Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets (Paperback)

Taleb has a clear admiration for Physics and adopts a physics approach. He dives right into the heart of the problem, finds the essential truth - that markets are random, the path we observe is only one of many, and that we cannot make proper assessments on trading strategies until a sufficient time-period has elapsed to give a significant sample which includes those rare but headline-making events that occur from time-to-time. He picks out several consequences of this phenomenon. The main one is Survivorship Bias (that those experiencing good fortune at picking the right investments will be elevated to guru status, until one of those rare but extreme events removes them from their pedestals). There are many other useful insights here; how the shorter the time-scale we use to study performance the more noise we see; how journalists comment on the one random outcome we observe and interpret it as significant news; how pseudo-science has spread to all sorts of unsuitable areas; and how groups of traders form collective opinions which defy rational analysis (the so-called "fire-station" effect); how lucky traders become all puffed-up with their own success, and the link to Seretonin levles and evolutionary benefits of being able to identify winners in competitions. This entertaining section gives compelling reasons for sharing Taleb's scepticism about much of the modern financial world.

Physics, however, has difficulty providing a complete explanation for any system more complex than a single particle. Real problems benefit from a more all-round approach, or a more heuristic analysis. Taleb's single parameter analysis of success in financial markets and the behaviour of participants and institutions soon runs into contradictions and problems. He frequently talks about "good traders" and "bad traders", but sees this only in terms of buying low-probability events which he insitst are universally undervalued, and gives pseudo-real case histories of bad traders who blew up buy selling these lo-probability events. Yet he also comes up with a list of distinguishing features of bad traders; so could a bad trader become self-aware and learn to become a good trader, but still sell low-frequency extreme events? Is anyone who buys extreme events a good trader? More analysis is needed here to give a water-tight case.

When discussing bubbles such as the recent tech-stock bubble, Taleb's single variable explanation misses a whole dynamic. Everyone knew it was a bubble that would burst, yet many made money from buying into it, and some who held out against going into it at lost their jobs. The mass-psychology that sucks so many people into bubbles against their better judgement is a fascinating subject. There is much that can usefully be said, and now would be a good time to say it, but it isn't said here.

Elsewhere, Taleb's explanations also fail to enlighten as much as they might. The influence of randomness in medical research and medical practise is mentioned briefly, and the use of statistics in the legal profession gets a mention as well. There are many legal cases where statistical arguments have formed the basis of judgements and mis-judgements, from the Dreyfus case right up to the Sally Clark case in the UK today, yet all we get is a couple of throw away-examples from the O.J. Simpson trial. Perhaps if Taleb had spent less time reading high-society gossip pages and a bit more time researching his arguments he might have produced more significant arguments here.

Taleb has written a useful, readable, and thought-provoking book. Reading it is probably a better use of your commuting time than reading the Wall Street Journal. Yet the book ultimately disappoints because Taleb is neither original enough to fill an entire book with his musings and thoughts, nor diligent enough to give a properly researched presentation of his case.

In investing, few can tell the difference between being lucky and smart. Being successful in the short term can come from either source. If it is coming from unrecognized sources of luck, however, the behavior that the investor associates with success can sink the ship. The cautionary tale of Long Term Capital Management is cited in the book as an example of this point. "If you're so rich, why aren't you smart?" is the wonderful reversal here on the old saw.

I see this effect all the time in my consulting practice with helping companies understand how their decisions affect their stock price. A large percentage of people feel that they know all the answers when their stock price is rising. They keep doing the same things when the stocks are falling. Few survive to still have top jobs when the cycle shifts again. Then a new group of self-confident people take over who often don't know any more than those who preceded them. It's just that their track records look better.

Fooled by Randomness will help make you more knowledgeably humble about what you can expect to accomplish with investments. Not only do fewer than one percent outperform the market averages over long time periods, the ones who do are probably often being aided by luck as well. "Get thee to the index funds as soon as possible" is the message that most should take away from this book. Better yet, buy them when multiples are low!

The book's fundamental point is that there is tremendous volatility in any investment. Ignore that volatility to your peril.

At the same time, you should be cautious about how well you understand the volatility. Stocks at their lows can still go to zero. There are all kinds of events that can happen, that have not done so yet. When they do, throw out all the old rules of investing. The terrorist attacks on the United States last week are probably an example of this. So each investment must be made as though you could be totally wrong. This means that you have to manage your risk exposure to events you don't even know how to expect.

I loved his example of the joint probabilities of having a rare disease if you get a positive result on a test for that disease. Even most doctors apparently don't know how to evaluate that one. If even well educated people cannot quantify two known risks occurring simultaneously in their own field, how can investors be expected to make good decisions?

Dr. Taleb has some very good advice for how to handle the psychology of being able to do this. He upholds the Stoic ideal -- "the attempt by man to get even with probability" which encourages "wisdom, upright dealing, and courage." This means not chasing the latest investment fad or fashion, not looking at your investments very often, and being open to both sides of any idea (it could go wrong as well as right --what are the consequences of both?). I especially liked his idea of watching CNBC with the sound off so that the "experts" seem humorous and you are less likely to hear and follow their advice. Even more poignant was his advice not to live on Park Avenue where living with all of the arrogant, temporarily lucky can make you feel small. Instead, live somewhere that the results of your cautious approach will cause you to be the envy of all.

Dr. Taleb impressed me with his willingness to tell stories on himself about how quickly he can become superstitious when things are going well, take on excess risks, and start looking too short term. After all, we are only human!

The importance of this book can only be appreciated if you go back and think about your biggest investing successes. How much was luck versus skill? A good way to test is to see if the same approach has continued to work for you whenever you use it. Another good test is to see how often it would have backfired in the past.

In my research on good decision making, I find that those who guard the downside first make the most money in the long run. They are able to find ways to get the best of both worlds!

Remember that the two-edged sword can cut in either direction!

Donald Mitchell...