Fooled By Randomness by Nassim Taleb

Summary

A good primer on the effect of randomness and asymmetry in our life, in business and in the world. Not as practical as Taleb’s Antifragile or Black Swan.

Key Takeaways

Alternative histories: one cannot judge a performance in any given field by the results but by the costs of the alternative (i.e., if history played out in a different way).
Heroes are heroes because they are heroic in behaviour, not because they won or lost.
People do not like to insure against something abstract; the risk that merits their attention is always something vivid.
My sole advantage in life is that I know some of my weaknesses.
Evolution means fitness to one and only one time series, not the average of all the possible environments.
Whenever there is asymmetry in outcomes, the average survival has nothing to do with the median survival.
You can more safely use the data to reject than to confirm hypotheses.
One cannot infer much from a single experiment in a random environment – an experiment needs repeatability showing some causal component.
I will use statistics and inductive methods to make aggressive bets, but I will not use them to manage my risks and exposure.
We tend to mistake one realization among all possible random histories as the most representative one, forgetting that there may be others.
The larger the deviation from the norm, the larger the probability of it coming from luck rather than skills. This does not apply to everything, but to the vast majority of cases.
Where jurors (and lawyers) tend to make mistakes, along with the rest of us, is in the notion of joint probability. They do not realize that evidence compounds.
Absence of evidence is not the same as evidence of absence.
Conditional information: Unless the source of the statement has extremely high qualifications, the statement will be more revealing of the author than the information intended by him.
It is emotionally harder to reject a hypothesis than to accept it.
Visibility of the skills content depends on:

The degree of randomness in such an activity.
Our ability to isolate the contribution of the individual.

What I got out of it

Fooled By Randomness was a good starting point to get used to Taleb’s writing style. Not as aggressive as his The Black Swan.

Reviewing my notes, there aren’t many practical takeaways in this book. Instead, it focuses on making you aware of randomness and the significant role it plays in (the outcomes in) our lives and work. Taleb also mentioned a few biases and heuristics that I was already aware of but might be new to others.

Three things I will change in my life after reading Fooled By Randomness:

Using statistics and induction to make aggressive bets, but not using them to manage my risks and exposure. Don’t feel safe simply because some numbers tell you that. These often exclude Black Swan events.
Making a distinction between fields and occupations where the outcomes are normally distributed versus those that have a power law distribution.
Create a checklist item that forces me to focus on putting in effort to reject a hypothesis or belief. Deduction over induction.

Summary Notes

Preface

Chance favours the prepared! Hard work, showing up on time, wearing a clean (preferably white) shirt, using deodorant, and some such conventional things contribute to success – they are certainly necessary but may be insufficient as they do not cause success. The same applies to the conventional values of persistence, doggedness and perseverance: necessary, very necessary.

One needs to go out and buy a lottery ticket in order to win. Does it mean that the work involved in the trip to the store caused the winning? Of course skills count, but they do count less in highly random environments than they do in dentistry.

If You’re So Rich, Why Aren’t You So Smart?

Intellectual contempt does not control personal envy.

Can we judge the success of people by their raw performance and their personal wealth? Sometimes – but not always. A large section of businessmen with outstanding track records are no better than randomly thrown darts.

Scientists found out that serotonin, a neurotransmitter, seems to command a large share of our human behaviour. It sets a positive feedback, the virtuous cycle, but, owing to an external kick from randomness, can start a reverse motion and cause a vicious cycle.

A Bizarre Accounting Method

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.

$10 million earned through Russian roulette does not have the same value as $10 million earned through the diligent and artful practice of dentistry. They are the same, can buy the same goods, except that one’s dependence on randomness is greater than the other. They are qualitatively different.

One need not actually compute the alternative histories so much as assess their attributes.

Reality is far more vicious than Russian roulette.

