Fooled By Randomness

I read a great book a few flights ago, entitled Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets by Nassim Nicholas Taleb. The book was written by a mathematics and statistics adept trader / academic / philosopher who explores fun and interesting questions about probability, causation, psychology, and life.

Simply put: if someone is successful in the financial markets, is it because they are skilled or lucky? Do they have a better strategy than someone else, or is their strategy simply, accidentally, more suited to given time period?

Taleb provides (anecdotal) example after example of traders who kept doubling down on given strategies only to “blow up” spectacularly in the end — often wiping out (thanks to leverage) in a single day the sum total of their profits over a period of years.

My favorite example from the book is a simple one, which he calls The Mysterious Letter (page 157). Suppose you open an anonymous letter on January 2 that says the market will go up during January, and it proves to be true. Then you receive another letter on February 1 saying the market will decline, which also proves to be true. This continues each month. By July, you are amazed by the prescience of the sender, who then proposes an investment offer in an offshore fund. You quickly wire your life’s savings to the advisor only to find that weeks later your money is all gone and that you’ve been conned. What happened?

In January, the con man pulls 10,000 names from a phone book. He mails a bullish letter to half the list and a bearish letter to the other half. The next month, he mails only those who received the correct prediction, sending half a bullish prediction and half a bearish one. He continues this process month after month. Assuming the market goes up and down each month with a 50% probability, by the end of June there are 156 people who are simply amazed with the accuracy of the predictions in the anonymous letters. If you can get half of them to invest $50K, then you’ve just conned your way into nearly $8M.

Much to my surprise and pleasure he covers the very real increasing returns that can result from chance luck. While traders will, in my opinion, rarely see these benefits, some types of financial firms might. For example, assume 10 equally skilled venture capital partnerships all start at the same time. After 10 years, assume a distribution of results that varies from 15% to 30% annual returns. Further yet, assume that distribution is pure chance — i.e., that each firm really was equally skilled. What happens next?

The top firm then gains a reputation for being the top firm. It therefore sees more business plans than the other firms, thus providing it with the pick of the business plan litter. What’s more, due to its higher skill, it’s able to offer lower valuations than competitors, competing literally on the greenness of its money (and not the quantity of it) and the reputation of the firm. Simply put, a chance advantage has become very real.

I’m not saying this is true in venture capital. I know plenty of venture capitalists and they certainly appear to me to be of fairly varied skills. And I know whose money I’d rather take and at what valuation. But am I fooled by randomness along with everybody else? Who knows. But it’s a fun and interesting question.

For those interested in a summary, the central argument of the book is available here in this Forbes article by the author.

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