Fooled by Randomness?

[PsyopRanger]

Someone recommended this book to me in saying that investing is mostly luck?

Has anyone read this? Looks way to mathematical for me.

Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life, First Edition
by Nassim Nicholas Taleb

http://www.amazon.com/gp/product/1587990717/103-5989505-8367063?v=glance&n=283155

Claims that luck has a major part in financial success.

He also has a website with tons of data that I don’t have the time or desire to read.

http://www.fooledbyrandomness.com/

 

[unclemick]

Nope he's wrong - it's mostly De Gaul.

heh heh heh heh heh heh heh heh heh - when your forum secret decoder ring arrives in a small unmarked package - you too shall become enlightened and ready for the inside skinny on dryer sheets. Wonder what's in this iced tea?

 

[wabmester]

I read a quick blurb. His philosophy matches mine pretty closely: make your best guess, but hedge in case your guess is wrong (which it likely will be).

 

[haha]

I read this book. I liked it enough to go buy it for my library.

It likely will not appeal to many here.

Ha

 

[wabmester]

It likely will not appeal to many here.

So, it looks like his premise is that humans are fools. Does he tell you how to exploit that, and have you been able to use his ideas successfully?

 

[haha]

So, it looks like his premise is that humans are fools.   Does he tell you how to exploit that, and have you been able to use his ideas successfully?

That is not how I would summarize his message. I think he says that we generalize too much form scant evidence, and that we tend to place inappropriately narrow limits around our expectations of the future.

As to whether I have used anything I picked up here. I would say yes, but in fairly soft ways. For example, I own a lot fewer stocks than I did before I read him, but he owns no stocks. He purchases options, and uses involved option strategies which he does not explain, and which would probably be unwieldy for someone with less than $10mm or so.

I also purchase options, but only when I feel comfortable with a directional bias. Also, like him, I won’t do any option strategy with an open-ended loss possibility.

I have a low threshold for heavy duty investing books. Investing is an occupation where not only can you make a fair amount of money, you can lose a lot too. So if I think I will get something from a book, I will read it and possibly buy it.

Ha

 

[wabmester]

I think he says that we generalize too much form scant evidence, and that we tend to place inappropriately narrow limits around our expectations of the future.

I absolutely buy that.   We're pattern recognition machines and we try to extrapolate the patterns we recognize into predictions of the future.   That seems like it should be an exploitable weakness; I just haven't figured out how to exploit it yet.

Is he basically making bets on low-probability events that he figures the market has mispriced?   If so, I wonder how long he needs to wait.   How often do the markets get blind-sided?

 

[Scrooge]

I absolutely buy that.   We're pattern recognition machines and we try to extrapolate the patterns we recognize into predictions of the future.   That seems like it should be an exploitable weakness; I just haven't figured out how to exploit it yet.

Is he basically making bets on low-probability events that he figures the market has mispriced?   If so, I wonder how long he needs to wait.   How often do the markets get blind-sided?

According to this New Yorker article:

Taleb, by contrast, has constructed a trading philosophy predicated entirely on the existence of black swans. on the possibility of some random, unexpected event sweeping the markets. He never sells options, then. He only buys them. He's never the one who can lose a great deal of money if G.M. stock suddenly plunges. Nor does he ever bet on the market moving in one direction or another. That would require Taleb to assume that he understands the market, and he doesn't. He hasn't Warren Buffett's confidence. So he buys options on both sides, on the possibility of the market moving both up and down. And he doesn't bet on minor fluctuations in the market. Why bother? If everyone else is vastly underestimating the possibility of rare events, then an option on G.M. at, say, forty dollars is going to be undervalued. So Taleb buys out-of-the-money options by the truckload. He buys them for hundreds of different stocks, and if they expire before he gets to use them he simply buys more. Taleb doesn't even invest in stocks, not for Empirica and not for his own personal account. Buying a stock, unlike buying an option, is a gamble that the future will represent an improved version of the past. And who knows whether that will be true? So all of Taleb's personal wealth, and the hundreds of millions that Empirica has in reserve, is in Treasury bills. Few on Wall Street have taken the practice of buying options to such extremes. But if anything completely out of the ordinary happens to the stock market, if some random event sends a jolt through all of Wall Street and pushes G.M. to, say, twenty dollars, Nassim Taleb will not end up in a dowdy apartment in Athens. He will be rich.

 

[Alan]

That is not how I would summarize his message. I think he says that we generalize too much form scant evidence, and that we tend to place inappropriately narrow limits around our expectations of the future.

... as proven some years ago by the experiment with the chickens v humans experiment using 2 feeding stations....

