Fooled by Randomness

The information that a person derived some profit in the past... by itself, is neither meaningful nor relevant. We need to know the size of the population from which he came. If the initial population is 10,000 managers, I would ignore the results.

[B]ecoming more rational, or not feeling the emotions of social slights, is not part of the human race... not with our current biology. There is no solace to be found from reasoning...

A mistake is not something to be determined after the fact, but in the light of the information until that point.

Many scientists... are... subject to such foolishness... One flagrant example is... global warming... These scientists initially ignored the fact that these [high temperature] spikes, although rare, had the effect of adding disproportionately to the cumulative melting of the ice caps. ...[A]n event, although rare, that brings large consequences cannot be ignored.

[E]conomists are evaluated on how intelligent they sound, not on a scientific measure of their knowledge of reality. (page 85)

Let us use 10,000 fictional investment managers... [O]nce a manager has a single bad year, he is thrown out of the sample. ...[T]oss a coin; heads and the manager will make $10,000 over the year, tails and he will lose $10,000. ...We have, in a fair game, 313 managers who made money five years in a row. ...[I]f we throw one of these ...into the real world we would get ...comments on his remarkable style, his incisive mind... His biographer will dwell on ...a great mind in the making. ...[S]hould he stop performing (...his odds ...have stayed at 50%) they would start ...finding fault with his dissipated lifestyle. They will find something he stopped doing, and attribute his failure... The truth ...he simply ran out of luck.

I always remind myself that what one observes is at best a combination of variance and returns, not just returns.

Maximizing the probability of winning does not lead to maximizing the expectation from the game when one's strategy may include , i.e., a small chance of a large loss and a large chance of a small win. If you engaged in a Russian Roulette-type strategy... you are likely to show up as the winner in almost all samples—except in the year when you are dead.

What is easier to remember, a collection of facts glued together, or a story, something that offers a series of logical links? Causality is easier to commit to memory. ...What is induction exactly? ...It is very handy, as the general takes much less room in onel's memory than a collection of particulars. The effect of such compression is the reduction in the degree of detected randomness.

At no point during his ordeal did Nero think of himself as 72% alive and 28% dead.

Why do [people] confuse probability and expectation, that is, probability [vs.] probability times payoff? Mainly because much... schooling comes from examples in symmetric environments... the... bell curve... is entirely symmetric.

Optimism, it is said, is predictive of success. ...It can also be predictive of failure. Optimistic people... take more risks as they are overconfident of the about the odds; those who win show up among the rich and famous, others fail and disappear from the analysis.

I will use statistics and inductive methods to make aggressive bets, but I will not use them to manage my risks and exposure. ...[A]ll the surviving traders I know seem to have done the same. ...[T]hey make sure the cost of being wrong is limited ...they know ...which events would prove their conjecture wrong and allow for it ...They would then terminate their trade. This is called a stop loss ...I find it rarely practiced.

Just as an animal could have survived because its sample path was lucky... free of the evolutionary rare event, the "best" operators in a given business can... One vicious attribute is that the longer these... can go without encountering the rare event, the more vulnerable they will be to it. ...[S]hould one extend time to infinity, then by , that event will happen with certainty—the species will be wiped out! For evolution means fitness to... only one time series, not the average of all possible environments.

Probability is not about the odds, but about the belief in the existence of an alternative outcome, cause, or motive.

I have organized my career and business in such a way as to... benefit... I am profiting from the rare event, with asymmetric bets.

[In] economics... you can disguise charlatanism under the weight of equations and nobody can catch you since there is no such thing as a controlled experiment. Now the spirit of such methods, called scientism by its detractors, continued into the discipline of finance as a few technicians thought their mathematical knowledge could lead them to understand markets. The practice of financial engineering came along with massive doses of pseudoscience. (page 115)

[W]e like to emit logical and rational ideas but we do not enjoy this execution.

Even the fathers of statistical science forgot that a random series is bound to exhibit some pattern... Pearson was among the first scholars interested in creating artificial random number generators, tables one could use as inputs for... simulations (precursors of our Monte Carlo simulator). ...[T]hey did not want these tables to exhibit... regularity. Yet real randomness does not look random! ...A single random run is bound to exhibit some pattern ...

We favor the visible, the embedded, the personal, the narrated, and the tangible; we scorn the abstract.

Wittgenstein's ruler: "Unless you have confidence in the ruler's reliability, if you use a ruler to measure a table you may also be using the table to measure the ruler." (page 224)

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.

Statistics... is all based on... the steady augmentation of the confidence level... [F]or an n times increase in sample size, we increase our knowledge by the square root on n. ...Where statistics ...fails us, is when we have distributions that are not symmetric... If there is a very small probability of finding a red ball in an urn dominated by black ones, then our knowledge about the absence of red balls will increase [even more] slowly. ...On the other hand, our knowledge of the presence of red balls will dramatically improve once one of them is found. This asymmetry in knowledge... is the central philosophical problem for... David Hume and Karl Popper.

Science had shifted, thanks to Bacon, into an emphasis on empirical observation. The problem is that, without a proper method, empirical observations can lead you astray. Hume came to... stress the need for some rigor in the gathering and interpretation of knowledge... epistemology... Hume is the first modern epistemologist... he was an obsessive skeptic and never believed... that a link between two items could be established as being causal.

[W]e read too much into shallow recent history... but not from history in general [which] teaches us that things that never happened before do happen. ...outside of the narrowly defined time series; the broader the look, the better the lesson.

