Johannes' blog

Key Takeaways from "Fooled by Randomness"

My takeaways from "Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets" by Nassim Taleb.

On investments, the financial markets, and banking systems

Likelihood of a crisis changes: The market is very random, and inferences have a lifetime.

We take past history as a single homogeneous sample and believe that we have considerably increased our knowledge of the future from the observation of the sample of the past. What if vicious children were changing the composition of the urn? In other words, what if things have changed?

Rational investors and predictable patterns do not exist.

Robert Lucas dealt a blow to econometrics by arguing that if people were rational, then their rationality would cause them to figure out predictable patterns from the past and adapt, so that past information would be completely useless for predicting the future. We are human and act according to our knowledge, which integrates past data. I can translate his point with the following analogy. If rational traders detect a pattern of stocks rising on Mondays, then immediately such a pattern becomes detectable, it would be ironed out by people buying on Friday in anticipation of such an effect. There is no point searching for patterns that are available to everyone with a brokerage account; once detected, they would be self-canceling.

The peso problem: Currency traders are fooled by the stability of a currency.

The designation "peso problem" does not appear to be undeservedly stereotypical. Things have not gotten better since the early 1980s with the currency of the United States' southern neighbor. Long periods of stability draw hordes of bank currency traders and hedge fund operators to the calm waters of the Mexican peso; they enjoy owning the currency because of the high-interest rate it commands. Then they "unexpectedly" blow up, lose money for investors, lose their jobs, and switch careers. Then a new period of stability sets in. New currency traders come in with no memory of the bad event. They are drawn to the Mexican peso, and the story repeats itself.

Financial analyst models are broken because they remove outliers.

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. Unfortunately, the techniques used in economics are often imported from other areas—financial economics is still a young discipline (it is certainly not yet a "science"). People in most fields outside of it do not have problems eliminating extreme values from their sample when the difference in payoff between different outcomes is not significant, which is generally the case in education and medicine.

Skewed bets: bet on a few very unlikely events, small bets, high upside.

Short time scales will only tell you the variability of an investment, not the returns.

Probabilities are only one part and perspective; statistics is a powerful tool for investments, but it is bad at risk assessment.

Monte Carlo Simulations

"The Monte Carlo man's realism without the shallowness, combined with the mathematician's intuitions without the excessive abstraction. For indeed, this branch of mathematics is of immense practical use—it does not present the same dryness commonly associated with mathematics. I became addicted to it the minute I became a trader. It shaped my thinking in most matters related to randomness."

Markets are not efficient because people are biased and over/undervalue stock prices.

"Shiller made his mark with his 1981 paper on the volatility of markets, where he determined that if a stock price is the estimated value of 'something' (say the discounted cash flows from a corporation), then market prices are way too volatile in relation to tangible manifestations of that 'something' (he used dividends as a proxy). Prices swing more than the fundamentals they are supposed to reflect; they visibly overreact by being too high at times (when their price overshoots the good news or when they go up without any marked reason) or too low at others."

News is broken and actually carries low information.