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

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3 Sentence Summary

This book will alter your worldview and change the way you think about perceived luck. Taleb writes incredibly smart, yet refreshingly informal, in his personal treatise on the role of randomness in life and business. Eye-opening, independent-minded and insightful – if Fooled by Randomness does its job, then you’ll walk away convinced that you know even less about how the world works than before.

5 Key Takeaways

1. We underestimate the share of randomness and luck. Especially in endeavors with high degrees of randomness and large sample sizes.
2. Consider alternative histories—what could have happened. One cannot judge a performance in any given field (war, politics, medicine, investments) by the results, but by the costs of the alternative.
3. Think in terms of expected value. Individual probabilities are meaningless without knowing the magnitude of their outcomes.
4. Life is nonlinear. Small acts can have disproportionate consequences (good or bad).
5. We are blind to probabilities. We do not make rational choices, but emotional ones.

Fooled By Randomness Summary

If You’re So Rich, Why Aren’t You So Smart?

• We can’t always judge the success of people by their raw performance and their personal wealth. Luck often plays an outsized role that goes unacknowledged.
• 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.
• Behavioral scientists believe that one of the main reasons why people become leaders is not from what skills they seem to possess, but rather from what extremely superficial impression they make on others through hardly perceptible physical signals—what we call today “charisma,” for example.
• Arguably, in expectation, a dentist is considerably richer than the rock musician who is driven in a pink Rolls Royce or the entrepreneur who collects private jets. For one cannot consider a profession without taking into account the average of the people who enter it, not the sample of those who have succeeded in it.
• We must take into account both the observed and unobserved possible outcomes.

A Bizarre Accounting Method

• One cannot judge a performance in any given field (war, politics, medicine, investments) by the results, but by the costs of the alternative (i.e., if history played out a different way).
• $10 million earned through Russian roulette does not have the same value as $10 million earned through the diligent and artful practice of dentistry. They are the same, can buy the same goods, except that one’s dependence on randomness is greater than the other.
• Few people are grateful for insurance that protects them from something that did not take place.
• Our tendency to make and unmake prophets based on the fate of the roulette wheel is symptomatic of our ingrained inability to cope with the complex structure of randomness prevailing in the modern world.
• We are not wired in a way to understand probability.

Simple Explanations in Journalism

• Arguments should be simplified to their maximum potential; but people often confuse complex ideas that cannot be simplified into a media-friendly statement as symptomatic of a confused mind.
• Both risk detection and risk avoidance are not mediated in the “thinking” part of the brain but largely in the emotional one. The consequences are not trivial: It means that rational thinking has little, very little, to do with risk avoidance. Much of what rational thinking seems to do is rationalize one’s actions by fitting some logic to them.
• In people’s minds lower prices are far more “volatile” than sharply higher moves. Volatility seems to be determined not by the actual moves but by the tone of the media.
• Journalism may be the greatest plague we face today—as the world becomes more and more complicated and our minds are trained from more and more simplification.

Reality is More Vicious Than Russian Roulette

1. It delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands, of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet, under a numbing false sense of security.
2. The exact odds are undefined, imprecise, and unobservable. One can unwittingly play Russian roulette—and call it by some alternative “low risk” game.

Beware the Confusion Between Correctness and Intelligibility

• What sounds intelligent in a conversation or a meeting, or, particularly, in the media, is suspicious.
• Almost all the smart things that have been proven by science appeared like lunacies at the time they were first discovered.

A Mathematical Meditation on History

• 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.

Monte Carlo

• Alternative sample path = The invisible histories that could have happened, but didn’t.
• Random sample path = A succession of virtual historical events, starting at a given date and ending at another, except that they are subjected to some varying level of uncertainty.
• Monte Carlo simulation = Generates thousands, perhaps millions, of random sample paths, and look at the prevalent characteristics of some of their features.

It is Unnatural For Us to Learn From History

• Reading history will not help you “learn from other’s mistakes.”
• In some respects we do not learn from our own history.
• For example, people fail to learn that their emotional reactions to past experiences (positive or negative) were short-lived—yet they continuously retain the bias of thinking that the purchase of an object will bring long-lasting, possibly permanent, happiness or that a setback will cause severe and prolonged distress.
• Every man believes himself to be quite different, a matter that amplifies the “why me?” shock upon a diagnosis.

