Fooled by Randomness

Recently, I read a very interesting book about probabilities (actually quite a comprehensive treatise on probabilistic applications on the real world), and how it applies to our lives, and in the financial market (particularly so). This book is by Nicholas Nassem Taleb.

The interesting point is that, the author goes about illustrating how not only the common people, but specialists and professionals in their jobs would go about making absurd claims which are counter to what statistics and probability could tell us. I suppose this book would be more understandable and readable to the person more in tune with mathematics and computer programming, as most concepts are gathered from here.

However, simple examples are often used to highlight how people make fools of themselves. The author mentions that, journalists are actually entertainers, paid to entertain us with daily doses of insignificant events (or what a signal engineer would consider noise).

One important concept to illustrate of how he thinks traders are foolish. He claims that people are more prone to enjoy making small profits, daily, than to look at the expected profits in the longer term. Traders, or people who buy and sell securities and options, tend to be not open to the idea of losing small but making big. Instead, they multiply the small amount of profit to be made by making big bets. These are what lead to blow ups, situations where people make huge losses which they can no longer tolerate, emotionally and monetarily. It is a given that there are black swan events in the real world, especially so in the financial markets.

What are black swans? Consider this claim, "All swans are white" made by a person after observing say maybe all the different lakes available in the US. Can this claim be 100% true? It definitely cannot be, as what he has not observed does not give a confirmation that the un-observed event or thing is not present. It takes only 1 black swan to negate the claim.

Similarly, people in the financial markets tend to make absurd forecasts on the market based on past data. Can we say that we know everything about the market just by looking at (the maximum) all the historically available data and derive a causality to pinpoint the market direction tomorrow? Furthermore, the author also claims, most of the time, so called financial analysts or economists tend to retrofit explanations unto past data. Well, this is a very serious flaw, as it means anyone can come up with anything that sounds reasonable to the 'conventional thinking' to explain past data. Journalists in particular, who are not trained in these specific fields (like finance, mathematics, medicine, engineering), tend to oversimplify and over assume numbers and results.

Back to the main concept, so the author believes that since there are black swan events in the market (2 examples are the 1997 crisis, and the 9/11 attack), events that cannot be predicted, yet lead to severe market downfall, we should not overestimate our knowledge of the market. And his strategy is to profit from these events.