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Fooled by Randomness: A Review

September 26, 2005 • Posted in Big Ideas

Nassim Taleb’s central theme in Fooled by Randomness (the 2004 second edition) is that noise generally swamps signal (true outperformance or underperformance) in financial markets, and in life generally. A standard deviation much larger than an associated average excess return, encountered consistently in the search for outperforming investing/trading strategies, is an indicator of such swamping. The book effectively uses corollaries and examples to reinforce Nassim Taleb’s contention that past performance is neither a guarantee of future returns nor a proof of either intelligence or stupidity. Rather than recount his arguments, we focus this review on his conclusions as they relate specifically to speculating in financial markets. These conclusions are:

Ignore the Noise

From page 61:

“The opportunity cost of missing a ‘new new thing’ like the airplane or the automobile is minuscule compared to the toxicity of all the garbage one has to go through to get to these jewels. …[R]espect for the time honored provides arguments to rule out any commerce with the babbling modern journalist and implies a minimal exposure to the media as a guiding principle for someone involved in decision-making under uncertainty.”

More starkly, from pages 121-122:

“The composition of Part I [of this book] made me even more confident in my withdrawal from the media and my distancing myself from other members of the business community, mostly other investors and traders for whom I am developing more and more contempt. …[B]y withdrawing myself entirely I can have a better control of my fate.”

Play Rare Events

From page 98:

“…I try to benefit from rare events, events that do not tend to repeat themselves frequently, but, accordingly, present a large payoff when they occur. I try to make money infrequently, as infrequently as possible, simply because I believe that rare events are not fairly valued, and that the rarer the event, the more undervalued it will be in price…; I think that the counterintuitive aspect of the trade (and the fact that our emotional wiring does not accommodate it) gives me some form of advantage.”

From page 106:

“In the markets, there is a category or traders who have inverse rare events, for whom volatility is often a bearer of good news. These traders lose money frequently, but in small amounts, and make money rarely, but in large amounts. I call them crisis hunters. I am happy to be one of them.”

How to Play

From page 112:

“…I buy [out-of-the-money options] for a living (by selling an out-of-the-money option one is betting that an event will not happen; by buying one I am merely betting that it may happen). …I prefer a lumpy and rare payoff.”

From page 121:

“…I will use statistics and inductive methods to make aggressive bets, but I will not use them to manage my risks and exposures. Surprisingly, all the surviving traders I know seem to have done the same. They trade on ideas based on some observation (that includes past history) but…they make sure that the costs of being wrong are limited (and their probability is not derived from past data)… {T]hey know before getting involved in the trading strategy which events would prove their conjecture wrong and allow for it… They would then terminate their trade. This is called a stop loss, a predetermined exit point, a protection from the black swan.”

From page 197:

“I have a trick to know if something real in the world is taking place… The trick is to look only at the large percentage changes. Unless something moves by more than its usual daily percentage change, the event is deemed to be noise… In addition, the interpretation is not linear; a 2% move is not twice as significant an event as 1%, it is rather like four to ten times. A 7% move can be several billion times more relevant than a 1% move!”

From page 214:

“Since my heart does not seem to agree with my brain, I need to take serious action to avoid making irrational trading decisions, namely, by denying myself access to my performance report unless it hits a predetermined threshold.”

The book offers no discussion of how to identify rare event opportunities, or any quantitative analysis showing that Nassim Taleb’s strategy/tactics of speculating on rare events generates excess returns.

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