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Fooled By Randomness

The Hidden Role of Chance in Life and in Markets

Nassim Nicholas Taleb

The business of journalism is about pure entertainment, not a search for truth, particularly when it comes to radio and television. The trick is to stay away from those who do not seem to know that they are just entertainers and actually believe they are thinkers.

European intellectual life has an irreversible taste for symbolism - seeing messages where there is just random noise. An academic looking at texts, or an economist looking at financial data. French poet Paul Valery was surprised to listen to a commentary of his poems which found meanings that had until then escaped him. (Of course, it was pointed out to him that these were intended by his subconscious.)

Investors take risks, not bc they are brave, but bc their overconfidence leads them to underestimate the chances of bad outcomes.

"Courage" comes not from noble bravery but from an underestimation of the risks ("It won't be me who dies").

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Homo sum (I am a man). I am fallible and see no reason to hide my minor flaws if they are part of my personality.

The thing is, we are faulty, and it's pointless trying to correct our flaws - have to work around them. We spend our whole adult lives trying to get our emotions under control of our rational mind, but only time we succeed is when we go round our emotions rather than forcibly try to conquer them.

Despise the moralizers who dish out advice which assumes our rational brain rather than our emotional machinery somehow exercises meaningful control over our actions.

" .... susceptible to conference room boredom."

The Survivor Effect - imagine a bored billionaire offers all takers $1 million to play Russian roulette. Lots of people take up the offer repeatedly. After 20 years there are a few multimillionaires and a very full graveyard.

Black Swan problem as it affects investing: reality is far more dangerous than Russian roulette in that the revolver has hundreds or thousands of chambers instead of six. After a few dozen tries one forgets all about the bullet waiting. Compounded by the fact that most do not realize they are playing RR - the revolver is not visible. And for Taleb, the worst part is that he alone seems to see the gun, so that when he constructs investment packages which protect against the unforeseen, investors complain: "You wasted my money on insurance last year; the factory didn't burn down."

We remember Alexander the Great and Julius Caesar bc they took considerable risks, and got away with them. We have forgotten the many similar generals who took similar risks, but whose gambles failed. Same applies to 'star' investment managers.

Problem with 'historical' explanations is that you are drawing on anecdotes about the past without allowing for the fact that most of the (outcomes of) the events have arisen randomly.

Einstein: "Common sense is nothing more than a set of misconceptions acquired by age 18."

Cars and airplanes - a huge number of companies started out (when startup costs low) but very few have survived. The opportunity cost of 'missing' the investment in Ford or Boeing is far outweighed by the toxic cost of the thousands of other investments that would have failed.

The problem is that information is just about as toxic - most of it is irrelevant or distractingly deceptive. Hypothetical investor who checks the value of his investments every 5 minutes. In a normally volatile portfolio the value will regularly go up and down. At the end of the day he's had about 50 pleasant experiences (stocks went up) and 50 unpleasant ones (stocks went down). But of course the bad experiences always outweigh the good. Taleb deals with this by not paying any attention. Figures that any really impt news will eventually get to him - the rest he can safely ignore.

Financial theory says that markets should be 'efficient' - ie the price should reflect all the available information. But clearly prices swing far more than the fundamentals they are supposed to reflect.

Random fools - don't understand that the success of their model may be just due to chance, and has only been tested on periods when it did work. So the black swan destroys them.

Many people suddenly become "long-term investors" when they refuse to sell their shares at a loss.

Confuse mean and median. Group of 10 people, 9 of them earning $30,000 and one $1000. The average is $27,100, and 9 out of 10 have above average wealth.

The peso problem - the Mexican peso (denominated bonds) usually steadily earn a higher interest rate than US, but periodically blow up and wreck the portfolio. The holders of Russian ruble bonds lost 97% of investment in summer of 1998. A long period of good returns overshadowed by a single event. Like playing Russian roulette with a gun holding thousands of empty chambers - you are likely to show up as a winner in every sample, except in the last one, when you are dead.

Market 'crisis hunters' - happy to lose a small amount every month, and make money rarely, but in very big amounts.

past data has a lot of good things in it, but it doesn't have the little bit of bad stuff that is very bad.

The number of "very good" investment managers depends more on the size of the initial pool than on the actual ability of the managers. Even if they are all actually incompetent, simple luck will ensure that some of them will survive and apparently produce good results.

Linus Pauling, a Nobel Prize winner in chemistry, made strong claims that massive doses of Vit C had curative qualities. The fact that multiple medical studies failed to replicate his claims did not overcome the "Nobel Prize winner" authority, even though he was unqualified in medicine.

Flawed, not imperfect. Some economists think that studies should be based on the hypothesis that humans are rational and act rationally because that is the best thing to do. The opposite side is to study what people actually do. The first group were unwilling to accept that our thinking processes are fundamentally and predictably flawed, as Kahneman and Tversky showed with their studies into the shortcuts and consequent biases that characterise human thinking processes.

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