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Tue Jun 3 22:38:01 2008
Fooled By Randomness
A book report.

Don't be fooled!
Image courtesy of Maximaximax (wiki)

I recently read (well, re-read) Nassim Taleb's Fooled By Randomness, subtitled "The Hidden Role of Chance in Life and the Markets."

It is an excellent book, well-worth reading for two reasons:

It is written in a fairly direct style. Mr. Taleb is clearly opinionated and felt he should tell his story, regardless of what publishers thought.
It makes a strong case for how much randomness influences what we do and perceive, and how little we notice it.

Randomness definitely affects everyone. But Mr. Taleb has worked for over a decade as an options trader, subject to the daily fluctuations of multiple global markets. And he has seen traders and companies rise and fall based on randomness. Randomness was very explicit there (although not obvious to everyone), and once he saw its pervasive effects in that industry, he was able to generalize the concept to other areas.

I had two main take-aways.

The first take-away was a deeper appreciation for the Survivor Bias, which occurs when a supposedly statistical study fails to include all data properly. In finance, it is common to compare only long-lived mutual funds (for example) and ignore all of those that have failed. It is very sobering to realize that if you put a bunch of people and funds into place, had them guess randomly about investments and tracked them over time, you would see many fail and a few survive for a long time (by chance)--exactly the same situation we observe today! Only we don't say long-lived or successful funds are random survivors. We say the fund managers are geniuses, and expect them to repeat their successes. (Again, soberingly, most don't).

The second take-away was people's poor appreciation for probability. Even in his world of trading, where people with scientific and mathematics backgrounds were working on algorithmic strategies, there was a disconnect with simple statistics. Even basic concepts such as Expected Value were often missed!

Nassim's main point was that a person well-versed in basic probability, and aware of the large role of randomness in the world, could avoid many common mistakes and maybe even make money off other peoples' ignorance. Certainly that's true in his profession.

It isn't a perfect book. He extended some of the survivorship bias to good people management. I think enough of us have had good (and bad!) managers to know that good managers often aren't survivors--they are actually good managers. I see Nassim's point that sometimes managers get lucky (due to happening to manage an organization during a moment of critical success or riding a market bubble, etc.), so a few "star" CEOs may actually be just average managers who happened to be at the right place at the right time. But some of his arguments here felt a bit jaded.

Still, an overall enjoyable read, and a good reminder while the markets are in their current volatile state.

I don't know how Mr. Taleb did in the subprime mortgage crash, but given his stated preference for targeting large crashes, I suspect he did quite well.

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