Randomness

There is little doubt that preparation does play a considerable role in life’s endeavors, but so do the effects of randomness — the difference is being able to recognize which is which. A “lucky fool” does not know which is which until it is too late.

IF YOU’RE SO RICH, WHY AREN’T YOU SO SMART?

How random is randomness exactly? Despite our position as the most intelligent species on the planet, we as a human race have not exactly handled randomness and uncertainty with the greatest of ease. It is no secret that we are an amazing species — we have trekked the Himalayas, sent men to the moon, and created countless scientific and technological wonders to our own benefit, but we still are notoriously bad with what we cannot directly control. We as people do not have to be smart to be wealthy, nor do we have to be wealthy to be smart, but how much can we chalk up to being lucky, or simply exploiting randomness?

There is little doubt that preparation does play a considerable role in life’s endeavors, but so do the effects of randomness — the difference is being able to recognize which is which. In Fooled By Randomness, author Nassim Nicolas Taleb explains in many small examples how randomness is inescapable, but can be harnessed so as to protect and perhaps provide gains for the cognizant investor. As Taleb puts it, “the best description of my lifelong business in the market is ‘skewed bets,’ that is, I try to benefit from rare events.”

NERO AND JOHN

The main example begins with the two extremes of the risk spectrum, typified in trader form and explained in painstaking detail. On one end lies Nero, an extremely risk-averse but intellectually curious statistician with PhDs in philosophy and statistics, and on the other — John, an Ivy-league MBA with sterling credentials but an insatiable appetite for high yields. Summary profiles of the two traders can be found below.

It does not take much imagination to deduce that these two neighbors do not run in the same social circles. While Nero values trading as an experience that he does not want taken away, John views trading as a means to a rich and happy end. Both are successful and lead interesting lives at their respective positions, but for some reason, Nero can’t help but feel as if he is performing poorly. Nero is clearly the more intelligent, the more resourceful, and the more refined individual — he even works out four times a week; but something still bugs him about his situation relative to John’s.

Nero tried to soothe his jealously by bringing psychology into the picture. He knows that more people prefer to make $70,000 when those around them are making $60,000 than make $80,000 when others around them are making $90,000, but that didn’t quite suffice. What about John’s risk? Of course Nero was taking much less risk and still doing quite well, but it was also easy to see how an appetite for risk could easily be transformed into a bright red Ferrari in John’s driveway. Nero was doing just fine at his position and had considerable assets to take care of himself and his family for years to come. After deliberating, Nero could find no rational explanation why he should feel inadequate compared to John, but no matter how sound the logic in human behavior, he still felt slighted. Was John merely lucky? Could he have been riding the rollercoaster of the market? Soon enough, Nero would receive his vindication.

BLOWING-UP

John’s gains quickly materialized into thin air during the summer of 1998. After one week, he had lost $600 million that belonged to his employer and $50 million of his personal investment, $36 million of which was in borrowed money. “As in a biblical cycle, it took seven years to make John a hero and just seven days to make him a failure.” His over-indulgence on risk had cost him his job, and his excessive leverage in his investments had cost him his savings. John typified what is known as the cross-sectional problem: “At a given time in the market the most successful traders are likely to be those that are best fit to the latest cycle.” John was the victim of external success, and he had no reason to attribute his personal success to something other than his own skill and insight. The successful trader was indeed a lucky fool, “and by definition lucky fools do not know that they belong to such a category.”

Every trader has the potential to “blowup,” loosely defined as “losing money when one does not believe that such a fact is possible at all.” John and Nero are no exceptions, but how they go about managing their hidden risk is completely different. John has been extremely profitable for years and is considered to be a great asset for his company, but in the end he was blindsided by the market, blown-up thanks to his appetite towards risk assets and dependence on historical information. In short, John was exposed to all sorts of risk in the event that his positions turned sour, something that the conservative Nero had nothing to worry about during John’s years of outperformance.

IS JOHN RUINED?

