This book is about luck disguised and perceived as non-luck (that is, skills) and, more generally, randomness disguised and perceived as non-randomness (that is, determinism). p1
We are genetically still very close to our ancestors who roamed the savannah. The formation of our beliefs is fraight with superstitions… p1
…this book has two purposes: to defend science (as a light beam across the noise of randomness), and to attack the scientist when he strays from his course (most disasters come from the fact that individual scientists do not have an innate understanding of standard error or a clue about critical thinking). p5
Part 1: Solon’s Warning - Skewness, Asymetry, Induciton
It is called the problem of induction. I call it in this book the black swan or the rare event… it doesn’t matter how frequently something succeeds if failure is too costly to hear. p10
One: If You’re So Rich Why Aren’t You So Smart?
Trading forces someone to think hard; those who merely work hard generally lose their focus and intellectual energy. p17
Psychologists [[Daniel Kahneman]] and Tversky showed that most people prefer to make $70k when others around them are making $60k than to make $80k when others around them are making $90k. Economics, schmeconomics, it is all pecking order, he though. p20
Some imperceptible changes in deportment, like an ability to express oneself with serenity and confidence, makes the subject look credible. p23
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. p24
Two: A Bizarre Accounting Method
I start with the platitude that 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 in a different way). p26
The reader can see my unusual notion of alternative accounting: $10 million earned through Russian roulette does not have the same value as $10 million earned thought diligent and artful practive of dentistry. They are the same, can buy the same goods, excepct that one’s dependence on randomness is greater than the other. p28
Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather frequently, like a revolver that would have hundreds, even thousands of chambers instead of six. p28
The failure rate of these scientists, though, was better, but only slightly so than of MBAs; but it came from another reason, linked to their being on average (but only on average) devoid of the smallest but of practival intelligence. Some successful scientists had the judgement (and social graces) of a door knob–but by no means all of them. Many people were capable of the most complex calculations with utmost rigor when it came to equations, but were totally incapable of solving a problem with the smallest connection to reality… p31
Such tendency to make and unmake prophets basedo n the fate of the roulette wheel is sypmtomatic of our genetic inability to cope with the complex structure of randomness prevailing in the modern world. p36
…we are not wired in a way to understand probability… researchers of the brain believe that mathematical truths make little sense to our mind, particularly when it comes to the examination of random outcomes. p37
Like a doctor town between the two types of errors, the false positive (telling the patient he has cancer when in fact he does not) and the false negative (telling the patient he is healthy when in fact he has cancer), they need to balance their existence with the fact that they are inherently need some margin of error in their business. p39
Three: A Mathematical Mediation on History
Monte Carlo methods, in brief, consist in creating artificial history using the following concept. p41
First, consider the sample path. p41
…the examination of a sequence of scenarios along the course of time. We are not just concerned at where a bird can end up tomorrow night, but rather at all the various places it can possibly visit during the time interval. p42
A random sample path, also called a random run, is the mathematical name for such succession of virtual events, starting at a given date and ending at another, except that they are subjected to some varying level of uncertainty. p42
Stochastic processes refer to the dynamics of evenys unfolding with the course of time. Stochastic is a fancy Greek name for random. This branch of probability concerns itself with the study of the evolution of successive events–one could call it the mathematics of history. The key about a process is that it has a time in it. p42
For we can replace a large portion of mathematical knowledge with a Monte arlo simulator (and other computational tricks). p43
If the tone of this book seems steeped in the culture of Darwinism and evolutionary thinking, it does not come from any remotely formal training in the natural sciences, but from the evolutionary way of thinking taught by my Monte Carlo simulators. p47
Mathematications of probability give that a fancy name: ergodicity. It means, roughly, that (under certain conditions), very long sample paths would end up resemling each other. The properties of a very, very long sample path would be similar to the Monte Carlo properties of an average of shorter ones. p51
I will show you how my Monte Carlo simulation toy taight me to favor distilling thinking, by which I mean the thinking based on information around us that is stripped of meaningless but diverting clutter. p51
For an idea to have survived so long acorss so many cycles is indicative of its relative fitness. Noise, at lease some noise, was filtered out. p52
The problem with information is not that it is diverting and generally useless, but that it is toxic. p52
…life insurers in renaissance Italy reached the same conclusion, by charging the same insurance for a man in his 20s as they did for a man in his 50s, a sign that they had the same life expectation. p55
If an event is important enough, it will find its way to my ears. p59
Four: Randomness, Nonsense, and the Scientific Intellectual
Needless to say that inductive statements may turn out to be difficult, even impossible, to verify, as we weill see with the black swan problem–and empiricism can be worse than any other form of hogwash when it gives someone confidence. p61
If I am going to be fooled by randomness, it better be of the beautiful (and harmless) kind. p67
Five: Survival of the Least Fit – Can Evolution Be Fooled by Randomness?
