Fooled by Randomness (2001) is a collection of essays on the impact of randomness on financial markets and life itself. Through a mixture of statistics, psychology and philosophical reflection, Nassim Taleb outlines how randomness dominates the world.

Taleb insists that…

• we are all frequently fooled by randomness insofar that we underestimate the impact of luck and random events on our lives
• too much emphasis is placed on terms like “skills” and “determinism” and these are better replaced by terms such as “randomness” and “luck”
• the stock market is rife with such misdiagnosis preferring the description of “lucky idiot” over a so-called “capable investor”

Key Point: The randomness of stock markets has the ability to mask inability and cultivate the status of “successful investor” where pure luck more accurately captures the reality

A Black swan

• The basis of all empirical science is a process called induction
• Inference about the nature of our world is gained on our observations
• Problem of induction [no theory can ever be proved correct, only wrong] is illustrated via the famous “black swans” example by the philosopher John Stuart Mill

“No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion”

Behavioural biases

• Humans are ill-equipped to handle the probabilistic reasoning required by today’s high-information environment
• Human minds are not sophisticated computers with the ability to make rational decisions at break-neck speed. Instead they are a patchwork of rules and shortcuts called heuristics
• Taleb offers the example of “Attribution bias” whereby investors tend to disproportionally ascribe successes to their own abilities, and failures to “bad luck”.

Large and unexpected events…

Post financial crash many fund managers will point to “large and unexpected events” which caught their risk management models by surprise. The truth is that things which have never happened before actually happen all the time, and are always unexpected

Taleb asks the reader to imagine that you are playing a game where you have a 999/1000 chance of winning $1 and a 1/1000 chance of losing $10,000. It is a natural human tendency to base decisions on “what is likely to happen”, but in this case it would be a costly mistake. Though it is very likely that you will win $1, the disproportionately large loss you incur every thousandth time means that actually the expected outcome of each round is a loss of circa $9.

What is Taleb’s point here?

Even experienced portfolio/ fund managers fall into this trap. Trading strategies are deployed to secure small sums without taking account of the so-called “black swan” event which inevitably leads to huge and catastrophic losses.

Lessons from Nassim Taleb

1. Always consider the possibility that your theories and assumptions may be proved wrong, and examine how such a development would affect/impact your investment portfolio
2. We err [and face potential ruin] if we assume that the past is a relevant sample of what the future holds
3. Any activity or process involving human engagement will be heavily laden by “change”
4. Human reasoning is context-dependent and mostly based on simple heuristics
5. Emotions may overwhelm our capacity for rational reasoning
6. In some instances it may be wise to avoid emotional input to protect investor reasoning. An investor who is prone to irrational action upon incurring loss for instance may be well served by simply not looking at the performance of their portfolio unless a pre-determined alarm is triggered upon reaching certain price levels.
7. Random noise is prevalent both in markets and media outlets – Ignore both!
8. In retrospect, we always find patterns, causes and explanations in past events, but these are mostly useless for predicting the future.