Imagine the most obnoxious tai tai you have ever come across – demanding and loud, dripping with bling, overpowering perfume; a total assault on all your senses. In the realm of books, this is exactly what Fooled by Randomness is. Nassim Taleb has an axe to grind with traditional market thinkers and like the extremely wealthy socialite in the classy restaurant, he isn’t afraid of gesticulating wildly and demanding that immediate and undivided attention be lavished on his ideas. And like the lady in question, there is no question that this book is rich. It is so laden and dripping with gems of ideas and knowledge that one cannot help but grudgingly admire and be captivated.
As with many high society women of leisure, trader, hedge fund manager, academic and self styled philosopher Nassim Taleb does not come across as an agreeable person. His biggest beef with the market is that the majority of the market participants do not understand the assessment of risk. He explains this through the Black Swan argument – just because no one has ever sighted a black swan does not mean that black swans do not exist. Hence, the statement ‘Markets never go down more than 20% in more than one day’ is essentially a black swan statement waiting to be falsified. Just because markets have never done so, does not mean they never will.
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To prove his point, he shares his experience with Victor Niederhoffer. Niederhoffer is acknowledged as a seller of naked options. A call option allows the owner of the option the right to buy the underlying share or commodity at a predetermined strike price at some time in the future, while a put option bestows on the owner the right to sell.
Niederhoffer’s publicized hiccup comes from his selling naked options based on his testing and assuming that the what he saw in the past was an exact generalization about what could happen in the future. He relied on the statement ‘The market has never done this before’, so he sold puts that made a small income if the statement was true and lost hugely in the event of it turning out to be wrong. When he blew up, close to a couple of decades of performance were overshadowed by a single event that only lasted a few minutes.
Taleb claims such instances belies a skewed understanding of expectancy. He suggests a strategy whereby there are only two outcomes, A or B. Event A happens 99 out of 100 times. When that happens, one wins $1. Event B, the rare event, occurs only once in every 100 trials. However, in that instance, one actually loses $1000. It has become rather apparent that while the probability of a win is 99%, the expectancy (probability multiplied by magnitude), what Taleb thinks is the more critical factor, is actually -901. (In other words, in the long run, i can expect to lose $901 for every 100 trials). In other words, should the player persist in the game, he or she will, over a large number of trials, end up the loser.
Ultimately, he was the first to admit that human beings are not wired for such trades. It is much less painful to make $1 a day for one hundred days and lose $100 in one catastrophe event (with everyone else) than to lose $1 a day for the chance to make $100 occasionally. This loss aversion bias is what makes people approach risk – take constant small gains but exposing oneself to a massive loss – is this misshapen manner. Taleb likens it to picking up pennies in front of a steamroller
Maximising the probability of winning does not does not lead to maximizing the expectation from the game when one’s strategy may include skewness, ie a small chance of a large loss and a large chance of a small win.
To illustrate his point further, he relates an incident that took place while he was working in the New York office of a large investment house.
I was once asked in one of these meetings to express my views on the stock market. I stated, not without a modicum of pomp, that I believed that the market would go slightly up over the next week with a high probability. How high? ‘About 70%’. Clearly, that was a very strong opinion. But then someone interjected, ‘But Nassim, you just boasted being short a very large quantity of SP500 futures, making a bet that the market will go down. What made you change your mind?’ ‘I did not change my mind! I have a lot of faith in my bet! [Audience laughing.] As a matter of fact I now feel like selling even more. The other employees in the room seemed utterly confused. I replied that I could not understand the terms bullish and bearish outside of their purely zoological consideration. My opinion was that the market was more likely to go up, but that it was preferable to short it because in the event of its going down, it could go down a lot.
