When the Titanic sank in 1912 in the North Atlantic frozen ocean, historians attributed a substantial share of the responsibility of the disaster to its captain who allegedly maintained a high cruising speed despite warnings about the presence of icebergs ahead. When Princess Diana died in 1998 while trying to avoid paparazzi that were following her by speeding up, the whole British people had a rant at paparazzi and their profession, blaming them for playing a role in the death of their Princess. I can go on with countless examples like these, where our immediate search for causality among random events that happened in the past, make us construct a narrative fallacy about the reason they happened, and more dramatically, make us view the future while looking in the rear view mirror. How many times did the captain of the Titanic get warnings about presence of icebergs which were exaggerated and generated by people who are only looking to protect their back side? How many tabloid superstars have been chased by paparazzi and didn’t die trying to avoid them? But do we think about these?
“Of course chance favors the prepared,” argues Taleb, but we should get weary of not inversing the causality. Assume good qualities bring success in all cases, that does not mean that every successful person has good qualities. Now assume all successful people have good qualities, that does not mean that everybody who has good qualities will be successful. Or does it?
Taleb is a very controversial individual. His views are extreme to say the least, but among a few other things I owe him, I would point out two things: his light shedding on the role of chance in life, as well as his ability to build his credibility outside the rigid world of the academia (he did go one to get a PhD later on though). While he is mostly known for his Black Swan which luckily for him was published shortly before the financial crisis making him rise to the stature of a prophet in the minds of a few naive individuals, Fooled by Randomness is his first non-technical aka for the masses book which I chose to review for you guys here, perhaps in an attempt to raise your curiosity into reading it yourselves.
On the Limits of Pure Empiricism
A few disciplines, among which finance, use empirical studies to draw conclusions and make decisions. Empiricism is a theory of knowledge that asserts that all knowledge should be tested in real life in order to be qualified as true. Taleb uses as an example of the following statement:
automobile accidents happen closer to home
Say we take a sample of 1000 accidents and we find out that 20% of these accidents happen within a radius of 12 miles from the domicile of the driver. A naive empiricist could conclude that you are more likely to have an accident when driving close to home, ignoring the fact that most of your driving is around home anyways, which increases the likelihood of having an accident in the driver’s home area. Taleb insists that empiricism can be used to refute a hypothesis, and not to conclude that its opposite is true. Say I find out that:
The market did not go down more than 20% in the past 3 months
This does not mean the market never goes down more than 20% in a 3 months period. Making the leap from “has never gone down” to “never goes down” is impossible. Read the following induction fallacy to understand better:
I have just completed a thorough examination of the life of President Bush and found out that for the past 55 years, close to 21,000 observation, he did not die once. I can then pronounce him as immortal with a high degree of statistical significance.
Given that we cannot infer anything from observations we have made from our environment so far, Taleb takes it to the next step and sites the Austro-British philosopher Karl Popper idea:
There are only two types of theories, the ones that have been proven wrong, and the ones that have not yet been proven wrong.
For how many years did we think the earth was flat? Until we found out it is not. Here I would like to thank my friend Tico El Hage for enlightening me about the American philosopher Thomas Kuhn’s ideas. In line with Karl Popper’s statement above, Kuhn explains that science counter intuitively does not evolve in a linear shape whereby previous knowledge adds up to past knowledge, but instead evolves in paradigm shifts, where previous events are seen under a totally different perspective, which helps to explain them, but explains a big portion of their exceptions too.
But What About Warren Buffett?
Philosophers of Randomness like Nassim Taleb and Economists of the Efficient Market Hypothesis school like Eugene Fama are all faced with a major exception to the rules they try to set up. People often ask them how can they explain phenomena like the famous American stock trader who became one of the world’s richest person by trading stocks. In my opinion, Warren Buffett’s case shows the limitations of Taleb and Fama’s hypothesis. Taleb argues that there are so many people trying to be Warren Buffett (trying to make money from trading stocks) that one of them is going to make a streak of good trades out of pure luck and become a billionaire. Fama makes a somehow more plausible explanation by reminding us that Buffett does not only buy stocks but buys out entire businesses and takes controlling power in them, restructuring them like a private equity would, making them better businesses and de facto increasing their stock price. Assuming there is less luck in restructuring companies than trading stocks, Fama explains that Buffett’s success is not only due to luck.
Behind many fancy terms lies simple explanations, and survivorship bias is no exception. It is the phenomena which induces a fallacy in the conclusions one can draw about statistic results on a population, simply because these statistics did not take into consideration those items which have disappeared from the sample. Say you take a sample of Hedge Funds (risky and opaque investment management funds which are free to take on many investment decisions and are not forced to disclose their strategy or balance sheet to the public) and show that on average their return beat the returns from pension funds (funds that typically invest in safe assets). Your statistics would need to take survivorship bias into consideration, as they do not measure the returns from all those Hedge Funds that went bankrupt within the experiment’s time frame.
Here’s another way to look at survivorship bias: take a random walk in a casino and ask players about their beginnings. A few of them are likely to talk to you about how they were lucky when they started gambling, calling it beginner’s luck. But can beginner’s luck be partially explained by the fact that those players who were lucky the first time they played are precisely the ones still playing, while the ones who were unlucky the first time decided never to play again?
One last example of survivorship bias, I would like to bring up Taleb’s citation of Carl Sagan, an astronomer, who found out that the rate of cures from cancer that resulted from a visit to Lourdes (a so called Holy place in the south of France) is actually lower than the rate of cures from cancer patients who did not go to Lourdes!
Loser Take All Effect
Life is unfair in a non-linear way, argues Taleb. Next, he opens our eyes on what he calls path dependent outcomes in which the outcome that prevails is not necessarily the best one, but the one that had a bit of luck. Research has found that the distribution of keys on a QWERTY keyboard is not the most efficient. Attempts were made to build more efficient keyboards and type writers, but the reluctance of the users to learn a new typing habit was too strong, and QWERTY prevailed. Do similar stories come to your mind? Do you know of the story of a company whose name starts with a Micro and ends with a Soft?
Randomness and Personal Elegance
In light of this gigantic role of luck in life, Taleb advocates stoicism as a response to personal misfortune. Here I could not but copy and paste his own sentences, as any attempt to paraphrase would dilute the power of his words: ” Dress at your best on your execution day (shave well). Try not to play victim when diagnosed with cancer. The dignified attitude will make both defeat and victory feel equally heroic. Try not to blame others for your fate, even if they deserve the blame. Do not complain, and do not start playing nice guy if your business dries up. The only article lady fortuna has no control over is your behavior. Good Luck”