TECH TALK: Fooled by Randomness: The Philosophy

Business Week had a review of the book and a profile of Taleb in October 2005:

“I’m not saying that everything is random,” he explained in a wide-ranging two-hour interview in a Manhattan coffee shop in mid-October. “But that we often see causality where there may be none.”

So how does an appreciation of randomness lead to successful trading? Take the coin-flipping example one step further. It might be tempting after a string of 20 heads-up coin tosses to think that you have a knack for turning up heads. You might be willing to wager that the 21st coin toss would also come up heads. Truth is, odds are still 50-50 the next coin toss will come up tails.

In the same way, argues Taleb, just because an investor has beaten the market for 10 years doesn’t mean he will continue to do so. The same goes for the track records of companies, economic cycles, and almost any financial market. “The past is not predictive of the future,” he says. His mantra is that if something really terrible could happen to financial markets, it probably will at some point, and investors need to be prepared or risk getting wiped out.

Taleb calls such unanticipated events “black swans,” in reference to philosopher Karl Popper’s observation that just because you’ve seen 100 white swans doesn’t mean that a black swan doesn’t exist. “My basic message is, don’t cross the river if it’s an average of four feet deep.”

Perhaps the best profile of Nassim Taleb and his approach comes from a profile in the New Yorker by Malcolm Gladwell in 1992:

For Taleb, then, the question why someone was a success in the financial marketplace was vexing. Taleb could do the arithmetic in his head. Suppose that there were ten thousand investment managers out there, which is not an outlandish number, and that every year half of them, entirely by chance, made money and half of them, entirely by chance, lost money. And suppose that every year the losers were tossed out, and the game replayed with those who remained. At the end of five years, there would be three hundred and thirteen people who had made money in every one of those years, and after ten years there would be nine people who had made money every single year in a row, all out of pure luck. Niederhoffer, like Buffett and Soros, was a brilliant man. He had a Ph.D. in economics from the University of Chicago. He had pioneered the idea that through close mathematical analysis of patterns in the market an investor could identify profitable anomalies. But who was to say that he wasn’t one of those lucky nine? And who was to say that in the eleventh year Niederhoffer would be one of the unlucky ones, who suddenly lost it all, who suddenly, as they say on Wall Street, “blew up”?

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.

Nassim Taleb decided that he could not pursue an investment strategy that had any chance of blowing up.

So, the question is: what can we as entrepreneurs learn from Nassim Taleb? Is it all about smarts or luck?

Tomorrow: Lucky or Smart

TECH TALK Fooled by Randomness+T

Published by

Rajesh Jain

An Entrepreneur based in Mumbai, India.