Book Review: Fooled by Randomness

I chanced upon Fooled by Randomness – The Hidden Role of Chance in Life and in the Markets by Nassim Nicholas Taleb at a friend’s place and took the time to read it. Having a bit of a financial background – I work in a company that did some financial modeling before I joined it – I had heard of Taleb and was curious. Besides, I want to understand probability better than I currently do – I mean philosophically, not mathematically – and the title was attractive.

The book is divided in three parts. Part I starts off with a long and rather boring story of two traders – a rash, ignorant and over-confident John and a conservative Nero. John succeeds for a time – purely through luck – makes a lot of money and then blows up – market slang for losing more money than you thought possible. Nero remains risk-averse and makes a steady amount but suffers snubs from people like John before being vindicated. The reason for including this story is primarily to show how large a role randomness plays in the markets. Taleb also comments on the fact that Nero suffered emotionally from the snubs by people who made more money than him though he always knew himself to be better. Taleb says that this shows that the rational mind cannot prevent us from experiencing irrational emotions. Taleb then discusses an “accounting method” by which a dentist is much richer than a lottery winner. If one were to consider all the “paths” that the dentist’s life could take, there would not be much variation in the money he makes and the “average” would be close to what he makes in any particular “path”. If one considers all the paths that the lottery winner’s life could take, the average would be much lower than the money he makes on the winning path. This notion should seem familiar to anyone with a knowledge of Monte-Carlo simulations but I had not seen anyone putting it so explicitly. Taleb then goes on to discuss the difference between noise and significant information and how noise can affect perceptions in short timescales. He also discusses the dangers in fitting models to historical data. This is interrupted by an unexpected attack on Hegel’s pseudo-scientific philosophy that draws on Alan Sokal’s famous hoax. Taleb then talks of rare events, how their existence makes the difference between the median and the mean important and how most people including statisticians often unwittingly ignore this difference. He then talks briefly about Bacon, Hume and Popper in relation to the problem of induction and the difficulty of induction in the presence of rare events.

Part II deals with various biases in the perception and evaluation of events and outcomes in areas where randomness plays a major role. He draws on work by Kahneman and Tversky – which I am not even remotely familiar with – to claim that in dealing with uncertainty, our minds adopt certain heuristics/biases that are blind to reason (Prospect theory, Affect heuristic, Hindsight bias, Belief in the law of small numbers, Two systems of reasoning and Overconfidence). While it is easy to see how a person with no understanding of probability theory could be misled in the many examples Taleb gives, it is difficult to believe that people trained in probability would also be misled.

Part III deals with Taleb’s interpretation of stoicism as the solution to living in a world with so much uncertainty. Taleb writes that we should accept that we are incapable of making our emotions rational and attempt to behave with dignity in all circumstances. He writes that stoicism should not mean a stiff upper lip and a banishment of emotions but an acceptance of emotions and the uncertainties of life with the focus being on the process rather than the outcome. This part is titled Wax in my ears in a reference to the story of Odysseus and the Sirens. Taleb writes that he knows that he is not as great as Odysseus and instead of tying himself, he chooses to have wax in his ears. That is, he chooses to accept that his emotions will always be fooled by randomness and the only solution is to avoid situations where he might encounter such emotions (by not listening to the news or not tracking prices of assets on a moment-by-moment basis etc).

Overall, several anecdotes in the book are mildly entertaining, but intellectually, there is very little that I gained from the book. I agree with a lot of Taleb’s views on the role of luck in the markets and the inadequacy or even meaninglessness of most financial models, but I had already reached these views before reading Taleb and frankly I don’t think they merit a significant part of a book. These views can be easily expressed in a few pages – perhaps I will write a post myself. Taleb does not provide any definition of probability – something that I had hoped for – apart from the following excerpt. Taleb’s style is quite disconnected and the numerous back and forward references are irritating, especially since the references are hardly convincing. For example in the following excerpt he refers to something in Chapter 3, but there is no convincing arguement there, not even a hint.

Ask your local mathematician to define probability, he would most probably show you how to compute it. As we saw in Chapter 3 on probabilistic introspection, probability is not about the odds, but about the belief in the existence of an alternative outcome, cause, or motive. Recall that mathematics is a tool to meditate, not compute. Again, let us go back to the elders for more guidance – for probabilities were always considered by them as nothing beyond a subjective, and fluid, measure of beliefs.

The only thing that I got from the book is a reminder that I need to formulate more completely a proper alternative to Popper’s scepticism.


3 Responses

  1. This is only tangentially related to the topic of the post, but…try Mises’ Theory and History. Its not on finance, probability etc but presents his idea that history, or statistics, is not “proof,” or “theory.” Unlike what people like DeLong think

    Theory is crystallized history – it can be nothing more. Someone observes some instructive case or some anecdotal or empirical regularity, and says, “This is interesting; let’s build a model of this.” After the initial crystallization, theory does, of course, develop according to its own intellectual imperatives and processes, but the seed of history is still there.

  2. Thanks for the link. Looks interesting. Will read it over the next week or two.

  3. I picked up this book because I read Mr. Taleb’s quantitative derivatives book, Dynamic Hedging. Dynamic Hedging was an extremely insightful and intuitive foray into vanilla and exotic options. It was enhanced by Mr. Taleb’s occasional commentary on life in the markets. I imagined that an entire book containing Mr. Taleb’s viewpoints on probability would be compelling.It was indeed compelling. But I did not wholly agree with him. I suppose that is my right.At risk of great oversimplification, Taleb argues quite articulately that extreme occurrences in a distribution happen a lot more frequently than humans are prone to believe. Ergo, in derivatives trading, it makes no sense for one to be "frontspread" (short gamma/vega). Ever.My experience is in equity derivatives. Mr. Taleb’s is presumably in fixed income and FX. Without knowing much about the world of FX options, I can assert that in the equity listed options markets, downdrafts in volatility can be almost as deadly as explosions in volatility. The vol crush of the summer of 2000 wiped out as many traders as the Russian debt default of 1998. Out of the money options are never cheap; lots of people buy them for the protection that Taleb seeks. Sometimes even they are too expensive to own.Going further, I found Mr. Taleb’s insights on the role of luck in human performance to be EXTREMELY unsettling. He talks at length about the rich idiot trader and the vastly more competent but underpaid trader (presumably himself). He goes on to ascribe most of those who are wildly successful in life to LUCK, and that individuals ascribe way too much of their own success to their own ability and hard work (which he scorns).I find this to be frightening. I’m sure Mr. Taleb would find this reaction entirely predictable. The implications are most frightening, from a political standpoint: if most wealth is undeserved, then therefore it can be rightfully taxed (expropriated) and redistributed to those are not so lucky. Furthermore, most individuals who despise hard work do so not because they are brilliant, but because they are lazy. Evaluation of a particular person’s work ethic is an imperfect but reasonably good indicator of performance.Many of the MBAs he derides as being shallow thinkers and pluggers, while may not be (ahem) the intellectual giant that Taleb is, are no slouches themselves. They do not represent the legions of clueless option sellers that Mr. Taleb has somehow encountered throughout his career. Most young associates do have the luxury of telling their boss they did not read the Wall Street Journal in the morning because it represents nothing but random noise.As you can tell from this review, I enjoyed the book. Otherwise I wouldn’t be so critical of it. I couldn’t put it down. You probably won’t agree with all of it, but it will cause you to think about things in a very different way for a long time.

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