The Dangers Of Underestimating Randomness In Investing: How “Lucky Idiots” Can Fool Us All
Nassim Taleb’s book “Fooled by Randomness” highlights the fact that many of us often overlook the role that luck and randomness play in our lives.
We tend to attribute success to skill and determinism, instead of attributing it to luck or random events.
This is particularly evident in the stock market, where “skillful investors” are often nothing more than lucky idiots.
Afterall, it’s not always skills that lead to success – sometimes luck plays a much bigger role!
As an example, consider a group of 10,000 investors who lack any real expertise when it comes to investing.
They would have only a 45% chance of being profitable each year – meaning their chances of success could be described as flipping a coin!
Even so, after five years (based on probability alone), around 200 of them will have posted profitable returns every year – making it seem as if they possessed exceptional skills.
But make no mistake: these successes were likely due simply to pure luck, not something they had done intentionally or mastered through practice.
And unfortunately, this sort of randomness has a way of “catching up” with us in the long run; Wall Street has seen countless traders who enjoyed years of success before one blow-up led them right back down again.
It is clear then that we should be careful about what we attribute our successes – or those of others – to.
Too often we mistake luck and randomness for skill and determination when attributing good outcomes, when the opposite may be true!
The Problem Of Induction: How We Can Never Be Sure Any Theory Is Right
No matter how sure we are that our theories and assumptions are correct, they could be proven wrong at any time.
This is known as the problem of induction: no amount of observations can prove that something is always true.
All it takes is one black swan to refute your conclusion.
It’s important to remember that things change constantly, so any theory or assumption you make today may be proved wrong tomorrow.
In terms of investing, this means you always need to consider the possibility that your ideas may turn out to be wrong and plan accordingly.
For example, if every Monday has seen stock prices rising, there’s no guarantee this will continue in the future – especially since rational investors will all buy on Sunday, thus eliminating the effect.
No matter what conclusions we reach through induction, whether we’re studying swans or economies, it’s important to keep in mind that nothing can ever truly be proven right – only wrong.
That’s why it’s critical for us to be mindful of the fact that things can change at any time and our theories may have to evolve in order to stay relevant and accurate.
The Unfair And Non-Linear Nature Of Life: Why The Best Don’T Always Win
Life is certainly unfair, and often unpredictable.
This is perfectly illustrated by the fact that the best don’t always win.
Take for example the common keyboard – QWERTY.
How this strange layout of keys became nearly universal was not because it was designed to be the optimal solution, but rather to avoid typewriters jamming.
Thus this suboptimal solution has endured ever since!
The same applies to products in a market too – inadequate products may come to dominate if they pass a ‘tipping point’ such as Microsoft, whose customers bought its product precisely because everyone else was using it.
Therefore when a product passes this ‘tipping point’, it is in an extremely strong position.
And even with scientific research, an individual may work fruitlessly without see any progress until suddenly they experience a breakthrough!!
It’s these non-linear events like sudden breakthroughs which are hard for us to predict, as our assumption is that incremental changes will lead to similar results, when in reality a single grain of sand can cause large structures like sandcastles to collapse!
Thus life is unfair and non-linear: The best does not always win.
Why We Struggle To Make Rational Decisions In A Complex World: How Our Intuition Can Lead Us Astray
Our cognitive abilities are limited, with our reasoning heavily dependent on our context and based mostly on simple heuristics.
We may believe that our minds are sophisticated but they often rely on rule-of-thumb techniques and shortcut tactics called heuristics to make decisions quickly.
This serves us well when we need quick reactions: If you spot a tiger outside your house, running away is probably the best option rather than trying to comprehend what’s happening.
But this means we commonly adopt irrational decisions and mental shortcuts known as biases.
For example, thanks to attribution bias we attribute successes to ourselves while failures are attributed mostly to luck.
Also known as path dependency, this means our thought process tends to be affected by how we reached the present situation – wins after heavy losses can feel worse than winning at a minor gamble even if the final outcome is the same.
This psychological phenomenon also makes us attached to our opinionated arguments, making it difficult for scientists and politicians alike to change their view or admit when wrong once invested in them – something which serves an evolutionary purpose but also hinder comprehension of new findings or ideas.
We Need To Take Action To Avoid The Risk Of Letting Emotions Overwhelm Our Rational Thinking
When it comes to making decisions, emotions can often play a powerful role – they are the “lubricant of reason”, helping to push through indecision and allowing us to make up our minds.
As the example of Buridan’s donkey shows us, having a dash of randomness helps us to break through an impossible decision-making process.
On the other hand, when it comes down to rational reasoning, emotions can sometimes be our undoing.
Neurobiologists have found evidence that suggests that we use our rational capacities to explain our emotions – rather than being driven by them.
