7 Big Ideas From Fooled By Randomness

by: Vishal Khandelwal

I have been re-reading Nassim Taleb's Fooled by Randomness.

It's an enlightening read in its entirety.

But here are seven key ideas I have picked up from the book.

I have been re-reading Nassim Taleb's Fooled by Randomness. The 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's an enlightening read in its entirety, but here are seven key ideas I have picked up from the book.

1. Beware the Hindsight Bias

Things are always obvious after the fact … When you look at the past, the past will always be deterministic, since only one single observation took place. Our mind will interpret most events not with the preceding ones in mind, but the following ones. Imagine taking a test knowing the answer. While we know that history flows forward, it is difficult to realize that we envision it backward. Why is it so?

…here is a possible explanation: Our minds are not quite designed to understand how the world works, but, rather, to get out of trouble rapidly and have progeny. If they were made for us to understand things, then we would have a machine in it that would run the past history as in a VCR, with a correct chronology, and it would slow us down so much that we would have trouble operating. Psychologists call this overestimation of what one knew at the time of the event due to subsequent information the hindsight bias, the "I knew it all along" effect.

The main culprit for our inability to acknowledge randomness is hindsight bias. When we look back at things that have happened, we see them as less random than they were. As they say, the hindsight vision is 20/20. Once we know the outcome of an event, we find it hard to imagine the other possible ways in which things could have happened. And that often causes us grave problems as we start expecting certainties in a highly uncertain world.

2. Don't Mistake Luck for Skill

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 markets … we often have the mistaken impression that a strategy is an excellent strategy, or an entrepreneur a person endowed with "vision, " or a trader a talented 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."

A consequence of confusing being skillful for being lucky is that we tend to think it's easy to be a successful investor. The ultra-successful, even though they are few, have an outsized effect on us. We believe we can succeed because they did.

The world of investing, like most things in life, produces success stories and failures. It's human nature to wish to copy success. However, an ironic truth is this: To accept success, and especially quick success at face value without acknowledging the role of luck is a strategy for failure.

3. Do Your Work, Then Let Randomness Do Its Own

…risk-conscious hard work and discipline can lead someone to achieve a comfortable life with a very high probability. Beyond that, it is all randomness: either by taking enormous (and unconscious) risks, or by being extraordinarily lucky. Mild success can be explainable by skills and labor. Wild success is attributable to variance.

In general, the world is a disorderly place, full of random events. And the irresistible urge to seek patterns can get us into serious trouble when we take this tendency to the field of finance and investing. As investors, it's important to know that we're dealing with something where randomness and chance can distort the expected outcome in the short term.

Time and again it has been proved that majority of stock price changes are nothing more than random jitters in the system for which no explanation is ever required - yet you can find people obsessing over every minuscule movement and explaining them like kids spotting animal shapes in the clouds.

4. Don't Be Blind to Alternative Histories

…one cannot judge a performance in any given field (war, politics, medicine, investments) by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly, the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).

We are blind to alternative histories - those silent events that could have happened but didn't. In the language of behavioural finance this irrationality is known as Survivorship Bias. The outcome which is visible 'survived' and the ones which didn't survive are hidden. As Taleb writes -

Imagine an eccentric (and bored) tycoon offering you $10 million to play Russian roulette, i.e., to put a revolver containing one bullet in the six available chambers to your head and pull the trigger. Each realization would count as one history, for a total of six possible histories of equal probabilities. Five out of these six histories would lead to enrichment; one would lead to a statistic, that is, an obituary with an embarrassing (but certainly original) cause of death.

The problem is that only one of the histories is observed in reality; and the winner of $10 million would elicit the admiration and praise of some fatuous journalist (the very same ones who unconditionally admire the Forbes 500 billionaires).

Like almost every executive I have encountered during an eighteen-year career on Wall Street (the role of such executives in my view being no more than a judge of results delivered in a random manner), the public observes the external signs of wealth without even having a glimpse at the source. Consider the possibility that the Russian roulette winner would be used as a role model by his family, friends, and neighbors.

In effect, the general belief is that if the outcome is good, the process and decisions made to arrive at that outcome must have been sound. Alas, life doesn't follow such straight patterns. The randomness and 'external factors' play a defining role in life and investing.

5. It Will Happen to You

…problem called denigration of history, as gamblers, investors, and decision-makers feel that the sorts of things that happen to others would not necessarily happen to them.

"It will never happen to me!" is a widely held but dangerous notion. Surely take some risks in life and investing, but only the ones that will not cause you permanent loss. Because sooner or later, it will happen to you.

6. Focus on Process over Outcome

Heroes won and lost battles in a manner that was totally independent of their own valor; their fate depended upon totally external forces, generally the explicit agency of the scheming god (not devoid of nepotism). Heroes are heroes because they are heroic in behavior, not because they won or lost.

As investors, we often struggle with judging whether a decision was good or not, even in hindsight, because we often only look at the outcome and not the process. The truth, however, is that a good process is the only thing that could help us bring the odds of success in our favour. It's only with a good process that we stand a chance to do well in investing over the long run.

With respect to the investment process, Michael Mauboussin writes in The Success Equation -

…in activities where luck plays a strong role, the focus must be on process. Where skill dominates, performance is a dependable barometer of progress. But where luck is a stronger force, the link between process and outcome is broken. A good process can lead to a bad outcome some percentage of the time, and a bad process can lead to a good outcome. Since a good process offers the highest probability of a good outcome over time, the emphasis has to be on process.

7. Know Thyself

It certainly takes bravery to remain skeptical; it takes inordinate courage to introspect, to confront oneself, to accept one's limitations - scientists are seeing more and more evidence that we are specifically designed by mother nature to fool ourselves.

One of the most underrated but among the most valuable skills required to succeed in stock market investing is resilience i.e., the ability to properly adapt to stress and adversity - either in the market or in the businesses one is owning.

How easily can you bounce back from a market crash? What would be your reaction to a sharp decline in your stocks' prices? How many 'surprises' can you withstand in quick succession? How safe are your overall finances in light of extreme stress on the equity component of your portfolio?

See, as Taleb says, we are anyways designed by mother nature to fool ourselves. But don't forget what the noted financial writer George J.W. Goodman - who used the pen name of Adam Smith - wrote in his wonderful book, The Money Game - "If you don't know who you are, this is an expensive place to find out."

It's a wonderful book, Fooled by Randomness. Read it certainly, and slowly.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.