It delivers the fatal bullet rather infrequently.
Unlike a well-defined, precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality. Very rarely is the generator visible to the naked eye. One is thus capable of unwittingly playing Russian roulette.
There is an ingratitude factor in warning people about something abstract.

It is hard to think of Alexander the Great or Julius Caesar as men who won only in the visible history, but who could have suffered defeat in others. If we have heard of them, it is simply because they took considerable risks, along with thousands of others, and happened to win. They were intelligent, courageous, noble (at times), had the highest possible obtainable culture in their day – but so did thousands of others who live in the musty footnotes of history.

Heroes are heroes because they are heroic in behaviour, not because they won or lost.

People do not like to insure against something abstract; the risk that merits their attention is always something vivid.

Our brain tends to go for superficial clues when it comes to risk and probability, these clues being largely determined by what emotions they elicit or the ease with which they come to mind.

I remind myself of Einstein’s remark that common sense is nothing but a collection of misconceptions acquired by age eighteen.

Almost all the smart things that have been proven by science appeared like lunacies at the time they were first discovered.

Epiphenomenalism: when one has the illusion of cause-and-effect. By “watching” your risks, are you effectively reducing them or are you giving yourself the feeling that you are doing your duty? Is such illusion of control harmful?

A Mathematical Meditation On History

Stochastic processes refer to the dynamics of events unfolding over the course of time.

The wise man listens to meaning; the fool only gets the noise.

Over a short time increment, one observes the variability of the portfolio, not the returns.

Our emotions are not designed to understand the point. I deal with it by having no access to information, except in rare circumstances. Again, I prefer to read poetry. If an event is important enough, it will find its way to my ears.

The news (the high scale) is full of noise and history (the low scale) is largely stripped of it (though fraught with interpretation problems).

My sole advantage in life is that I know some of my weaknesses.

Survival Of The Least Fit – Can Evolution Be Fooled By Randomness?

Cross-sectional problem: At a given time in the market, the most successful traders are likely to be those that are best fit to the latest cycle. This does not happen too often with dentists or pianists – because these professions are more immune to randomness.

The traits of the acute successful randomness fool:

An overestimation of the accuracy of their beliefs in some measure, either economic (Carlos) or statistical (John). They never considered that the fact that trading on economic variables has worked in the past may have been merely coincidental, or, perhaps even worse, that economic analysis was fit to past events to mask the random element in it.
The U.S. dollar was overpriced (i.e., the foreign currencies were undervalued) in the early 1980s. Traders who used their economic intuitions and bought foreign currencies were wiped out. But later those who did so got rich (members of the first crop were bust). It is random!
A tendency to get married to positions. Loyalty to ideas is not a good thing for traders, scientists – or anyone.
The tendency to change their story.
No precise game plan ahead of time as to what to do in the event of losses.
Absence of critical thinking expressed in absence of revision of their stance with “stop losses.”
Denial. When the losses occurred there was no clear acceptance of what had happened.

We will ignore the basic misuse of Darwinian ideas in the fact that organizations do not reproduce like living members of nature – Darwinian ideas are about reproductive fitness, not about survival.

Someone with only casual knowledge about the problems of randomness would believe that an animal is at maximum fitness for the conditions of its time. This is not what evolution means; on average, animals will be fit, but not every single one of them, and not at all times. Just as an animal could have survived because its sample path was lucky, the “best” operators in a given business can come from a subset of operators who survived because of overfitness to a sample path – a sample path that was free of the evolutionary rare event. One vicious attribute is that the longer these animals can go without encountering the rare event, the more vulnerable they will be to it. We said that should one extend time to infinity, then, by ergodicity, that event will happen with certainty – the species will be wiped out!

Evolution means fitness to one and only one time series, not the average of all the possible environments.

Skewness And Asymmetry

Whenever there is asymmetry in outcomes, the average survival has nothing to do with the median survival.

Do not confuse probability and expectation, that is, probability and probability times the payoff.