After hearing about the devastating blows to John‟s career and life, it would be logical for one to assume that John was in fact ruined. There was no question that he would not be able to sustain the lifestyle he had created for himself, and he certainly wouldn‟t be trading anytime soon. In reality, John‟s net worth was reduced to a paltry $1 million, a fraction of his original worth before the blow up. Still, John was not destitute and could certainly afford a reduced lifestyle for his family. He could no longer live in the same house or socialize in the same circles, but he could continue on and adapt to his new surroundings. John’s personal confidence was gone and he was filled with shame, but he wasn’t as ruined as he made it out to be.

John‟s net worth that he had accumulated for years went from $16 million to $1 million in a matter of days. However, his $1 million still put him in the top 99% of earners in the world and would make him the envy of any neighbor outside of the Hamptons. Would John have felt differently about his $1 million if he had spent the same amount of time earning it from below? There is a larger gap between $16 million and $1 million than there is between 0 and $1 million, but in absolute terms they are the same. As Taleb points out, “there is a difference between a wealth level reached from above and a wealth level reached from below.” John should feel lucky that he came out of the situation with such gains, but like John, we as humans are simply not built to accept all things in rational, absolute terms.

DENTISTRY ≠ TRADING

The next example offered by Taleb is the comparison between two distinctly unique professions, namely, trading and dentistry. Make no mistake; your dentist is rich, very rich indeed. Although traders are typically viewed as being higher earners in the short term, they are figuratively poor on the average of lives they could have led. The average of lives in this sense can conceptually be thought of as the many random variations that one’s life could take — a seemingly endless array. In contrast to trading, a dentist operates in an area that is safe, relatively well-known, and in constant demand. Over the average of lives a dentist can take, most of them will probably lead to steady financial gain. For every Nero, there exists 10 Johns, and all of them have to go to the dentist at one point.

Every investing record should be considered in light of other outcomes or combinations of outcomes. These outcomes can also be called “alternative histories,” outcomes that could have occurred just as easily as the one that materialized in actuality. Because the things that happened are a very small subset of what could have happened, the quality of a decision should not necessarily be tied to the outcome of it.

Extending the metaphor a little further and switching gears in the process, dentistry can also tell investors a great deal about how one perceives losses and gains in the market. Take for example a successful dentist who retires to Florida to play golf and actively manage his accumulated wealth. For the sake of the example, the dentist is a smart enough investor that he is expected to earn a return of 15% with 10% error rate per annum (volatility). In short, he has a 93% probability of success for any given year. Not a bad situation at all.

With the newfound time the dentist has in retirement, he is able to sit at his desk day after day and monitor his investments closely and almost instantaneously. Instead of playing golf or other hobbies the dentist enjoys, he spends more and more time in front of his monitor, watching the market activity and keeping an internal count of gains vs. losses. Every second, he has a 50.02% probability of observing success; every minute holds a probability of 50.17%, and every hour, 51.3%. Surely this cannot be, given that the dentist‟s investments are destined to produce better results than average? The fact is that the probability of success is relatively 50/50 given the narrow time horizon, and the dentist absorbs the ups and downs of every second. Furthermore, some psychologists estimate that the negative pang he feels with every loss is 2.5 times greater in magnitude than every positive one. The dentist’s internal balance of accounts is certainly not balanced.

Is the dentist living out a very happy retirement? Well, it depends. Holding other factors constant, the dentist will run an emotional deficit day after day; however, what happens when the time horizon increases? The table below measures the probability of success for the dentist‟s portfolio at different scales.

As one can see, the dentist would be better off receiving statements of his performance over longer time periods. Now a 54% probability of daily success could transform into a roughly 77% probability every quarter. The dentist should probably spend more time on golfing.

Taleb leaves the reader with three main takeaways in regards to our friend the dentist:

1. Over a short time increment, one observes the variability of the portfolio, not the returns.

2. Our emotions are not designed to understand the point.

3. When [he] sees an investor monitoring his portfolio with live prices on his Blackberry, he smiles and smiles. People who look too closely at randomness burn out.

BLACK SWANS AND INDUCTION

“Nowhere is the problem of induction more relevant than in the world of trading — and nowhere has it been as ignored!”

With the constant pressures to outperform the market, investors can often lose sight of how randomness plays a role in their decision-making, even after becoming veteran to the effects. Scottish philosopher David Hume summed up this phenomenon in biological terms as the black swan problem: “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.” In other words, just because an observer doesn’t necessarily see something after repeated observations doesn’t mean that it doesn’t exist.