Hindsight Bias

• It is hard to imagine that people who witnessed history did not know at the time how important the moment was.
• A mistake is not something to be determined after the fact, but in the light of the information until that point.
• Those who are very good at predicting the past will think of themselves as good at predicting the future, and feel confident about their ability to do so.

Distilled Thinking

• History is a better teacher than today’s media journalism.
• Mathematically, progress means that some new information is better than past information, not that the average of new information will supplant past information, which means that it is optimal for someone, when in doubt, to systematically reject the new idea, information, or method.
• People tend to infer that because is some inventions have revolutionized our lives that inventions are good to endorse and we should favor the new over the old.
• But the opportunity cost of missing a “new new thing” like the airplane and the automobile is minuscule compared to the toxicity of all the garbage one has to go through to get to these jewels. And the same argument applies to information.
• The thirty or more hours spent “studying” the news last month neither had any predictive ability during your activities of that month nor did it impact your current knowledge of the world.
• Survival of the fittest will be the oldest, simply because older people have been exposed longer to the rare event and can be, convincingly, more resistant to it.

The Difference Between Noise and Information

• Time scale is important in judging a historical event.
• A 15% return with a 10% volatility per annum translates into a 93% probability of success in any given year. But that decreases drastically with a narrower time scale.

• The pain of losing $100 is greater than the satisfaction of earning $100. Psychologists estimate the negative effect for an average loss to be up to 2.5 the magnitude of a positive one.
• Over a short time increment, one observes the variability of the portfolio, not the returns. In other words, one sees the variance, little else.
• Our emotions are not designed to understand the point. We still suffer from seeing the losses even if we rationally know that they represent short term noise.
• On the same token, daily news is full of noise, but history is mostly stripped of it.

My sole advantage in life is that I know some of my weaknesses, mostly that I am incapable of taming my emotions facing news and incapable of seeing a performance with a clear head. Silence is far better.

Randomness, Nonsense, and the Scientific Intellectual

• Randomness and irrationality can be pleasurable (e.g. poetry, art, religion).
• We do not need to be rational and scientific when it comes to the details of our daily life—only in those that can harm us and threaten our survival.
• If you are going to be fooled by randomness, it better be of the beautiful (and harmless) kind.

Survival of the Least Fit—Can Evolution Be Fooled By Randomness?

• The firehouse effect = When firemen with much downtime who talk to each other for too long come to agree on many things than an outside, impartial observer would find ludicrous.
• The cross-sectional problem = At a given time in the market the most successful traders are likely to be those that are the best fit to the latest cycle. This does not happen too often with dentists or pianists—because these professions are more immune to randomness.

A Review of Market Fools of Randomness Constants

• An overestimation of the accuracy of their beliefs in some measure, either economic or statistical.
• A tendency to get married to positions. Loyalty to ideas is not a good thing for traders, scientists—or anyone.
• The tendency to change their story. There is a difference between short term trading and long term investing. Yet many people become long-term investors after they lose money trading, postponing their decision to sell as part of their denial.
• No precise game plan ahead of time as to what to do in the event of losses.
• Absence of critical thinking expressed in absence of revision of their stance with “stop losses.” They do not stop to consider that perhaps their method of determining value is wrong, rather than the market failing to accommodate their measure of value.
• Denial. When the losses occurred there was no clear acceptance of what had happened.

Naive Evolutionary Theories

• Many amateurs believe that plants and animals reproduce on a one-way route toward perfection. Translating the idea in social terms, they believe that companies and organizations are, thanks to competition, irreversibly heading toward betterment.
• Things are not as simple as that.
• Negative mutations are traits that survive in spite of being worse, from the reproductive fitness standpoint, than the ones they replaced. However, they cannot be expected to last more than a few generations.
• Darwinian fitness applies to species developing over a very long time, not observed over a short term—time aggregation eliminates much of the effects of randomness.
• Owing to the abrupt rare events, we do not live in a world where things “converge” continuously toward betterment.

Skewness and Asymmetry

• Whenever there is asymmetry in outcomes, the average survival [expected outcome] has nothing to do with the median survival [50%].
• Asymmetric odds means that probabilities are not 50% for each event, but that the probability on one side is higher than the probability on the other. Asymmetric outcomes mean that the payoffs are not equal.

