Fooled by Randomness

Fooled By Randomness The Hidden Role of Chance in Life and in the Market

By: Nassim Nicholas Talab

Report on:

Submitted To:

Prof. Malathi Sriram

SDM IMD, Mysore.

Submitted By:

Nikunj Patel (10029)

Piyush Kakkar (10030)

SDM IMD, Mysore

Submitted as part of the curriculum of the course

Knowledge Seminar

E-mail: [email protected]

Knowledge Seminar (2010-12)

Report on Fooled by Randomness: Page 2

Objectives:

Fooled by Randomness- The Hidden Role of Chance in the Markets and in Life, by Nassim Nicholas Taleb- an unconventional mathematics professor, is about disguised luck and how we often mistake it for something else (eg. skill). While it is proposed this happens in all facets of life (eg. politics, business), it is very prevalent in investment and speculative trading.

This book is thought provoking. Author plays with the topics including philosophy, mathematics, human behaviour and history apart from Investment and stock market uncertainties with interesting anecdotes and real observations of the author which make this book very interesting to read.

Some of the objectives of this book:

To explain randomness present in surrounding environment and its impact

To revel many perceptions and misconceptions about luck and chance

To explain the theory of randomness in light of the theory of determinism

To explain the impact of Black Swan events (rare/Unpredictable events) and reactions after its happening

To explain the fact that what we don’t know is more important that what we know

To introduce a new facet of normal distribution curve with all dimensions of skewness

Author satisfies his objectives by explaining these points by using various true and hypothetical examples in form of small anecdotes.

Central Idea of the book:

If we watch a steam engine, we may not know how it works but we can soon get a fairly good idea of its behaviour, and we can predict its future behaviour accurately. Even though we don't understand its workings, we can see it's a pretty simple machine, so we can trust it to behave in a simple way: we have confidence in our predictions based on a short sample of its behaviour.

PART:-A



Most things in life are not like steam engines, but people treat them as if they were. Life and markets, involves large number of random factors, and regularly give surprises. Their behaviour over short time spans may have so little significance and that can be nothing but noise. Extrapolation of it is impossible or meaningless. Then also we continue to see patterns where none exist, misunderstand the role of randomness, seek explanations for chance phenomena, and believe that we know more about the future than we do and that is the core/point of this book.

The best way to summarize the central idea of this book is that it addresses situations where the left column is mistaken for the right one

Table of Confusion:

General Luck Skills Randomness Determinism Probability Certainty Belief, conjecture Knowledge, certitude Theory Reality Anecdote, coincidence Causality, law Forecast Prophecy

Market Performance Lucky idiot Skilled investor Survivorship bias Market outperformance

Finance Volatility Return Stochastic (random)variable Deterministic variable

Physics & Engineering Noice Signal

Literary Criticism None (literary critics do not seem to have a name for things they do not understand)

Symbol

Philosophy of Science Epistemic probability Physical Probability Induction Deduction Synthetic proposition Analytic proposition

General Philosophy

Contingent Certain Necessary(in the Kripke sense) True in all possible worlds

(Reproduced from the book)



Taleb explains why the more often we look at some fluctuating quantity (the value of your share portfolio, for example), the less meaning our observations have. Yet he sees traders who watch prices move up and down in real time on screen − the changes are so small as to be completely random − and think they are learning something.

Other important ideas in this book are:

1. The Black Swan: A large-impact, hard-to-predict, and rare event beyond the normal expectations. He gives the rise of the Internet, the personal computer, World War I, as well as the September 11, 2001 attacks as examples of Black Swan events.

2. Survivorship bias: We see the winners and "learn" from them, while forgetting the huge unseen cemetery of losers.

3. Skewed distributions: Many real life phenomena are not 50:50 bets like tossing a coin, but have various unusual and counter-intuitive distributions. Example: a 99:1 bet where you almost always win, but when you lose you lose all your savings.

