Nassim Nicholas Taleb – Fooled by Randomness

Title: Fooled by Randomness
Author: Nassim Nicholas Taleb
Year: 2001

I like to play games of almost all kinds, and thus I’ve also played games with lots of different people. Some of them are like myself, but most of them are just casually interested in playing in a social environment. What has struck me many times is that some people, even people who should know better, are continuously fooled by randomness. They have spent years playing games involving random elements such as cards or dice, but still they fail to grasp even basic concepts relating to probability. You are not more likely to roll a six the fifth time if you rolled a six four times in a row, neither are you less likely to be dealt pocket aces in Texas Hold’em if you’ve already been dealt that once that evening. Still, many people act as if these statements were actually true.

In his book Fooled by Randomness, Nassim Nicholas Taleb expands this concept to all kinds of walks of life, from playing the stock market to buying insurance. Randomness plays a crucial role in all our lives and yet almost nobody understands the nature of randomness. the effects of this ignorance isn’t simply that people lose a few extra bets when they play poker, but also that they act irrationally in a wide variety of situations. People tend to make the world more understandable than it really is, they see patterns where there is just pure noise.

I’ll give you two examples of what kind of arguments are characteristic for this book:

IF you hear that an investor has had a positive investment record over the past twenty years, it’s easy to think that he must be a very savvy investor; people will probably buy books to see what it takes to be a winner or what traits the most successful traders share. A certain trader might indeed be successful because of the way he is as a person, but in Taleb’s mind, this is more likely to be a fallacy. The problem is that since there are so many investors, many people fail to take into consideration the number of investors who fail. Say that we have 30 000 investors and they all have 50% chance of making a profit in any given year. Note that skill is not involved here, this is pure chance. In fifteen years, there would statistically be approximately one investor left who has made a profit fifteen years in a row. The invostor didn’t do this because of skill, but simply because of luck. This is called the surivor bias and can be found in many other areas.

Another example is also related to the stock market, but first some background. If I propose a game of betting on die rolls, and I say that for every time you roll 1-5, you will have to give me one dollar, but for every time you roll a six, I have to give you ten dollars, you should happily accept this setup. In six rolls, you will give me one dollar five times, but I will give you ten dollar once, which means you make a profit. This is elementary, even though most people don’t seem to understand it. However, let’s go back to the stock market for an application which is not so obvious. Let’s pretend I’m an investor and you’re curious about what I think about the stock market.

“Do you think that the stock market will go up next week?”
“Yes.”
“So I suppose you’re buying stocks then?”
“No, I’m going to sell.”

If this conversation leaves you perplexed, you haven’t really understoodd the example with the dice game above. If I believe that the stock market will go up next week (say 90% probability), but only a little bit (say 5%), I might be far better off selling if I think that there is small chance (the remaining 10%) that the market will collapse. Still, most people believe that if the market will probably go up, the more you buy, the better. This will invariably produce very successful investors, purely by chance. This is true for everything in life, even though the effect diminishes as the role of randomness becomes weaker (a doctor doesn’t rely heavily on luck, for instance).

These are only two examples in this book, there are many, many more and lots of anecdotes and stories relating to randomness. Some of them are in a financial context, but there are also numerous examples from everyday life. Most people (me included, of course) are continuously fooled by randomness. This is because there are psychological aspects of randomness that makes us prone to make mistakes. The author does not simply stay in the realm of pure reason and logic to explain why a certain decision is wrong, but he also makes an effort to use psychology and sociology to explain why we make these decisions anyway and even though we should know better. He does all this in an easy-going style which is pleasant to absorb. He’s even funny sometimes.

If you read this book, which I recommend that you do, you will still go on being fooled by randomness, that’s part of human nature and perhaps impossible (perhaps not even desirable) to avoid completely, but you will at least be more conscious of the decisions you are making and help you start thinking more clearly about the role of randomness in yours and other’s lives.

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