Tip of the Week #94 Tip Index

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

by Nassim Nicholas Taleb, 2001, TEXERE Publishing Ltd, London and NY, hardback, 203 pages, ISBN 1-58799-071-7, US$27.95.

People tend to underestimate randomness. Nassim Taleb has made a good living in trading options, betting on rare events that are sometimes under-priced in the market. The book takes the reader on a philosophical and somewhat auto-biographical tour of the author's thinking about risk. Anecdotes abound where people have mistaken fundamental concepts in probability and statistics.

Some notes:

Excellent performance or track records are often insignificant statistically. Traders and mutual funds that claim great performance can be explained by "survivorship bias," where only the good ones are left. People often mistake luck for skill.
The rule of pecking order (p. 20): People prefer to make $70,000 while others around them are making $60,000 than to make $80,000 when others around them are making $90,000 [this finding attributed to psychologists Kahneman and Teversky]. Also, "there is a difference between wealth reached from above and wealth reached from below. The road from $16 million to $1 million is not as pleasant as the one from 0 to $1 million." (p. 77)
Most traders seem unaware of the "blow up" or "black swan" problem. You can be making money well enough for a long time, then suddenly things go horribly wrong. The outlier event can put you out of business or end a career.
Because of emotionally weighing bad outcomes more heavily than good outcomes, most investors would feel better to rarely examine their portfolio. Check account statements only monthly or, better, yearly. There is lots of noise that is not meaningful. With about the same number of good and bad weeks, days, and hours, most investors tracking their stocks end up feeling poorly.
When examining two events, we have a tendency to form opinions about relationships. We have a bias toward seeing patterns where perhaps none exist. "Scientists know that it is emotionally harder to reject a hypothesis than to accept it. (p. 179)

Despite that he wrote this book, Taleb's wish is for investors in general to remain fools of randomness so he can trade against them (p. 39).

This book is short on quantitative methods and long on philosophy. Taleb does manage to explain quite a few ideas , woven into the many stories in the book. I enjoyed the book and recommend it.

From the dustjacket: "I really like this book. We need a book like this, that helps us deal with our hard-wired human tendency to underestimate randomness. It is fun to read, refreshingly independently-minded and at the same time playful." — Robert Shiller, Yale University, author of Irrational Exuberance.

—John Schuyler, October 2002.