Another very important point I picked up from the book is the role of variance in our predictions of where the market is going. In a section headed ‘We do not Understand Confidence Levels’, Taleb explains that it is neither the estimate nor the forecast that matters so much as the degree of confidence with the opinion. He used the analogy of packing clothes for a trip to bring across the point. Supposed one were to pack for a trip to a beach resort where the average daily temperature is 30 degrees, sunny days and warm evenings, the clothes would be relatively straightforward. On the other hand, packing for a trip into the desert would require more thought. While the average temperature remains at 30 degrees, it can now go up to 60 degrees in the day and down to freezing levels at night. He argues that being aware and focused on the mean temperature is insufficient and suicidal. Yet unfortunately many of us in trading the markets fail to understand the role of variance in making our trades. A prediction of 3000 for the STI means as much as saying that the mean temperature will 30 degrees – grossly insufficient.
The main thrust of the book is about the role of luck in the financial markets, and how traders and investors often confuse the role of skill and luck. Taleb urges us to consider two neighbors
John Doe A, a janitor who won the lottery and moved into a wealthy neighborhood, compared to John Doe B, his next door neighbor of more modest condition who has been drilling teeth eight hours a day over the past 35 years. Clearly one can say that, thanks to the dullness of his career, if John Doe B had to relieve his live a few thousand times since graduation from dental school, the range of possible outcomes would be rather narrow. At best he would end up drilling the rich teeth of New York Park Avenue residents, while the worst would show him drilling those of some semideserted town full of trailers in the Catskills. Furthermore, assuming he graduated from a prestigious teeth drilling school, the range of outcomes would be even more compressed. As to John Doe B, if he had to relive his life a million times, almost all would see him performing janitorial duties (and spending endless dollars on fruitless lottery tickets, and one in a million would see him winning the New Jersey lottery.
It is this idea of taking into account both the observed and unobserved possible outcomes that makes Taleb’s argument so difficult for many to accept. Nevertheless, I am convinced about the need to consider all outcomes, observed and probable, because at the root of it, such a mindset eradicates one of the biggest biases that plague and colour our understanding of the financial markets – the survivorship bias. Only successes show up on our radar, failures would all have fallen by the wayside and removed from the dataset. Consider the STI. It is made up of 30 counters with the largest capitalization. A company that grows in strength and breaks into the top 30 would see itself being included as a component stock, while one that loses value would be removed. Survivor of the fittest, fair enough, I have no disagreement with this. But the issue arises when people take the STI or indices to be the absolute indication of how equities have performed over the years. It cannot be further away from the truth, simply because the losers have already been removed. (If any of you need a painful reminder, think along the lines of Venture Corp, Creative Technologies, or Chartered Semiconductor, to name a few).
The dangers of overlooking the survivorship bias is best illustrated is Taleb’s example of you receiving letters at the beginning of the month accurately predicting the direction of the market for the following month. At the end of June and after six accurate predictions, greed overcomes you and you cannot help but commit your life savings into an offshore fund that trades as it predicts. If only you had been better informed, you would be aware that you could merely be a random recipient of a fraudster who sends out letters predicting either a bull or bear month ahead. Assuming the fraudster discards all wrong predictions and continues with the right ones, eventually he would have a small but fully convinced audience waiting to stuff money into his pockets. Rather than being a beneficiary of a failsafe trading system, the laws of probability dictate that someone has to survive and you are but a random victim of a well perpetrated fraud case.
Finally, implicit in Taleb’s claims is that moderate success is relatively replicable and hence is the result of skill. Extreme success like a lottery win is seldom (never) replicable and hence the role of luck is foremost. Let us end the review of a ‘rich’ book with an example of a rich (the richest in fact) investor. Warren Buffet – is he rich because he is extremely skillful in stock picking? And that by following a disciplined regime he could extract constant returns in excess of 20% from the market for the past 40 years? Or is he rich because he got lucky employing a method and trading an instrument that allowed him to participate in the longest equity bull run in his home country. (If he had been Japanese – Warrenshiro Buffeto, his story would have read rather differently).
Or could it simply be that his story is but one of survivorship and that we have all been Fooled by Randomness? The obnoxious tai tai in the room definitely thinks so.