A trader’s mental construction should direct him to do precisely what other people do not do. p73
He had observed that firemen with much downtime talk to each other for too long come to agree on many things than an outside, impartial observer, would find ludicrious (they develop political ideas that are very similar). p73
An overestimation of accuracy of their beliefs measure either economic (Carlos) or statistical (John). p79
A tendency to get married to positions. p79
The tendency to change their story. p79
No precise game plan ahead of time as to what to do in the event of loses. p80
Absence of critial thinking expressed in the absense of revision of their stans with “stop losses”. p80
Denial
This story illustrates how bad traders have a short- and medium-term survival advantage over good traders. p81
Things are not as simple as that. We will ignore the basic misuse of Darwinian ideas in the fact that organizations do not reproduce like living members of nature–Darwinian ideas are about reproductive fitness, not about survival. The problem comes, as everything else in this book, from randomness. Zoologists found that once randomness is injected into a system, the results can be quite surprising: what seems to be an evolution may be merely a diversion, and possibly regression. p81
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. p82
We said that should one extend time to infinity, then, by ergodicity, that event will happen with certainty–the species will be wiped out! For evolution means fitness to one and only time series, not the average of all possible environments. p83
Six: Skewness and Asymetry
Whenever there is an asymetry in outcomes, the average survival has nothing to do with the median survival. p 85
The frequency or probability of the loss, in and by itself, is totally irrelevant; it needs to be judged in conjunction with the magnitude of the outcome. p85
The besr description of my lifelong business in the market is “skewed bets”, that is, I try to benefit from rare events, events that to not tend to repeat themselves frequently, but, accordingly, present a large payoff when they occur. 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. p 89
I aim at profitting from the rare event, with my asymetric bets. p90
We could be either too lax or too stringent in accepting past information as a prediction of the future. As a skeptic, I reject a sole time series of the past as an indication of future performance; I need a lot more than data. My major reason is the rare event, but I have plenty of others. p93
We saw in Chapter 3 that the dentist does not like volatility as it causes a high incidence of negative pangs. The closer he observes his performance, the more pain he will experience owing to the greater variability at a higher resolution. Accordingly investors, merely for emotional reasons, will be drawn into strategies that experience rare but large variations. It is called pushing randomness under the rug. p95
Where statistics becomes complicated, and fails us, is when we have distributions that are not symmetric, like the urn above. 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 the red balls will increase very slowly–more slowly than the expected square root of n rate. On the other hand, our knowledge of the presence of red balls will dramatically improve once one of them is found. This asymetry in knowledge is not trivial; it is central in this book–it is a central philosophical problem for such people as [[David Hume]] and [[Karl Popper]] (on that, later). p96
I am now convinced that, perhaps, most of econometrics could be useless–much of what financial statisticians know would not be worth knowing. p97
Seven: The Problem of Induction
Now we discuss this problem viewed from the broader standpoint of the philosophy of scientific knowledge. There is a problem in inference well known as the problem of induction. It is a problem that has been haunting science for a long time, but science has not been harmed by it as the financial markets. Wh? Because the randomness content compounds it effects. Nowhere is the problem of induction more relevant than in my world of finance–and nowhere has it been as ignored! p99
In his Treatise on Human Nature, the Scots philisopher [[David Hume]] posed the issue in the following way (as rephrased in the now famous 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. p100
I experience a jump in my trading style in 1996, when Victor blurted out to me that any “testable” statement should be tested (it was so obvious but I had not done it until then). His advice went straight home. A testable statement is one that can be broken down into quantitative components and subjected to statistical examination. p101
[[Karl Popper]] came up with a major answer to the problem of induction (to me he came up with the answer). p106
There are only two types of theories:
Theories that are known to be wrong, as they were tested and adequately rejected (he calls them falsified).