For evidence of this phenomenon, one needs to look no further than John’s prior demise at the account of a devastating yet random event. To conclude, Taleb simply states that “extreme empiricism, competitiveness, and an absence of logical structure to one’s inference can be a quite explosive combination.”

WHAT GOOD IS INDUCTION?

Even though induction can be a dangerous concept, it is absolutely essential to our daily operations. Naïve empiricism, as referenced in the black swan problem, is something that every investor should be aware of when gathering information, but too much skepticism can be unhealthy and downright debilitating. As we will see later in the book, skepticism has its own use for the intelligent investor.

Induction can be explained as “going from the plenty of particulars to the general,” a sort of mental abstraction that “is very handy, as the general takes much less room in one‟s memory than a collection of the particulars.” Much like heuristics, induction is what allows the human being to act upon information before it is complete, an ability to make key decisions based on good, but not perfect information. This uniquely human trait is something extremely valuable, but each investor must realize that induction and timeliness operate inversely of one another.

Perhaps the best protection against black swans is the aptly named stop loss. Unlike John, a wise trader would have a predetermined set of events that would prove his conjecture wrong and allow for it. Based on this determination, the wise investor would terminate his/her trade at the predetermined exit point and thus be largely protected against further losses. It comes as no surprise that the conservative Taleb rarely finds this practiced.

ERGODICITY, BUT STILL FOOLED

The rule of ergodicity states that, given enough time, the annoying effects of randomness will be eliminated. Originally created to explain the phenomenon of evolution in the field of biology, the same term can be applied to the world of finance and trading. Over the long-term, different environments for a particular species change and may become more or less habitable. External forces, predators, and food supply all play a part in the viability of a species and eventually can lead to their downfall. Such is the world of trading, where fund managers that were profitable in the past five years cannot be expected to continue their profitability in any future time period with certainty.

“Remember that nobody accepts randomness in his own success, only his failure,” states Taleb as he recalls a particular meeting with the head of a department of “great traders.” These traders had been extremely successful in the early nineties, and were at no loss at providing explanations as to how their skill and prowess had gotten them where they were. After the harsh winter of 1994, however, the rule of ergodicity finally caught up with the traders, and Taleb, many years later, “could hardly find any of them still trading.” They had gone the way of the dinosaurs, become extinct as a result of their changing environment.

DEVIATING FROM THE NORM

If randomness is expected to be corrected after a given period of time, is there a need to worry about it now, or even in the immediate future? In the case of trading, high-magnitude deviations from the norm are what can absolutely make or break companies and careers. There is no question that trading deals extensively with the short-term, but understanding trading in the context of market cycles and longer-term horizons is absolutely critical for the novice and veteran investor alike.

Without digressing into an argument about Efficient Markets, Taleb simply states that “in real life, the larger the deviation from the norm, the larger the probability of it coming from luck rather than skills,” which is in effect a regression to the mean.

BILL GATES, BIASES, AND BURIDAN’S DONKEY

The second half of Fooled by Randomness deals more with concise examples of cognitive biases and other representations of how the average investor is not purely rational. Some of the more salient examples are noted below:

The Sum of Zeros: A sum of zeros, even repeated a billion times, remains zero; likewise an accumulation of research and gains in complexity will lead to naught if there is no firm ground beneath it. Taleb emphasizes the need for a proper, well-tested benchmark, if one can actually be found. If an investor should find himself dealing in unknown territory, “in the absence of much additional information it is preferable to reserve one’s judgment. It is safer.”

Network Externalities: What do Bill Gates and typewriters have in common? They both enjoy the suboptimal effects of network externalities. People have consistently been shown to be reluctant to change from the inefficient layout of the traditional QWERTY keyboard, which was created to slow down typing so as to prevent ribbon jams. Similarly, Bill Gates‟ ground-breaking software has been criticized by many since its inception, but it continues to dominate well over 90% of all personal and corporate systems to date because of its early widespread adoption. What is the reason behind these irrational examples? As more people use a keyboard or Microsoft Windows, they become more valuable to each owner thanks to consistency. Over time, network externalities may not represent the most optimal solution, but they will have become so ingrained at that point that change is very difficult, if not impossible.