Both chickens and humans could figure out that the random light appeared more often at one station than the other. Having figured it out, a chicken would stop guessing and just stand collecting its snack when the light came on. The human invariably figured he could guess right more often than not. ..... the chickens won that particular behavioral experiment.....

 

[ERD50]

So Taleb buys out-of-the-money options by the truckload. He buys them for hundreds of different stocks, and if they expire before he gets to use them he simply buys more.

So he is expecting an occasional big payoff to overcome the many, many small loses. I guess if you do enough analysis, and spread your money out across many, many stocks/sectors you might find that there is some statistical advantage to this.

But I think the typical investor would more than likely run out of money in between the big jackpots. As an example, ORCL is trading @ $14.42 - you could buy Jan 2007 calls and puts. The $20 call and the $10 put each go for $.10. So, you could control 1000 shares for $200 plus commissions (~$35). Oracle would need to either go above $20.235 or below $9.765 for you to break even. In between $10 and $20, you lose it all. For every $1 above/below those points you make $1000 - there's the 'fun' part!

So it is a long bet - if you put money into a hundred of those, and invested $23,500 - you would need a few stocks with a very wide swing to avoid losing it all. Since you definitely risk losing it all every six months, you probably would not place more than 2.5% of your NW in the approach - so it would take around a million $$$ to start playing this game (with my example numbers, which may vary a lot - it was just one example).

Maybe his examples are better than mine, but I bet I pegged the reality pretty close.

Here's a simple analogy - imagine a hypothetical bizzaro-world lottery that paid out 10x more than they took in. Even though the odds are in your favor, if you lose every penny before you get a winning ticket, you still lost everything.

Interesting theory though - and he may have something for institutional investors, but these schemes seem to pop up every decade, and slowly go away.

-ERD50

 

[ats5g]

I thought it was a good read. My favorite line from the book is:

It does not matter how frequently something succeeds if failure is too costly to bear

The book basically talks about [what else] ramdomness and how we really don't understand it.

- Alec

 

[wabmester]

So he is expecting an occasional big payoff to overcome the many, many small loses. I guess if you do enough analysis, and spread your money out across many, many stocks/sectors you might find that there is some statistical advantage to this.

That's the way I see it, but I'd love to see his data. I'd expect the exploitable effect to be pretty large, since just about everybody underestimates the "fat tails" of the probability distribution. I wonder how often he sees a giant "black swan." Daily? Yearly? Once a decade?

 

[Scrooge]

That's the way I see it, but I'd love to see his data.   I'd expect the exploitable effect to be pretty large, since just about everybody underestimates the "fat tails" of the probability distribution.   I wonder how often he sees a  giant "black swan."   Daily?  Yearly?  Once a decade?

I have a different question: How much money has he made using his method? His otherwise neutral-to-favorable Wikipedia article claims:

Taleb now focuses on being a student of the philosophy of randomness and the role of uncertainty in science and society. When he was primarily a trader...

which makes one wonder

 

[ERD50]

I thought it was a good read.
- Alec

Well, if is a good read, that might be enough to motivate me to at least check it out at the library. I'm skeptical that a personal investor could use this technique, but there may be something to learn from it.

Even if all you learn is that it won't work for you, that eliminates one thing. Isn't that how Edison approached his light bulb experiments?

edit/add - I just looked at that wiki entry - now I remember, this guy was on Brinker's show a few months back. I caught only a few minutes in the car. But he did have some interesting thoughts on randomness, and how it does not really apply to stocks/markets. Again, I'm not sure you can profit from it, but it was a fresh and interesting view.

-ERD50

 

[saluki9]

It likely will not appeal to many here.

Ha

I disagree. It's an interesting read, and as long as you aren't reading it to learn a new trading strategy (because it isn't about that) then I think most here will find it interesting

 

[ronin]

I enjoyed it quite a bit, although I'm sure some folks are put off by his style/attitude. I think some of the condescension is at least a bit tongue in cheek. The principles that he discusses are certainly thought provoking enough. The concept of the black swan event gives one pause.

 

[CCdaCE]

Another good part that I liked about the book is what boils down to pointing out some "rich people" .... They chalk up their "richness" to being smart, not lucky. Conversely, if someone is down and out they consider themselves "unlucky", not dumb.

Or even you or I, for that matter. Do you consider where you are in life because you "worked hard", or you're "smart" or whatever. Do you give any heed to just being lucky enough to get your present job, etc. Was the timing just right that someone else didn't apply with more experience, was a better interviewer, etc.?

There's more to "luck" than people admit or are aware of, when it comes to a lot of things in life.