• The frequency or probability of the loss, in and by itself, is totally irrelevant; it needs to be judged in connection with the magnitude of the outcome.
• Don’t confuse probability with expectation, that is, probability and probability times the payoff.
• It is not how likely an event is to happen that matters, it is how much is made when it happens that should be the consideration.
• The statistic that 90% of all option positions lost money is meaningless, (i.e., the frequency) if we do not take into account how much money is made on average during the remaining 10%.
• Rare events that bring large consequences cannot be ignored as outliers.

History teaches us that things that never happened before do happen.

• I [Taleb] associate rare events with any misunderstanding of the risks derived from a narrow interpretation of past time series [like the adage says, “beware of calm waters”].
• Investors, merely for emotional reasons, will be drawn into strategies that experience rare but large variations…The agent would prefer the number of losses to be low and the number of gains to be high, rather than optimizing the total performance.

The Problem of Induction

• Induction is going from plenty of particulars to the general. It is very handy, as the general takes much less room in one’s memory than a collection of particulars. The effect of such compression is the reduction in the degree of detected randomness.
• 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.
• You can use data to disprove a proposition, never to prove one.
• Why do we consider the worst case that took place in our own past as the worst possible case? If the past, by bringing surprises, did not resemble the past previous to it, then why should our future resemble our current past?
• Maximizing the probability of winning does not lead to maximizing the expectation from the game when one’s strategy may include skewness, i.e., a small chance of large loss and a large chance of a small win.
• Books often make a strong impression, but they rarely affect behavior. Only self-discoveries—personal experiences—last.
• There are some types of knowledge that do not increase with more information.
• Verification is not possible. Verificationism is more dangerous than anything else.
• Science is mere speculation, mere formulation of conjecture.

There are only two types of theories

1. Theories that are known to be wrong, as they were tested and adequately rejected.
2. Theories that have not yet been known to be wrong, not falsified yet, but are exposed to be proved wrong.

A theory is never right, because a theory cannot be verified. It can only be provisionally accepted.

Monkeys on Typewriters

• Just because someone performs better than the crowd in the past does not necessarily have any correlation to predicting their success in the future. It all depends on two factors: The randomness content of their profession and the number of monkeys in operation.
• The greater number of businessmen [monkeys], the greater the likelihood of one of them performing in a stellar manner just by luck.
• It is natural for those who failed to vanish completely. Accordingly, one sees the survivors, and only the survivors, which imparts such a mistaken perception of the odds.

We do not respond to probability, but to society’s assessment of it.

Too Many Millionaires Next Door

• The social treadmill: Get rich, move to a rich neighborhood, then become poor again.
• We tend to mistake one realization among all possible random histories as the most representative one, forgetting that there may be others.
• The survivorship bias implies that the highest performing realization will be the most visible. Why? Because the losers do not show up.

It Is Easier to Buy and Sell Than Fry an Egg

• A population entirely composed of bad [money] managers will produce a small amount of great track records.
• Even if the long-term expected return is negative for the entire population, owing to volatility, some of them will make money.
• The expectation of the maximum of track records depends more on the size of the initial sample than on the individual odds per manager. In other words, the number of managers with great track records in a given market depends far more on the number of people who started in the investment business rather than on their ability to produce profits.
• The maximum track records—the top performers—are all that we see due to survivorship bias.
• Regression to the mean = The larger the deviation from the norm, the larger the probability of it coming from luck rather than skill.
• Not all deviations come from this effect, but a disproportionately large proportion of them do.

Loser Takes All—On the Nonlinearities of Life

• Chaos theory concerns itself primarily with functions in which a small input can lead to a disproportionate response.
• Chance events coupled with positive feedback rather than technological superiority will determine economic superiority—not some abstrusely defined edge in a given area of expertise.
• Our brains is not cut out for nonlinearities.
• There are routes to success that are nonrandom, but few, very few, people have the mental stamina to follow them. Those who go the extra mile are rewarded. Most people give up before the rewards.
• There is a nonlinear effect behind success in anything. And the information age is worsening this effect.

Too much success is the enemy (think of the punishment meted out on the rich and famous); too much failure is demoralizing. I would like the option of having neither.

Randomness and Our Mind: We Are Probability Blind

• We cannot think in probabilistic shades. Consumers consider a 75% fat-free hamburger to be different from a 25% fat one.
• We follow rules not because they are the best but because they are useful and they save time and effort.
• If we were to optimize at every step in life, then it would cost us an infinite amount of time and energy. Accordingly, there has to be in us an approximation process that stops somewhere.
• Satisficing = You stop when you get a near satisfactory solution.
• We cannot make decisions without emotions.
• We feel emotions then find an explanation.
• People overvalue their knowledge and underestimate the probability of their being wrong.
• The confidence interval often matters far more than the expected value.

