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Fooled by Randomness

July 07, 2004
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This past month I decided to re-read Fooled by Randomness an excellent book written by Nasim Taleb. The book is a great read for anyone that hasn’t looked or isn’t used to looking at various events from a mathematical or statistical perspective.

As the title suggests the crux of the book is about the whole notion of being fools of random events; something that many of us fall victim to, including yours truly and even the author who as a mathematical trader is already aware of the subject. As the author himself puts it 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 manifests itself in the shape of lucky fool, defined as a person who benefited from a disproportionate share of luck but attributes his success to some other, generally very precise, reason.” 

The reason why I thought this would be a good subject to start my first blog post was that I also believe that many of us fall victim to associating many and at times all events around ourselves to our own or someone else’s skills, instead of simply to luck. Now I’m not denying that skills can’t be the sole or at least play a major role in an outcome of an event, but because we usually do not actually take the time to analyze the outcome of various events in our lives we can’t also deny that it could have also been as a result of pure luck. As Taleb admitted in his book there is no way one can be sure that an action or an event is not due to luck, and although he knows that not every rich man is an idiot and every unsuccessful person unlucky, but in the absence of full information about the situation he rather reserves judgment.

In his book Taleb writes: “Such confusion crops up in the most unexpected areas, even science, though not in such an accentuated and obvious manner as it does in the world of business. It is endemic in politics, as it can be encountered in the shape of a country’s president discounting on the jobs that “he” created, “his” recovery, and “his predecessor’s” inflation. We are genetically still very close to our ancestors who roamed the savannah. The formation of our beliefs is fraught with superstitions – even today (I might say, especially today). Just as one day some primitive tribesman scratched his nose, saw rain falling, and developed an elaborate method of scratching his nose to bring on the much-needed rain, we link economic prosperity to some rate cut by the Federal Reserve Board, or the success of a company with the appointment of the new president at the helm”.

For example in the world of politics partisan Republicans seem to always use the economic growth during Pres. Reagan era to promote the idea that deregulated free markets and more importantly tax cuts would promote sustainable economic growth. On the other side partisan Democrats who attributes the 1990’s economic boom to President Clinton’s fiscal policies advocate positions that are more similar to that time frame. Policies such as having a balanced budget – how times have changed that now it is the Dems who are advocating fiscal discipline.

I’m not here to suggest that in the long run fiscal and monetary policies do not have any impact, because they do especially the extreme ones. However what gets lost in the political rhetoric made by the advocates of these policies is that — by what factor these policies contributed to the end results they are promising to their constituents and what are the odds of it repeating itself.

Life is at times difficult for realists like myself who are mainly dependent on facts to make decisions, but it becomes even tougher when we add to our realism a dose of probabilistic skepticism. For example it is such probabilistic skepticism that could make people think and behave as that all assets have a specific fair value range, and when they go far above that value or below it then there is a high probability that the price will revert back to mean or another word an average fair value. So they don’t buy a home in this hot real estate market boom or perhaps bubble.

Having said that I also realize that being a realist and/or a probabilistic skeptic doesn’t mean that we have a case of analysis paralysis, or forgo making any decisions such as voting in an election, or choosing a wife or husband until we have all the facts and have analyzed all the possible outcomes. No I realize the impossibility of such tasks in certainsituation, but in some situations where it isn’t as difficult or impossible we tend to choose the easy way out.

To wrap it up it is interesting that even after the collapse of the stock market in the three year period of 2000-2003 we still have some fools of randomness that believe the current real estate market boom is different than the stock market bubble or other real estate bubbles or any other past asset bubbles.