Theories that have yet not been known to be wrong, not falsified yet but are exposed to be proved wrong.
He refused to blindly accept the notion that knowledge can always increase with incremental information– which is the foundation of statistical inference, but we do not know which ones. p107
…we like to emit logical and rational ideas but we do not necessarily enjoy this execution. Strange as it sounds, this point has only been discovered very recently… p109
I will use statistics and inductive methods to make aggressive bets, but I will not use them to manage my risks and exposure. Surprisingly, all of the surviving tradres I know seem to have done the same. They trade on ideas based on some observation (that includes past history) but, like the Popperian scientists, they make sure that the costs of being wrong are limited (and their propability is not derived from the data). p110
Part II: Monkeys on Typewriters - Survivorship and Other Biases
If one puts an infinite number of monkeys in front of (strongly built) typewriters, and lets them clap away, there is a certainty that one of them would come out with an exact version of the Illiad. Upon examination, this may be less interesting a concept than it appears at first: such probability is very low. But let us carry the reasoning one step beyond. Now that we have found that hero among monkeys, would any reader invest his life’s savings on a bet that the monkey would write the Odyssey next?
In this story, it is the second step that is interesting. How much can past performance (here typing the Illiad) be relevant in forecasting future performance? p113
I do not deny that if someone performed better than the crowd in the past, there is a presumption of his ability to do better in the future. But the presumption might be weak, very weak, to the point of being useless in decision making. Why? Because it all depends on two factors: the randomness content of his profession and the number of monkeys in the operation. p114
The initial sample size matters greatly. p114
The greater the number of businessmen, the greater the likelihood of one of them performing in a stellar manner just by luck. p114
They are hidden away, as one sees only thr winners– it is natural for those who failed to vanish completely. Accordingly, one sees the survivors, and only thr survivors, which imparts such a mistaken perception of the odds. p115
Eight: Too Many Millionaires Next Door
In other words, those who failed do not show up in the sample data at all, thus making him look as if he were not doing well at all. By living on Park Avenue, one does not have exposure to the losers, one only sees the winners. p120
The first bias comes from the fact that the rich people selected for their sample are among the lucky monkeys on typewriters. p122
In a nutshell, the survivirship bias implies that the highest performing realization will be the most visible. Why? Because the losers do not show up. p 123
Nine: It Is Easier To Buy and Sell Than Fry an Egg
I adduce the analysis of data mining and the study of survivorship biases. These have been refined in finance but can extend to all areas of scientific investigation. These have been refined in finance but can extend to all areas of scientific investigation. Why is finance so rich a field? Because it is one of the rare areas of investigation where we have plenty of information (in the form of abundant price series), but no ability to conduct experiments as in, say, physics. This dependence on past data bring about its salient defects. p127
My approach is that, with our Monte Carlo engine, we can manufacture purely random situations. We can do the exact opposite of conventional methods; in place of analyzing real people hunting for attributes we can create artificial ones with precisely know attributes. Thus we can manufacture situations that depend on pure, unadultered luck, without the shadow of skills or whatever we have called non-luck… p127
The first counterintuitive point is that a population entirely composed of bad managers will produce a small amount of great track records. p129
The second counterintuitive point is that the expectation of the maximum of track records, with which we are concerned, depends more on the size of the initial sample, than on the individual odds per manager. p129
It also depends on the volatility. p129
…the properties of ergodicity, namely, that time will eliminate the annoying effects of randomness. p130
Now let us look at a situation where there are 23 people in a room. What is the chance there being two people with the same birthday? About 50%. For we are not specifying which people need to share a birthday; and pair works. p132