I try to benefit from rare events, events that do not tend to repeat themselves frequently, but, accordingly, present a large payoff when they occur. I try to make money infrequently, as infrequently as possible, simply because I believe that rare events are not fairly valued, and that the rarer the event, the more undervalued it will be in price.

In most disciplines, such asymmetry does not matter. In an academic pass/fail environment, where the cumulative grade does not matter, only frequency matters. Outside of that, it is the magnitude that counts.

No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion.

But there is a more severe aspect of naive empiricism. I can use data to disprove a proposition, never to prove one. I can use history to refute a conjecture, never to affirm it.

You can more safely use the data to reject than to confirm hypotheses.

He conducts what he calls a “trading experiment,” and uses the success of the trade to imply that the theory behind it is valid. This is ludicrous: I could roll the dice to prove my religious beliefs and show the favourable outcome as evidence that my ideas are right. The fact that Soros’ speculative portfolio turned a profit proves very little of anything. One cannot infer much from a single experiment in a random environment – an experiment needs repeatability showing some causal component.

There are only two types of theories:

Theories that are known to be wrong, as they were tested and adequately rejected (he calls them falsified).
Theories that have not yet been known to be wrong, not falsified yet, but are exposed to be proved wrong.

A theory cannot be verified.

Karl Popper’s famous quote: ”These are men with bold ideas, but highly critical of their own ideas; they try to find whether their ideas are right by trying first to find whether they are not perhaps wrong. They work with bold conjectures and severe attempts at refuting their own conjectures.”

“These” are scientists. But they could be anything.

I speculate in all of my activities on theories that represent some vision of the world, but with the following stipulation: No rare event should harm me. In fact, I would like all conceivable rare events to help me.

Memory in humans is a large machine to make inductive inferences. What is easier to remember, a collection of random facts glued together, or a story, something that offers a series of logical links? Causality is easier to commit to memory. Our brain would have less work to do in order to retain information. The size is smaller.

What is induction exactly? Induction is going from plenty of particulars to the general. It is very handy, as the general takes much less room in one’s memory than a collection of particulars. The effect of such compression is the reduction in the degree of detected randomness.

My own method of dealing with the problem of induction.

If the science of statistics can benefit me in anything, I will use it. If it poses a threat, then I will not.
I want to take the best of what the past can give me without its dangers.
I will use statistics and inductive methods to make aggressive bets, but I will not use them to manage my risks and exposure.
All the surviving traders I know seem to have done the same. They trade on ideas based on some observation (that includes past history) but, like the Popperian scientists, they make sure that the costs of being wrong are limited (and their probability is not derived from past data)

Monkeys On Typewriters

The major problem with inference: the more data we have, the more likely we are to drown in it.

it all depends on two factors: The randomness content of his profession and the number of monkeys in operation.

The initial sample size matters greatly.

Biases:

The survivorship biases arising from the fact that we see only winners and get a distorted view of the odds.
The fact that luck is most frequently the reason for extreme success.
The biological handicap of our inability to understand probability.

Too Many Millionaires Next Door

The mistake of ignoring the survivorship bias is chronic, even among professionals. How? Because we are trained to take advantage of the information that is lying in front of our eyes, ignoring the information that we do not see.

We tend to mistake one realization among all possible random histories as the most representative one, forgetting that there may be others. In a nutshell, the survivorship bias implies that the highest-performing realization will be the most visible. Why? Because the losers do not show up.

It Is Easier To Buy And Sell Than Fry An Egg

The first counterintuitive point is that a population entirely composed of bad managers will produce a small number of great track records. As a matter of fact, assuming the manager shows up unsolicited at your door, it will be practically impossible to figure out whether he is good or bad.

The second counterintuitive point is that the expectation of the maximum of track records, with which we are concerned, depends more on the size of the initial sample than on the individual odds per manager.

In real life, the larger the deviation from the norm, the larger the probability of it coming from luck rather than skills.

One word of warning: All deviations do not come from this effect, but a disproportionately large proportion of them do.