Buridan’s Donkey: How do we as human beings break internal stalemates? Because we are not purely rational, we tend to embrace linear relationships: if you study more, you will be more successful on the exam. “Our brain is not cut out for nonlinearities,” says Taleb, who cites the famous example of Buridan‟s donkey that is equally hungry and thirsty and placed at exactly equal distance between sources of food and water. “In such a framework, [the donkey] would die of both thirst and hunger as he would be unable to decide,” but with any randomness injected into the situation, the result will be a well-fed, then well-hydrated donkey — or vice versa.

The Firehouse Effect: Veteran trader Marty O’Connell observed that firemen with much downtime who talk to each other for too long come to agree on many things that an outside, impartial observer would find ludicrous. Next, consider the group of economists tasked with covering a particular geographic area or market. Put simply, like-minded individuals placed in relatively isolated situations can become too immersed in their work to the detriment of the organization as a whole.

Satisficing Tigers: “Consider that those who started theorizing upon seeing a tiger on whether the tiger was of this or that taxonomic variety, and the degree of danger it represented, ended up being eaten by it.” Heuristics are extremely important in decision-making, but also note that “we follow them not because they are the best but because they are useful and they save time and effort.” Thus, we satisfy and sacrifice (satisficing); we stop when we get to a near-satisfactory solution in exchange for the savings in time.

EMOTION IN DECISION MAKING

It should be clear by now that the human mind is much different than the rationality imposed on it in most situations. “Our minds are far more complicated than just a system of laws,” but we still are able to function relatively efficiently. In fact, most people would probably agree that the world has certainly benefited from our sub-optimal dealings. Now that some notable biases have been discussed, we turn our attention to why we have them in the first place and what effect they play on a more personal level.

Have you heard the popular phrase “we only use 10% of our brains at any given time,” at one point during your childhood years? Although false — our brains are fully activated around 100% of the time — there is still some interesting merit to the phrase. Think about how hard our brains work every day and compare that with the deluge of information we are subjected to during the same time period. Regardless of how hard we think, we cannot utilize all of that information in order to make useful decisions. The cause of our biases is quite simply that it is “the fact that [our] mind cannot retain and use everything [we] know at once…one central aspect to a heuristic is that it is blind to reasoning.” This has also been supported by medical science, as exhibited by the famous case of a patient who could not register emotions. After a tumor and its surrounding brain tissue had been removed from the patient‟s skull, scientists witnessed that the “purely unemotional man was incapable of making the simplest decision […] he would lie in bed all day, unable to make any decision.” We need emotions in our decision-making, even if it results in sub-optimization. We do use 100% of our brains, but we cannot fully utilize 100% of the information we receive.

HOW DO WE FEEL ABOUT CHANGE?

Relative change is a particularly interesting phenomenon, as referenced earlier with Nero and John. Most people are naturally resistant to change primarily because of their discomfort with the unknown. This can also be extrapolated to how individual traders view changes in the market, or how gamblers view fluctuations in their gains, or more likely, their losses.

Humans are more receptive to relative changes on a local scale than the same changes, or total, on a global one. You will be hard pressed to overhear people at a casino say: “My net worth will end up at $99,000 or $101,500 after this gamble,” but rather, “I will either lose $1,000 or win $1,500.” As John the high-yield trader so eloquently displayed, people are much more likely to focus on the changes in score rather than the scoreboard itself. As Taleb states, “the fact that the losses hurt more than the gains, and differently, makes your accumulated performance, that is, your total wealth, less relevant than the last change in it.”

Although Fooled by Randomness cites a plethora of heuristics that are fascinating to the reader, the main points can be summarized in the table below. As a veteran trader, Taleb has associated some common labels rooted in trader vernacular to their appropriate scientific terms.

INDEPENDENT SKEPTICISM

Given all of the different theories, biases, and studies, it can be understandable for an intelligent observer to become quite skeptical. Contrast this with the naïve investor’s predilection towards extreme empiricism, and it begins to seem as if Fooled By Randomness is a practice in contradiction. Overall, skepticism is healthy in moderation, and it can come in quite handy when faced with too-good-to-be-true situations. Furthermore, Taleb suggests to the reader that skepticism should be embraced and utilized in the realm of trading, although in moderate doses.