This means that our decisions might not always be driven by reason even if we believe they are; they may be strongly influenced by emotional impulses.
To protect ourselves against this tendency towards irrationality, we need to recognize that emotional input has the potential to overwhelm our rational decision-making capacity.
For example, an investor who is aware that he tends towards irrational behaviour when incurring losses might opt not to monitor his portfolio unless it triggers an alarm that he has set beforehand.
In such cases, it pays off well for us to follow Ulysses’ model and “stuff wax in our ears” so as not succumb too deeply into the spell of emotions!
Humans Tend To Look Into The Past For Patterns That Don’T Exist, But Beware Of Applying Them To The Future
A common mistake we humans make is to think that history can teach us about the future.
We often look for patterns in the past and use them as predictors of what will happen – but this rarely works out.
Take stock market crashes, for example.
Even after multiple “unexpected” crashes, many traders still believe they can predict when the next one will come and dodge it before it happens.
But with hindsight bias in play, looking back at events always makes them seem more predictable than they actually were in the moment.
You could analyze any data given time long enough and find a pattern – an author even claimed to have used the Bible to make predictions!
Our tendency to search for meaning in randomness can lead some traders down false paths – like relying on “gambler’s ticks” or blindly following rules generated by backtesters with no regard to reality.
These patterns might work out well using historical data, but that doesn’t mean they’re reliable predictors for what’s about to happen – hindsight bias gets us every time!
At the end of the day, all we can really learn from looking at the past is that how things turn out tends to be largely unpredictable, so don’t rely too heavily on your own “patterns”.
We Can Easily Underestimate The Impact Of Rare Events In Decision-Making
When it comes to analysing data, many of us tend to ignore the events that don’t fit into the norm.
For example, early climate researchers thought any abnormally large temperature spikes as too unlikely to consider as part of their data.
But as we know now, these spikes had a disproportionately large impact over time and were thus important factors to take into account.
Similarly, when playing games with a 999/1000 chance of winning just $1 but a 1/1000 chance of losing $10 000, humans are inclined to base decisions off what is likely to happen – often neglecting or downplaying the fact that while it is extremely unlikely they’ll lose a lot at once, such an event will dramatically change the outcomes of each round – resulting in an expected loss each time.
And even experienced investors have been known to make this mistake from time-to-time and engage in strategies where they usually win small sums but may then lose all at once afterwards.
The key here lies in understanding that although an event itself may be rare and using low probability range predictions for trading can often result greater payoffs should said event actually happen.
In conclusion, we are inherently poor at understanding the true impact rare events can have until it is too late.
The Art Of Appreciating The Randomness In Life: Enjoy The Harmless Kind And Use Stoicism To Handle The Harmful Ones
We all must come to terms with the fact that randomness can be both harmless and harmful.
On the one hand, harmless randomness is enjoyable when it comes to art and poetry.
But, when it comes to science and finances, this kind of randomness can be deadly.
On the other hand, whenever we get stuck in a situation caused by bad luck or harmful randomness (such as an unexpected illness), stoicism gives us advice on how to react correctly: never show self-pity, don’t blame anyone for our misfortunes, and so on.
The way we’re handling our own behavior is the only bit of control we have over randomness – so that’s why stoicism can be so helpful!
In conclusion, enjoy harmless randomness while using stoicism to tackle any adversity caused by the malicious kind.
It’s Not About Winning Or Losing, It’s How Frequently You Check: The Pitfalls Of Listening To Too Much Noise
Reading the daily news or checking up on your stock portfolio too often can be a huge waste of time and energy.
This is because much of what you read in the news and see in the stock market is nothing more than random noise – it’s not based on real changes to the value of stocks.
If you check your stock portfolio every minute, you’ll mostly only see normal fluctuations that have nothing to do with the performance of the stock.
These fluctuations will cause emotions like joy or sadness, depending on whether the stock goes up or down, even though it doesn’t make sense to feel either way.
However, if you check your portfolio annually, any changes are likely to reflect the performance of the stock and leave you feeling positive more times than not.
For this reason, both in media and stocks, it’s important to remember that random noise is not worth focusing all your attention and energy on.
The Fooled by Randomness Book Summary can be summed up in one sentence: We are all fooled by randomness, but frequently mistake it for something deterministic.
This book helps us understand why this is so and what we can do to deal with it.
We fail to appreciate the impact of randomness because our reasoning depends on context and simple heuristics.
Emotions can help us make decisions but also overwhelm our capacity for rationality.
It’s also important to recognize that past events give us no guarantee of what will happen next and that rare events often have unanticipated outcomes.
Finally, the book recommends embracing harmless randomness and using stoicism to deal with harmful randomness.
In both the media and stock markets, it’s essential to understand the difference between genuine information and useless noise.