If enough trading rules are considered over time, some rules are bound by pure luck, even in a very large sample, to produce superior performance even if they do not genuinely possess predictive power over asset returns.

Real randomness does not look random.

It’s hard to know who’s lucky or unlucky. Remain sceptical and reserve judgment when lacking sufficient information. It’s safer.

Loser Takes All – On The Nonlinearities Of Life

Life is unfair in a nonlinear way.

Chaos theory concerns itself primarily with functions in which a small input can lead to a disproportionate response. Population models, for instance, can lead to a path of explosive growth, or extinction of a species, depending on a very small difference in the population at a starting point in time.

Independence is a requirement for working with the (known) math of probability.

Randomness And Our Mind: We Are Probability Blind

Just as Nero cannot “think” in complicated shades, consumers consider a 75% fat-free hamburger to be different from a 25% fat one. Likewise with statistical significance.

Rule-determined behaviour does not require nuances. Either you kill your neighbour or you don’t. Intermediate sentiments are either useless or downright dangerous when you do things.

The distinction between normative and positive sciences.

A normative science (clearly a self-contradictory concept) offers prescriptive teachings; it studies how things should be.
The opposite is a positive science, which is based on how people actually are observed to behave.

In order to be able to put things in general context, you do not have everything you know in your mind at all times, so you retrieve the knowledge that you require at any given time in a piecemeal fashion, which puts these retrieved knowledge chunks in their local context. This means that you have an arbitrary reference point and react to differences from that point, forgetting that you are only looking at the differences from that particular perspective of the local context, not the absolutes.

The simulation heuristic: the ease of mentally undoing an event – playing the alternative scenario. It corresponds to counterfactual thinking: Imagine what might have happened had you not missed your train

The affect heuristic: What emotions are elicited by events determine their probability in your mind.

(1) We do not think when making choices but use heuristics; (2) We make serious probabilistic mistakes in today’s world – whatever the true reason

One cannot make a decision without emotion. Emotions are there to prevent us from temporizing. Psychologists call them “lubricants of reason.”

Joseph LeDoux’s theory about the role of emotions in behaviour is even more potent: Emotions affect one’s thinking. He figured out that many of the connections from the emotional systems to the cognitive systems are stronger than connections from the cognitive systems to the emotional systems. The implication is that we feel emotions (limbic brain) and then find an explanation (neocortex).

Where jurors (and lawyers) tend to make mistakes, along with the rest of us, is in the notion of joint probability. They do not realize that evidence compounds.

The probability of my being diagnosed with respiratory tract cancer and being run over by a pink Cadillac in the same year, assuming each one of them is 1/100,000, becomes 1/10,000,000,000 – by multiplying the two (obviously independent) events.
Arguing that O. J. Simpson had 1/500,000 chance of not being the killer from the blood standpoint (remember the lawyers used the sophistry that there were four people with such blood types walking around Los Angeles) and adding to it the fact that he was the husband of the person and that there was additional evidence, then (owing to the compounding effect) the odds against him rise to several trillion trillion.

People overvalue their knowledge and underestimate the probability of their being wrong.

Absence of evidence is not the same as evidence of absence. This is a common misinterpretation in medical research announcements.

By a law of probability called distribution of the maximum of random variables, the maximum of an average is necessarily less volatile than the average maximum.

When reviewing news, ask yourself:

Significance: does it matter? Unless it’s more than the norm, it’s unimportant.
Causality: is there an alternative cause-and-effect explanation? Avoid Post hoc ergo propter hoc (it is the consequence because it came after).

Causality can be very complex. It is very difficult to isolate a single cause when there are plenty around.

Why do I want everybody to learn some statistics? Because too many people read explanations. We cannot instinctively understand the nonlinear aspect of probability.

