more than those who preceded them. It¿s just that their track records look better. Fooled by Randomness will help make you more knowledgeably humble about what you can expect to accomplish with investments. Not only do fewer than one percent outperform the market averages over long time periods, the ones who do are probably often being aided by luck as well. ¿Get thee to the index funds as soon as possible¿ is the message that most should take away from this book. Better yet, buy them when multiples are low! The book¿s fundamental point is that there is tremendous volatility in any investment. Ignore that volatility to your peril. At the same time, you should be cautious about how well you understand the volatility. Stocks at their lows can still go to zero. There are all kinds of events that can happen, that have not done so yet. When they do, throw out all the old rules of investing. The terrorist attacks on the United States last week are probably an example of this. So each investment must be made as though you could be totally wrong. This means that you have to manage your risk exposure to events you don¿t even know how to expect. I loved his example of the joint probabilities of having a rare disease if you get a positive result on a test for that disease. Even most doctors apparently don¿t know how to evaluate that one. If even well educated people cannot quantify two known risks occurring simultaneously in their own field, how can investors be expected to make good decisions? Dr. Taleb has some very good advice for how to handle the psychology of being able to do this. He upholds the Stoic ideal -- ¿the attempt by man to get even with probability¿ which encourages ¿wisdom, upright dealing, and courage.¿ This means not chasing the latest investment fad or fashion, not looking at your investments very often, and being open to both sides of any idea (it could go wrong as well as right --what are the consequences of both?). I especially liked his idea of watching CNBC with the sound off so that the ¿experts¿ seem humorous and you are less likely to hear and follow their advice. Even more poignant was his advice not to live on Park Avenue where living with all of the arrogant, temporarily lucky can make you feel small. Instead, live somewhere that the results of your cautious approach will cause you to be the envy of all. Dr. Taleb impressed me with his willingness to tell stories on himself about how quickly he can become superstitious when things are going well, take on excess risks, and start looking too short term. After all, we are only human! The importance of this book can only be appreciated if you go back and think about your biggest investing successes. How much was luck versus skill? A good way to test is to see if the same approach has continued to work for you whenever you use it. Another good test is to see how often it would have backfired in the past. In my research on good decision mak

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