Handling Finances

Fooled by Randomness by Nassim Nicholas Taleb is an absolute must-read for anybody involved with or interested in stock market investing. The book provides a much-needed reality check in an investing world where, despite the ubiquitous disclaimers suggesting that past performance does not guarantee future returns, we make our decisions based largely on past performance and recent past performance to boot! Of course, Nassim explains it as only one with extensive experience (as a professional trader) could, but here’s a taste of some of his wisdom.

I haven’t read the entire book yet, but one point in the first few chapters jumped out at me as vitally important. It is a Bad Idea to judge market gurus and advice columns by recent performance because there is so much randomness in the market that huge risk will always propel somebody to the top of the heap. Articles and advice should always be judged based on the likelihood that the writer or adviser could have failed. For example, somebody heavily invested in Asian markets is taking a rather large risk. They may earn many times their investment as might have happened in recent years, or they might have lost everything in Japan’s crash in 1990. As Taleb puts it, “I will repeat this point until I get hoarse: A mistake is not something to be determined after the fact, but in light of the information until that point.”

Another example he refers to is winning the lottery. Somebody will always win the lottery (barring a rigged system). If we judged lottery winners by the same standard the media likes to judge traders or fund managers, we would herald each winner as a lottery genius — to be emulated and consulted on how to make money through the lottery. Because stock markets (and generally any widespread investing vehicle) is absolutely full of randomness, simply making large bets and taking large risks will similarly propel a small number of traders to vast fortune but they generally have earned their ‘winnings’ no more than the lottery winner. The only difference, is that we carefully listen to the advice of successful high-risk traders where a simple evaluation of their high-risk peers shows that they have simply benefited from luck, not any particular skill.

Don’t take this summary to suggest that Taleb is simply sitting in an ivory tower passing judgement on successful high-risk traders! He does not come off at all as bitter, though he readily admits to envy and then guilty satisfaction in one of his anecdotes about a high-risk colleague. Instead of chasing billions in the markets for his employers, Taleb has been content to accrue ‘mere’ millions by steady and relentless statistical evaluation of probabilities and a high aversion to risk. In short, he has been actively successful in methodically producing good gains when his peers would routinely fly higher and higher until, like Icarus, they crashed and disappeared.

The book is also not written on “how to beat the market” which is why I feel I can suggest it so strongly. The book simply provides a framework from which we can recognize our statistical biases (like buying based on recent past performance even as we are adamant we know it doesn’t guarantee future returns). I certainly don’t agree with everything he says, but I’ve never felt that one has to agree 100% with an author to learn from them. There are many great lessons to be learned in this book and I’m sure I’ll write about more as I delve deeper into the book. For now, all I can say is that this book (and Taleb’s newer book, The Black Swan) should not be missed by any investor!

This entry was posted on Saturday, February 9th, 2008 at 6:18 am and is filed under Economy, Investing. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.