4. Taleb Distribution: This is a term applied to situations in which there is a high probability of a small gain, and a small probability of a very large loss. In these situations the expected value is (very much) less than zero, but this fact is camouflaged by the appearance of low risk and steady returns. The term is therefore increasingly used in the financial markets to describe a situation of moral hazard on the part of hedge fund managers and bankers.

Author’s intent of writing book:

Author makes his intention clear in this book by advising readers to,

Be careful and not to attribute all success to skill, and failure only to bad luck He warns about black swan events and says that no amount of observations of white

swans can discount the possibility of a black swan (later discovered with the discovery of Australia) Eg. Something did not happen in the last 10 years does not mean that it will never happen in future.

Learn from history, even though it is unnatural. Eg: Funds that crashed in 1987, 1990 (Japan), 1994 (bonds), 1998 (Russia), 2000 (NASDAQ) all offered well constructed arguments why times were different, Children only learn not to touch the stove until being themselves burned

Differentiate between noise and Information Eg. Don’t review short-term performance, avoid daily market commentary. Employ reason, not emotion or superstition, when making a decision. For this author says he



doesn’t read news paper and make himself away from daily or rather minute based market updates.

Is it significant to pay attention on it?? Eg. At the end of the day journalist will explain how & Why market went up or down by 100 points today and we will accept the reasons but before concluding something we need to check where it is a significant change or just a noice? Because 100 point change in BSE SENSEX is just 0.05%.

Be willing to change your mind in the event of new contradictory information.

Structure followed by the author in the book:

Taleb’s style of narration is such that it takes some time to get a grip on the book. However, his book is full not only of infuriating meanderings and off-putting self-importance but also of extreme brilliance, and that is what makes the reading entirely satisfactory. Nevertheless, once we are on it, it is one interesting drive/ride which will change the way we look at business forever. His idiosyncratic literary approach to the book consists of providing a modern-day philosophical tale by mixing narrative fiction, often semi-autobiographical, with scholarly and scientific commentary. Taleb opens packet after packet of insights in front of us and we feel like Alice down the rabbit hole.



Dilemmas presented by the author and options for appropriate actions:

Some of the dilemmas present in the book and we find interesting and important are as ..

Is it luck or skill? When we succeed in life we should think, is it really a fruit of my hard work or skill? or it happened just like that and luck played major role in it. One can differentiate between the role of luck or skill in the success by observing consistent performance as over the period of time role of luck will be negligible.

Should we predict the future performance based on one’s past performance? Author gives an example, if one puts an infinite number of monkeys in front of a typewriter, there is certainty that one of them would come out with an exact version of the “Iliad”. Would anyone bet their life savings that the same monkey would write the Odyssey next? He says he does not deny that if someone performed better than the crowd in the past, there is a presumption of this ability to do better in the future. But the presumption may be very weak.

Is it noise or Information? We observe 0.7 parts noise for every one part performance over one year, 2.32 parts noise every month, 30 parts noise every hour and 1796 parts noise every second. It is very difficult to differentiate between noise and information in real life so better keep ourselves away from watching updates from live screen.

Should we depend on theory or reality? Here author gives example of Dr. John (Statistician) & Fat Tony (layman). If we toss a fair coin for 99 times and suppose we get heads for all the times then what is the probability that on 100th time we will get a heads? If we ask Dr. John, he will say it is 0.5 (50%) but if we ask to Tony he will say it is 100% because we got it for 99 times so this coin is not actually fair. Dr.John’s answer is mathematically right but it is only based on theory not what he has seen for past 99 times. So the moral is sometimes we need to look beyond the theories because mathematical model may crash when applied to real life situation.

Is it significant to worry about? Author says that he got Bloomberg software on his desktop. It shows some of the headlines related to stock market performance. He gives an example of “Dow is up 1.03 on lower interest rates”, “Dollar down 0.12 yen on higher Japanese surplus”. The change of 1.03 against 11,000 is just a 0.01% and it is a perfect noise and not a significant at all, no need to justify it by saying it is because of lower interest rates or so on. The moral

PART:-B



from this is before justifying something find out is it significant change? then go on justifying it.