The method is to consider that when a change in amplitude is small, it is more likely to result from noise – with its likelihood of being a signal increasing exponentially as its magnitude increases. The method is called a smoothing kernel. Our brain cannot see the difference between a significant price change and mere noise, particularly when it is pounded with unsmoothed journalistic noise.

It is not the estimate or the forecast that matters so much as the degree of confidence with the opinion.

Wax In My Ears

The epiphany I had in my career in randomness came when I understood that I was not intelligent enough, nor strong enough, to even try to fight my emotions. Besides, I believe that I need my emotions to formulate my ideas and get the energy to execute them.

I am just intelligent enough to understand that I have a predisposition to be fooled by randomness – and to accept the fact that I am rather emotional.

Conditional information: Unless the source of the statement has extremely high qualifications, the statement will be more revealing of the author than the information intended by him. This applies, of course, to matters of judgment.

Wittgenstein’s ruler: Unless you have confidence in the ruler’s reliability, if you use a ruler to measure a table you may also be using the table to measure the ruler.

Gamblers’ Ticks And Pigeons In A Box

We are not made to view things as independent from each other. When viewing two events A and B, it is hard not to assume that A causes B, B causes A, or both cause each other. Our bias is immediately to establish a causal link.

For it is harder to act as if one were ignorant than as if one were smart; scientists know that it is emotionally harder to reject a hypothesis than to accept it (what are called type I and type II errors).

Most of us know pretty much how we should behave. It is the execution that is the problem, not the absence of knowledge.

Carneades Comes To Rome: On Probability And Skepticism

One forgets rather quickly what one has not thought about with depth, what has been dictated to you by imitation, by the passions surrounding you.

There is a simple test to define path dependence of beliefs (economists have a manifestation of it called the endowment effect).

Say you own a painting you bought for $20,000, and owing to rosy conditions in the art market, it is now worth $40,000.
If you owned no painting, would you still acquire it at the current price?
If you would not, then you are said to be married to your position. There is no rational reason to keep a painting you would not buy at its current market rate – only an emotional investment.
Beliefs are said to be path dependent if the sequence of ideas is such that the first one dominates.

We have been getting things wrong in the past and we laugh at our past institutions; it is time to figure out that we should avoid enshrining the present ones.

My lesson from Soros is to start every meeting at my boutique by convincing everyone that we are a bunch of idiots who know nothing and are mistake-prone but happen to be endowed with the rare privilege of knowing it.

Attribution bias: you attribute your successes to skills, but your failures to randomness

Bacchus Abandons Antony

Having control over randomness can be expressed in the manner in which one acts in the small and the large. No matter how sophisticated our choices, how good we are at dominating the odds, randomness will have the last word.

The stoic is a person who combines the qualities of wisdom, upright dealing, and courage.

The interesting thing about stoicism is that it plays on dignity and personal aesthetics, which are part of our genes. Start stressing personal elegance at your next misfortune. Exhibit sapere vivere (“know how to live”) in all circumstances.

The only article Lady Fortuna has no control over is your behaviour.

Three Afterthoughts In The Shower

Visibility of the skills content depends on:

The degree of randomness in such an activity.
Our ability to isolate the contribution of the individual.

Repetitiveness is key for the revelation of skills.

The law of large numbers: consider the difference between judging on process and judging on results.

Our attribution of heroism to those who took crazy decisions but were lucky enough to win shows the aberration – we continue to worship those who won battles and despise those who lost, no matter the reason. I wonder how many historians use luck in their interpretation of success – or how many are conscious of the difference between process and result.

Randomness is not always unwelcome.

A slightly random schedule prevents us from optimizing and being exceedingly efficient, particularly in the wrong things. This little bit of uncertainty might make the diner relax and forget the time pressures. He would be forced to act as a satisficer instead of a maximizer.
We are not designed for schedules. Our ancestors were not subjected to outlines, schedules, and administrative deadlines.
A mild degree of unpredictability in your behaviour can help you to protect yourself in situations of conflict.
Unpredictability is a strong deterrent.