The major problem with inference... is that those whose profession it is to derive conclusions from data often fall into the trap faster and more confidently... The more data we have, the more likely we are to drown in it. For common wisdom... is to base... decision making on the following principle: It is very unlikely for someone to perform... well in a consistent fashion without doing something right. ...[I]f someone performed better... in the past then there is a great[er] chance of performing better than the crowd in the future... But... [a] small knowledge of probability can lead to worse results than no knowledge at all.

I reject a sole time series of the past as an indication of future performance; I need a lot more than data.

[T]here is a category of traders who have inverse rare events, for whom volatility is often the bearer of good news. Those traders lose money frequently, but in small amounts, and make money rarely, but in large amounts. ...crisis hunters. I am happy to be one of them.

In most disciplines... asymmetry does not matter. ...People in most fields ...do not have problems eliminating extreme values from their sample, when the difference in payoff between different outcomes is not significant ...A professor ...removes the ...s, and takes the average of the remaining ones, without ...being ...unsound. A casual weather forecaster does the same ...So people in finance borrow the technique and ignore infrequent events, not knowing that the effect ...can bankrupt a company.

David Hume posed the issue in the following way (as rephrased in the black swan problem by... John Stuart Mill) No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion.

[E]conomics is a narrative discipline, and explanations are easy to fit retrospectively. (page 257)

Sometimes market data becomes a simple trap; it shows you the opposite of its nature... [e.g.,] Currencies that exhibit the largest historical stability... are the most prone to crashes.

Professor Karl Pearson... devised the first test of nonrandomness... He examined millions of runs of what was called a Monte Carlo (the old name for a roulette wheel)... He discovered... the runs were not purely random. ...Philosophers of statistics call this the reference case problem to explain that there is no true attainable randomness in practice, only in theory.

Mild success can be explainable by skills and labor. Wild success is attributable to variance.

I do not dispute that arguments should be simplified to their maximum... but people often confuse complex ideas that cannot be simplified into a media-friendly statement as symptomatic of a confused mind. ...MBAs tend to blow up in financial markets, as they are trained to simplify... beyond... requirement. (...I am myself the unhappy holder of the degree.)

[N]ews... is full of noise and... history is largely stripped of it.

There is a saying that bad traders divorce their spouse sooner than abandon their positions. Loyalty to ideas is not a good thing for traders, scientists - or anyone.

I have two ways of learning from history: from the past, by reading the elders; and from the future, thanks to my Monte Carlo toy.

A trader's mental construction should direct him to do precisely what other people do not do.

It does not matter how frequently something succeeds if failure is too costly to bear.

[T]he epic poet did not judge heroes by the result... their fate depended on totally external forces... Heroes are heroes because they are heroic in behavior, not because they won or lost.

Mixing forecast and prophecy is symptomatic of randomness-foolishness...

Delivering advice assumes that our cognitive apparatus rather than our emotional machinery exerts some meaningful control over our actions.

Lucky fools do not bear the slightest suspicion that they may be lucky fools - by definition, they do not know that they belong to such a category.

There are hordes of thoughtful journalists... [I]t is just that prominent media journalism is a thoughtless process of providing the noise that captures people's attention and there exists no mechanism for separating the two.

My models showed that ultimately almost nobody really survived; bears dropped like flies in the rally and bulls ended up being slaughtered... But there was one exception... option buyers... could buy the insurance against blowup...

Trading forces someone to think hard; those who merely work hard generally lose their focus and intellectual energy. In addition, they end up drowning in randomness; work ethics draw people to focus on noise rather than the signal.

In the early 1990s... I became addicted to the various Monte Carlo engines, which I taught myself to build... The dividend of the computer revolution... did not come in... e-mail messages and... chat rooms; it was in the sudden availability of fast processors capable of generating a million sample paths per minute.

[T]hey share the traits of the acute successful randomness fool who, in addition, operates in the most random of environments. ...[T]heir bosses and employers shared the same trait. They, too, are permanently out of the market.

[A]t any point in time, the richest traders are often the worst traders. This I will call the cross-sectional problem: At a given time... the most successful traders are likely to be those fit for the latest cycle.

[H]istory cannot lend itself to experimentation. But... is potent enough... to eventually bury the bad guy. Bad trades catch up with you... Mathematicians of probability give that a... name: . [R]oughly... properties of a very... long sample path would be similar to the Monte Carlo properties of an average of shorter ones. ...Those unlucky... in spite of their skills would eventually rise. The lucky fool... would slowly converge to the state of a less-lucky idiot. Each ...would revert to his long-term properties.

[A]ge is beauty. ...[M]y instinct is to value distilled thought over newer thinking, regardless of its apparent sophistication—another reason to accumulate the hoary volumes by my bedside... For an idea to have survived so many cycles is indicative of its relative fitness. Noise, at least some noise, was filtered out. ...[P]rogress means that some new information is better than past information, not that the average of new information will supplant past information...

Over a short time increment, one observes the variability of the portfolio, not the returns. ...[O]ne sees the variance, little else. ...Our emotions are not designed to understand the point. ...I deal with it by having no access to information. ...I prefer to read poetry.

A... vicious effect of... is that those that are good at predicting the past... think of themselves as good at predicting the future... [W]e live in a world where important events are not predictable...

I... found a significant advantage in selecting aged traders, using as a selection criterion their cumulative years of experience rather than their absolute success... [O]lder people have been exposed longer to the rare event and can be, convincingly, more resistant to it.

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.

[T]he mental probabilistic map in one's mind is so geared toward the sensational that one would realize informational gains by dispensing with the news.

Veteran trader Marty O'Connell calls this the firehouse effect. ...[F]iremen ...who talk to each other for too long come to agree on many things that an outside, impartial observer would find ludicrous...

Unlike a well-defined, precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality.