Not Quite Random Foolishness


I read a shockingly interesting book this weekend: Fooled by Randomness, by Nassim Nicholas Taleb.  He’s an incredibly intelligent man, who amongst other things, derides MBA’s for their attempts to summarize the complexities of the world.

As a result, here’s my attempt at summarizing his book in 200 words or less.  Basically, randomness is much more prevalent than we believe.  For example, we commonly mistake survival as evidence of performance (e.g., in a world of thousands of mutual funds a few will always beat the S&P for 5 years in a row)-always look at the sample size before deciding if it’s performance or chance.  Moreover, we fail to recognize that in the short term we may just be seeing noise rather than the signal (e.g., if you check your stocks daily there’s a slightly better than 50% chance they’ve gone up; it’s almost 100% if you only check them annually).

Similarly we vastly underestimate the probability of abnormal events (e.g., a 7% move in the market) and compound this by looking at probability but not expectation (e.g., 90% of options end up worthless but the 10% that aren’t more than make up the for the others).  A corollary: don’t get yourself into a situation where an abnormal event will completely wipe you out.

Finally, by definition we are emotional animals-we need emotion to help us make quick decisions in a complex world.  However, be aware of how poor we are at judging probability, don’t be afraid to change your mind and recognize that we are biased to seek simplistic and non-existent linear/cause-and-effect relationships (epiphenomenalism!).

There you go: a summary in 214 words (just a little over).  This book is a fascinating read; go buy it.

Follow-up: Tom sent me an interesting profile of Taleb by Malcom Gladwell.  Turns out Taleb started a hedge fund called Empirica to take advantage of volatility; it closed down recently because of too much stability.  The irony is killing me.

Monday, March 27, 2006

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