I mistake the distribution of the maximum of a variable with that of the variable itself. The publisher will never put on the jacket of the book anything but the best praise. p134
Beset with insomnia, the computerized day-traders become night-testers plowing the data for some of its properties. By dint of throwing their monkeys on typewriters, without specifying what book they want their monkeys to write, they will hit upon hypothetical gold somewhere. Many of they blindly believing in it. p136
Ten: Loser Takes All – On the Nonlinearities of Life
The twist: life is unfair in a nonlinear way. p142
Chaos theory concerns itself primarily with functions in which a small input can lead to a disproportionate response. p143
Eleven: Randomness and Our Brain: We are Probability Blind
At no point during his ordeal did Nero think of himself as 72% alive and 28% dead. p 151
Who are the most influential economists of the century, in terms of journal referenes, their followings, and their influence over the profession? …They are [[Daniel Kahneman]] and [[Amos Tversky]], psychology researchers whose specialty was to uncover areas where human beings are not endowed with rational thinking and optimal economic behavior. p157
We are, whether we like it or not, prisoners to our biology. p158
We are built only to survive and procreate. To survive, we need to overstate some probabilities, such as those that can affect our survival. p158
Our brain has been wired with biases that may hamper us in a more complex environment, one that requires a more accurate assessment of probabilities. p159
I managed to build an instinctive way of knowing if something serious is going on. The trick is to look only at the large percentage changes. p166
We can see that my activity in the market depends far less on where I think the market is going so much as it does on the degree of error I allow around such a confidence level. p168
Part III: Wax in My Ears - Living with Randomitis
The epiphany I had in my career in randomness came when I understood that I was not intelligent enough, nor strong enough, to even try to fight my emotions. p172
I am just intelligent enough to understand that I have a predisposition to be fooled by randomness–and to accept the fact that I am rather emotional. p172
Life would be unbearably bland if we had no enemies on whom to waste efforts and energy. p172
Twelve: Gambers’ Ticks and Pigeons in a Box
This problem has a more worrying extension; 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 cause each other. Our bias is immediately to establish a causal link. p179
Thirteen: Carneades Comes to Rome: On Probability and Skepticism
As the skeptics’ main teaching was that nothing could be accepted with certainty, conclusions of various degress or probability could be formed, and these supplied a guide to conduct. p184
…has the remarkable attribute of being completely free of any path dependence in his beliefs. He exhibits absolutely no embarrassment buying a given currency on a pure impsule, when only hours ago he might have voiced a strong opinion as to its future weakness. What changes his mind? He does not feel obligated to explain. p186
One of his strengths is that he revises his opinion rather rapidly, without the slightest embarrassment. p186
What characterizes real speculators like [[George Soros]] from the rest is that their activites are devoid of path dependence. They are totally free from their past actions. Everyday is a clean slate. p187
Many people get married to their ideas all the way to the grave. Beliefs are said to be path dependent if the sequence of ideas is such that the first one dominates. p187
Such trait of absence of marriage to ideas is indeed rate among humans. p187
They made aobsolutely no allowance in the LTCM episode for the possibility of their not understanding markets and their methods being wrong. That was not a hypothesis to be considered. p189
My lesson from [[George Soros]] is to start every meeting at my trading boutique by convincing everyone that we are a bunch of idiots who know nothing and are mistake prone, but happen to be endowed with the rare privilege of knowing it. p189
Fourteen: Bacchus Abandons Antony
What is wrong with not following the heroic, or at least, the dignified path. That is what stoicism truly means. It is the attempts by man to get even with probability. p193
Its tenets can thus be summaraized as follows: the stoic is a person who combines the qualities of wisdom, upright dealing, and courage. The stoic will thus be immune from life’s dirty tricks. p194