The most famous example of skepticism, albeit extreme, comes from ancient Rome, where the philosopher Carneades argued to the Roman Senate both in favor and in opposition to the same point on justice. Carneades had so eloquently fought for the rights of justice and its effect on human motivation only to completely tear his previous argument apart the very next day. Simply put, this level of skepticism is not something one would expect to see in a Congressional assembly, sadly enough. The main point is that Carneades took no immovable position on any point and never committed himself to something he argued on behalf of. What changed Carneades mind we will never know, but he certainly didn’t feel obligated to explain it. Like the perfect investor, Carneades actions were independent of one another. The Roman philosopher had become, “totally free from [his] past actions. Every day [had become] a new slate.” All intelligent investors should seek to inject a little bit of Carneades in their everyday lives.

WITTGENSTEIN’S RULER

On a more personal note for the author, skepticism also helped to keep Taleb from over- analyzing feedback on his own literary works. Too often would he be tempted to pull up Amazon reviews, lamenting over the scores of people that disagreed with his books. He quickly noticed that the majority of the remarks aimed toward his work were more reflective of the reader than the information itself. He termed this Wittgenstein’s Ruler: “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.” The salient point is that not everything can be used as a reliable benchmark, especially when little is known about the so-called benchmark to begin with. Given the surplus of ratios, formulas, analyses, and models that circulate around Wall Street, it is often difficult to differentiate the table from the ruler. As previously mentioned, whenever an appropriate benchmark cannot be found, it is probably safer to withhold judgment rather than jump to a conclusion.

Our physical and emotional make-up has made us a truly unique species, but we are obviously not without our faults. Although Taleb does not state it explicitly, the reader can implicitly conclude that in most situations, “common sense goes a long way.”

WE’RE ALL IDIOTS

As the examples come to a close, the author reveals to the reader his company’s philosophy towards trading and the markets. Every meeting at his boutique is started “by convincing everyone that we are a bunch of idiots who know nothing and are mistake-prone, but happen to be endowed with the rare privilege of knowing it.” The effects of randomness are so pervasive and insurmountable that they cannot be avoided, but for those who are intelligent enough to become aware, the nasty effects of randomness can be greatly mitigated.

We should again be reminded that there is a great difference between randomness and skill in the market. In the same vein, we should also know “that there is a difference between noise and signal, and that noise needs to be ignored while a signal needs to be taken seriously.” All of this seems much easier said than done, but steady rewards can come to those that don’t buy-in to the latest trend or contribute to the next speculative bubble. Regardless of the amount of calculation or science applied to the problem, history will tend to repeat itself. After all, “it is said that science evolves from funeral to funeral.”

Taleb spent a great deal of time trying to explain the effects of randomness and how we as investors and traders can better understand it, and he has developed no perfect equation or formula to negate the effects. There is also no spending threshold that will ensure us against the unknowable. Simply put, the best way to go toe-to-toe with randomness is to know it and study it. Although sports teams practice every week for a different team (the strategy), they must still be prepared to play in the big game on Saturday (the tactics).

In addition, Taleb also leaves the reader with some unsolicited advice:

• Dress your best on your execution day
• Try not to play victim when diagnosed with cancer
• Be extremely courteous to your assistant when you lose money
• Try not to blame others for your fate, even if they deserve blame

AND WHAT BECAME OF NERO?

With Nero’s continual success came increasing complexity. He had been required to travel more often to meet up with individual clients, and London had become his second home. In fact, he was spending almost more time in London traffic than he was in front of his clients, and he became more frustrated by the day. Although Nero was never the indulgent type, he did allow himself one occasional excess from time to time. He had enrolled himself in a helicopter training course, became licensed, and purchased a modest machine that would allow him to cut down on his travel time significantly. However, “Nero’s excessive probability-consciousness in his profession somehow did not register fully into his treatment of physical risk. For Nero‟s helicopter crashed as he was landing it near Battersea Park on a windy day. He was alone in it. In the end the black swan got its man.”

A link to the full book can be found here. The views expressed are, unless expressly stated, the views of the author or the brief writer, not Titans Of Investing as an organization.

Today’s Titans Brief was written by Preston Webb.