-CC

 

[haha]

Taleb is almost unbearably arrogant and condescending. That is why I would never call this book a "good read".  I am sure he has a high IQ, but the world is full of high IQ people, and they aren't all as obnoxious as he appears to be.

However, as little as I would ever want to know this guy, the book IMO is still worth reading. To me the best thing about it is the story about his protagonist’s at first envious and later victorious rivalry with his neighbor. The principle is that one has to differentiate between the frequency of an event, and the expectation, or (frequency*payoff). I think it is true that much of the structure of business, and especially banking is based on things which usually turn out well (high frequency of positive outcomes), but seem to be prone to going spectacularly bad from time to time. Thus wiping out all the profit from earlier operations, and often digging a big hole for the future.

An example that most of us will be familiar with is Long Term Capital Management (a misnomer if there ever was one) and the spectacular blowup that they experienced.

Ha

 

[unclemick]

Sooooo- ??

Taleb's Black Swan is Bernstein's 'at least once every 25 years the market/s go totally bonkers' or Buffett's 'oversexed teenager in a whorehouse analogy'.

?

When those events occur - the Nowegian widow can afford to hire someone to stand in the rain by the mailbox to get her dividend checks.

heh heh heh

 

[eridanus]

Taleb mainly deals in options for currencies, not stocks. The premiums go to flat only a little bit OTM. For example, the ask for an EUR 3% OTM put is less than $100; you can see how any market hiccup could net him a huge profit. Because his "margin" requirement is backed by Treasuries, he just loses money to inflation (spending the bond interest on buying slightly OTM puts and calls).

His counterpart is Niederhoffer, who makes the opposite bet -- that volatility won't go out of control for any given month and enough money can be made to compensate for the eventual black swan.

The analogy is correct: Taleb loses money by slow bleeding over a hundred cuts. Neiderhoffer loses it all in one huge machete gash across the chest.

 

[Scrooge]

There's more to "luck" than people admit or are aware of, when it comes to a lot of things in life.

See a recent discussion of "luck vs. "choices" at http://early-retirement.org/forums/index.php?topic=8534.0 

 

[haha]

Taleb mainly deals in options for currencies, not stocks.

How do you know this? Also, in your opinion, are these OTC options, or traded options on currency futures?

Thanks-

Ha

 

[bongo2]

This is a great book. One of the all-time best on the philosophy of risk measurment and investing. However, if you are looking for investment tips it is not for you.

 

[eridanus]

How do you know this? Also, in your opinion, are these OTC options, or traded options on currency futures?

Thanks-

Ha

His strategy has been written about in "Active Trader" magazine a few times. I have a link somewhere that contains some of the text from the (an) article (though sometimes the information is contradictory). In the meantime, this is an interesting read on their opposing strategies and vol.

http://www.activetradermag.com/special/cybermarch22.htm

If I was following his strategy today, I'd go with futures options because they're electronically traded. The OTC market is more liquid, I understand.

 

[Scrooge]

Sooooo- ??

Taleb's Black Swan is Bernstein's 'at least once every 25 years the market/s go totally bonkers' or Buffett's 'oversexed teenager in a whorehouse analogy'.

?

The primary practical implication of Taleb's philosophy in the real world appears to be that you can make money on certain (effectively undervalued) derivatives over a sufficiently long period of time. This is easily falsifiable unless his "sufficiently long period of time" is so long, e.g. unclemick's "25 years" above, that he hasn't gotten his money back yet. So, again, how much money has he made using his approach? After all, he was a trader for a while and presumably used his philosophy to make money. Or are there other practical implications that I am missing?

On a somewhat more elevated level, the New Yorker article that I linked above states:

Taleb remembered his childhood in Lebanon and watching his country turn, as he puts it, from "paradise to hell" in six months. His family once owned vast tracts of land in northern Lebanon. All of that was gone. He remembered his grandfather, the former Deputy Prime Minister of Lebanon and the son of a Deputy Prime Minister of Lebanon and a man of great personal dignity, living out his days in a dowdy apartment in Athens. That was the problem with a world in which there was so much uncertainty about why things ended up the way they did: you never knew whether one day your luck would turn and it would all be washed away.

It would appear that there are two separate issues here. The first one is whether these drastic "reversals of fortune" -- like Lebanon in 1975-1976, Germany in 1930-1933, Europe in 1914-1918, Russia in 1917-1918, etc -- are random or causal. Assuming that they are causal, as most historians will argue, then the second question is how good we are at predicting them as opposed to explaining them after the fact. Clearly, we are not very good at predicting individual events, but is the market bad enough at estimating their average probability and magnitude to make it an exploitable inefficiency 

Ah, well, I guess I just need to read the book...