We don’t think when making choices, we use heuristics

• When something is in relation to something else, that something else can be manipulated. This effect of comparing to a given reference is called anchoring.
• Due to anchoring, wealth itself does not really make one happy; but positive changes in wealth may, especially if they come as “steady” increases.
• The availability heuristic corresponds to the practice of estimating the frequency of an event according to the ease with which instances of the event can be recalled.
• The representativeness heuristic is when we gauge the probability that a person belongs to a particular social group by assessing how similar the person’s characteristics are to the “typical” group member’s.
• The simulation heuristic: The ease of mentally undoing an event—playing the alternative scenario.
• The affect heuristic: What emotions are elicited by events determine their probability in your mind.

Wax In My Ears

• We are not intelligent enough, nor strong enough, to even try to fight your emotions. Besides, you need your emotions to formulate ideas and get the energy to execute them.
• We are predisposed to be fooled by randomness.
• We must accept that we are irrational, emotional beings.
• A book review, good or bad, can be far more descriptive of the reviewer than informational about the book itself.

Gamblers’ Ticks and Pigeons In A Box

• We are not made to view things as independent from each other. When viewing two events A and B, it is hard not to assume that A causes B, B causes A, or both cuase each other. Our bias is immediately to establish a causal link.
• One of the most irritating conversations I’ve had is with people who lecture me on how I should behave. Most of us know pretty much how we should behave. it is the execution that is the problem, not the absence of knowledge.
• We need tricks to get us there but before that we need to accept the fact that we are mere animals in need of lower forms of tricks, not lectures.

Carneades Comes to Rome: On Probability and Skepticism

• Remain open to changing your mind and self-contradiction.
• One of his strengths [George Soros] is that he revises his opinion rather rapidly, without the slightest embarrassment.
• There are reasons to believe that, for evolutionary purposes, we may be programmed to build a loyalty to ideas in which we have invested time.
• The trait of being absent of marriage to ideas is rare among humans.
• Someone who says something was a “ten sigma event” either (a) knows what they are talking about with near perfection, knows their probabilities, and it is an event that happens once every several times the history of the universe; or (b) just does not know what they are talking about when they talk about probability, and it is an event that has a probability higher than once every several times the history of the universe.
• We have been getting things wrong in the past and we laugh at our past institutions; it is time to figure out that we should avoid enshrining the present ones.
• Attribution bias = You attribute your successes to skills, but your failures to randomness.
• It is a human heuristic that makes us actually believe so in order not to kill our self-esteem and keep us going against adversity.
• People confuse science and scientists. Science is great, but individual scientists are dangerous. They are human; they are marred by the biases humans have.

Bacchus Abandons Antony

• Epic heroes were judged by their actions, not by the results.
• No matter how sophisticated our choices, how good we are at dominating the odds, randomness will have the last word.
• We are left only with dignity as a solution—dignity defined as the execution of a protocol of behavior that does not depend on the immediate circumstance.
• The only article Lady Fortuna has no control over is your behavior. Good luck.

Three Afterthoughts in The Shower

1. The Inverse Skills Problem

• The higher up the corporate ladder, the higher the compensation to the individual. This might be justified, as it makes plenty of sense to pay individuals according to their contributions. However, and in general, the higher up the corporate ladder, the lower the evidence of such contribution.
• Repetitiveness is key for the revelation of skills.
• Repetitiveness requires a process.
• But we often judge managers on results, and pay precious little attention to their process.

2. On Some Additional Benefits of Randomness

• Uncertainty can protect us from ourselves.
• Randomness can be beneficial.
• Research on happiness shows that those who live under a self-imposed pressure to be optimal in their enjoyment of things suffer a measure of distress.
• Getting rich results in his seeing flaws in the goods and services he buys.
• People who get promoted to important positions usually suffer from tightness of schedules: Everything has an allotted time.
• I am convinced that we are not made for clear-cut, well-delineated schedules. We are made to live like firemen, with downtime for lounging and meditating between calls, under the protection of protective uncertainty.
• At a limit, you can decide whether to be (relatively) poor, but free of your time, or rich but as a dependent as a slave.
• Wouldn’t it be better if the length of movies were kept a secret?

3. Standing On One Leg

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

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