Book Review: Fooled by Randomness

Nassim Nicholas Taleb’s book should come with a warning on the cover: “If you are turned off by an arrogant, attacking, argumentative style, you will miss one of the best set of ideas on markets and investing in the last 20 years.”[1]

Now that I have given you, slyly, the same warning, let me emphasize the second part of my warning, because this book rewards the effort.

As in its successor, The Black Swan: The Impact of the Highly Improbable, Taleb tears down unexamined assumptions about the patterns we see in the world.  Similarly, Fooled by Randomness
hews to my preferred ‘How NOT To Invest’ rule on useful finance books, rather than the more typical airport bookstore “How To Invest” books that make me want to gag.

Taleb’s writing usefully addresses the question: When you consider investing in a successful money manager, posting consistently high returns over an impressive number of years, is that a brilliant investor or just the result of dumb luck?

Taleb walks the reader through a coin toss experiment which – for me at least – demolishes the typical treatment of the Financial Infotainment Industrial Complex’s celebration of “money manager brilliance,” in one clean hypothetical example.

Take 10,000 money managers, each of whom has a 50% probability of making $10K in a year, and a 50% probability of losing $10K in a year.  Any manager who loses $10K in a year gets tossed out of the pool of remaining managers.

At the end of the year, we expect approximately 5,000 money managers will be up $10K , while 5,000 money managers will permanently leave the pool of money managers.

When we run the game for a second year, 2,500 managers remain, each of whom has had a string of 2 good ‘up’ years.  After three years we have 1,250 managers, after four years we have 625 managers, and after five years we have 313 managers.  In Taleb’s experiment, these 313 managers have managed to post 5 brilliant years in a row, (with no down years!), although we know this is due to the pure dumb luck of the experiment.

As Taleb points out, and we know instinctively from the way the Financial Infotainment Industrial Complex works, these lucky 5-year managers will be hailed for their incisive minds, their vigorous yoga regimen, or their humble and strict upbringing.  If they then stumble in the next year, the Financial Infotainment Industrial Complex will point to the outdated approach of their investment thesis or the moral dissipations of their early success.  Or whatever.  The real truth is, as Taleb says, their luck changed more than they changed.

From a random dumb-luck cohort of investment managers, we can produce, consistently, a number of successful winners (3% in his example, over 5 years) who will receive undeserved accolades, even as their success appears to show a non-random seeming, statistically improbable, string of successes.

It’s easy to parody Taleb’s argument as ‘it’s all luck,’ but it’s more difficult, and more profitable, to examine ways in our own personal and financial lives in which we ascribe too much causality to random events and random markets.

In the simplest but most profound sense, about 99%[2] of the conversations I have or hear about investing, even (especially!) among serious people, invoke causality instead of luck, and see patterns instead of randomness.  We say the word ‘investing’ but we really mean, unknowingly, ‘gambling.’

A few other reasons I like Fooled by Randomness:

1. I love the section midway through Fooled by Randomness in which Taleb describes the successful and personable “Carlos,” an emerging markets bond trader who, throughout a number of years, made $80 million for his bank, with nary a down quarter, only to blow a $300 million hole in his firm’s balance sheet during one traumatic summer of 1998 featuring the blowout of swap spreads, The Russian bond default, and the implosion of Long Term Capital Management.  Since I lived and breathed that market, and those years, with bond trading colleagues just like Carlos, I can relate.
2. I serve as a fiduciary for a school whose endowment matters tremendously for the operation of the institution.  One of the never-ending challenges for any fiduciary who shares Taleb’s empirical skepticism is to keep returning to the role of luck and randomness in short and medium-term investment returns.  We want to be smart, but part of being smart, according to Taleb, is acknowledging that luck and randomness account far more for success than we prefer to believe.  We receive quarterly investment returns from our managers, but the value of that information is nearly zero.  It’s just noise.  As a natural corollary, decisions about money managers based on relatively short-term investment results should be made with a healthy dollop of skepticism.

Finally, one of the joys of Taleb is that he and his ideas engage productively in a dialogue with other thinkers.  Nate Silver’s The Signal and the Noise followed Fooled By Randomness in time but helps build a similar helpful skepticism about what we can know and not know from observable data and phenomenon.  The human tendency to see patterns and ascribe causality where none exists can be usefully counteracted through their thinking.

Taleb also explicitly attacks, among numerous others, a book I admire, Thomas Stanley’s The Millionaire Next Door.[3]  Taleb argues, correctly, that Stanley’s methodology crumbles in the face of statistical logic.[4]  I agree with Taleb on the statistical critique, while I also believe in Stanley’s conclusions and advice on how to conduct one’s personal and financial life.

One can be right for the wrong reasons, as well as wrong for all the right reasons, as I imagine Taleb would heartily agree.

Please also see my review of Nicholas Nassim Taleb’s Black Swan.

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