It has not happened till date; does it mean that it will not happen in future? This is typically called as black swan event or unpredictable events. We always try to co-relate future with the past events and take decisions and forget about the unusual nature of the market. Doing this we end up being fooled by randomness and could not predict the future losses by such events.

Our own conflicts with the thoughts presented in the book.

Author uses true anecdotes which he observed in the market and life. Apart from these he also uses some hypothetical situations to make us understand the concept in better way. After getting this book for the first time, we read the views expressed by the experts given at the back of the book. We found that this book is all about luck and how it affected our life and business decisions and so on. • Author says that luck has considerable role to play in our success. Though author clarifies

his view on role of luck, we are still not sure about even if person performs consistently well for considerably long period how can we neglect the role of luck? (We believe that for some people luck can be a major source of success for long time)

• Secondarily, as a management graduate we learn to back our point/s with statistics, if not all but most of the times. And book contradicts this point, so how to deal with the situation after being as a rational manager.

• In the book Author says that before taking any decision we need to look in to reality (beyond theory). But in this two year PGDM curriculum we will learn lots of theories (from each subject) and we had/ will have very less exposure to the reality (just for two months during our SIP). So we need to ask ourselves that are we really going to be good managers who deal with the real time situations every day.

How has the book affected our thinking?

After reading author’s dilemma presented in the book and working on our own dilemmas created from author’s thoughts one thing we learnt is never fully be dependent on the numbers or theories, do consider reality before taking any decision but same time we should know and learn them as well. • As a future managers/ leaders our decision should be rational and mature enough and that

will only come after taking all the outcomes into consideration.



• As a management graduate we should be different in our decision making process and that is why while taking decisions we should account the things that we don’t know in addition to the things we really know.

Book in relation to the other aspects:

This book is classified under management/finance/Investment. But if we think in the broader perspective this book talks about decision making and how random factors effects our decisions.

In that context, we can apply this in our daily life decision making. We believe that our decision should be for long term gain instead of short term gain because while concentrating on short term goals/ gains we might end up in big trouble in long run.

It is not that we can use this book only for investment management but tomorrow we became a marketing executive of the company and we need to take a decision on entering a particular market we can co-relate some of the concepts like… don’t fully depend on statistics or Market research reports, we need to observe and feel how market really works and behaves?, etc.

In short, we need to create some short of resonance between our theoretical world (MBA study) and practical world (real world) while taking the final decision.

How do we relate this book to ourselves?

We learnt so many important points from this book as mentioned in the central idea of the book. Author says that MBAs are not that much good at trading or investment decisions (but author himself is an MBA graduate). But after reading this book we can implement the concepts or knowledge gained from this book to our investment decision. It is not that only if we became portfolio manager, we can apply this, but we can apply these concepts in our own investment portfolio management as well.

As mentioned just above we need to create a resonance and that will add value to our decision making process and ultimately to our career. By this we can get success even in the uncertain market. (Where it is certain that future is uncertain and completely unpredictable).



Future reading Nassim Nicholas taleb has published Fooled by Randomness in 2001 after this book he published two other books i.e. “Black Swan” in 2007 and “The Bed of Procrustes- Philosophical and Practical Aphorisms”in Dec-2010. In his book “Black Swan” he talks about rare event and damage caused by this rare events and also predicts the down fall of the market of 2008-09. In book “The Bed of Procrustes- Philosophical and Practical Aphorisms”. He says we humans, facing limits of knowledge and things we do not observe, the unseen and the unknown, resolve the tension by squeezing life and the world into crisp commoditized ideas.

References

1. N.N. Taleb, fooled by Randomness-The Hidden Role of Chance in Life and in the Markets,Panguin Books, second edition,2004

2. www.fooledbyrandomness.com 3. www.wikipedia.com 4. Apart from these we used some of the Book reviews by other and experts of the fields.

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http://www.wikipedia.com/�

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