Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets
“This book is about luck—or, more precisely, about how we perceive and deal with luck in life and business. Set against the backdrop of the most conspicuous form in which luck is mistaken for skill—the world of [financial] trading.”
Nassim Nicholas Taleb is extremely smart, extremely well-read, and has studied deeply and broadly how we humans fool ourselves into believing that being in the right place at the right time is, in fact, proof that we, or others, possess above-average knowledge and skill. He has been described as an “erudite raconteur,” and this characteristic serves him well in his writing, where he interweaves interesting, entertaining stories of how people fool themselves (or are fooled by others) with rigorous explanations of why this occurs—over and over again.
A primary reason activities and events that involve human behavior cannot be modeled on physical science (see Mandelbrot’s The Variation of Certain Speculative Prices in an earlier post) is that we humans have a built-in bias to attribute our successes to skill, and our failures to bad luck. Paul E. Meehl demonstrated the “attribution bias” in his 1954 study of experts comparing their perceived abilities to their statistical ones. “It shows a substantial discrepancy between the objective record of people’s success in prediction tasks and the sincere beliefs of these people about the quality of their performance.”
Taleb is characteristically blunt in his assessment of risk managers in financial institutions.
“Corporations and financial institutions have recently created the strange position of risk manager, someone who is supposed to monitor the institution and verify that it is not to deeply involved in the business of playing Russian roulette.
“The risk managers’ job feels strange: As we said, the generator of reality is not observable. They are limited in their power to stop profitable traders from taking risks…On the other hand, the occurrence of a blowup [severe trading losses] would cause them to be responsible for it. What to do in such circumstances?
“Their focus becomes to play politics, cover themselves by issuing vaguely phrased internal memoranda that warn against risk-taking activities yet stop short of completely condemning it, lest they lose their job. (Personal note: this description could also be applied to the public pronouncements of a certain former fed chairman.)
“From the standpoint of an institution, the existence of a risk manager has less to do with actual risk reduction than it has to do with the impression of risk reduction.”
Anyone who has read a mutual fund prospectus is likely familiar with the phrase, “Past performance is no guarantee of future performance.” However, financial trading institutions routinely make decisions on the basis of past performance. One routinely used risk management tool is value at risk (VaR), defined as, “a technique used to estimate the probability of portfolio losses based on the statistical analysis of historical price trends and volatilities.” Taleb is adamant in his opposition to the use of VaR for managing risk. “An interesting problem is the ‘value at risk’ issue where people imagine that they have a way to understand the risk using ‘complicated mathematics’ and running predictions on rare events—thinking that they were able from past data to observe the probability distributions. The most interesting behavioral aspect is that those who advocate it do not seem to have tested their past predicting record, another Meehl type of problem.”
So, if the deck is so stacked against 1) accurately assessing the probability of a rare event, 2) including the consequence of a rare event in trading decisions, and 3) avoiding the madness of crowds, how did a small group of traders foresee the financial market collapse and make millions placing contrarian bets? That’s the subject of the next book.
Paul Solman interviews Nassim Taleb and Benoit Mandelbrot
Nassim Taleb urges the U.S. Congress to stop the use of Value at Risk (VaR)
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