Fooled by Randomness
For those of us that have come to believe of things that anything can be done and that there’s nothing called randomness will need to re-think. Most of us tend to believe in the correctness of our strategy or the path taken based on the previous success. The key question is, how much of our previous success can vouch for the future. For eg. You have been getting 30% + returns on your portfolio over the last 5 years, is it fine to say that you have beaten the markets and that you know how to make 30%+ for ever. This is where the author begs to differ from the rest of us mortals. How many cases do we see of rags to riches and riches to rags? Is it appropriate for us to shed our caution and say “we have done this before, we know about it”.
Randomness
Lucky fools never think or realize that they have been lucky. They act as if they deserved the money. Lets take the example of Russian roulette, where there’s only one bullet in the gun and the gun is placed point blank to the person and the trigger is pulled. There’s a 1 in 6 probability that the bullet goes and the person loses L(L for life). Let us say a few thousand people try this. You’ll have a large number of survivors based on probability. But this does not nullify the danger in the game. These survivors have survived not because of their strategy or skill. It’s sheer luck.
Lucky fools never think or realize that they have been lucky. They act as if they deserved the money. Lets take the example of Russian roulette, where there’s only one bullet in the gun and the gun is placed point blank to the person and the trigger is pulled. There’s a 1 in 6 probability that the bullet goes and the person loses L(L for life). Let us say a few thousand people try this. You’ll have a large number of survivors based on probability. But this does not nullify the danger in the game. These survivors have survived not because of their strategy or skill. It’s sheer luck.
Rendezvous with Randomness:
In the aftermath of the 1st world war, a few poets got together in cafes and performed this exercise. Each one would write on a piece of paper a pre-determined part of a sentence, not knowing other’s choice. The first would pick an adjective, the second a noun, the third a verb, the fourth an adjective, and the fifth a noun. After the exercise a really poetic sentence came out and that was “ The exquisite cadavers shall drink the new wine”. A totally random exercise.
We can find myriad accounts of traders building success and reputation in seven years and blowing it all up in seven days. Some of these traders estimate such an event to be a ten sigma event, with a probability of 1 in 1,000,000,000,000,000,000,000,000 years. The market fall need not have been catastrophic but their leverages must have been.
The difference between probability and probability times the payoff: It is very important for one to be aware of the difference. Probability vs. expectation.
Eg. There is a 80% probability that the stock will go up by 2% and 20% probability that it will go down by 10%. Where would you bet? This is a very important diffence that traders need to understand. It is not just the probability, one needs to pay heed to probability times the payoff. Its fine if you lose 1 % 5 times and get 10% once. The latter is still the better.
Sometimes market data becomes a trap: Currencies/stocks that have shown greatest stability are prone to greatest volatility in a rare event. Eg. the peso problem
Eg. There is a 80% probability that the stock will go up by 2% and 20% probability that it will go down by 10%. Where would you bet? This is a very important diffence that traders need to understand. It is not just the probability, one needs to pay heed to probability times the payoff. Its fine if you lose 1 % 5 times and get 10% once. The latter is still the better.
Sometimes market data becomes a trap: Currencies/stocks that have shown greatest stability are prone to greatest volatility in a rare event. Eg. the peso problem
Our hindsight suffers from short sight- People tend to remember the immediate past and the immediate environments and when they say “it has never happened before’, it is generally applicable to a narrow time frame or environment.
“Why do we consider the worst case that took place in our lives as the worst possible case?”
Rare events are always unexpected, otherwise they would not occur. That’s the author’s speciality. The rare events with a extremely large pay-off.
The black swans are the rare events. No number of white swans can prove that all swans are white whereas on black swan can disprove the theory that all swans are white. It is the example vs. counter example.
Similarly 20 years of statistical data cannot prove that “ On a single day, markets do not fall by more than 20%”, whereas one instance of a market falling by more than 20% can disprove the earlier made theory. Where we are arriving at is the point that gigabytes and tera bytes of data and statistical analysis cannot prove much while one event can disprove an age-old theory. So the fact that so many of our experts talk about statistical inferences might be proved wrong on one good day.
So, the point here is, historical data has limited value. Don’t be blown away by the historical evidences in life.
Statistical Scams: How many people that you know might have got letters from some company xyz, stating that we are bullish on the market for the next one month and you realize he’s right and this has happened over the past three months and you subscribe.
Lets see how this can be done. Company XYZ sends newsletters to 2000 contacts. For 1000 of them, bullish view on market and the other 1000 bearish. The market turns to be bullish. Great. Next month he selects the 1000 contacts who got it right(bullish ones) and send to 500 of them a bullish view and the 500 a bearish view. This time the market turns to be bearish. Great. 500 of them got it right the second time as well. The third time, he sends bullish to 250 and bearish to 250 of the 500 that got it right last time. This time again, 250 of them get it right. In principle, these 250 people got his advice right all three times and that is a good statistical record. Beware you subscribe to anonymous mailers
Lets see how this can be done. Company XYZ sends newsletters to 2000 contacts. For 1000 of them, bullish view on market and the other 1000 bearish. The market turns to be bullish. Great. Next month he selects the 1000 contacts who got it right(bullish ones) and send to 500 of them a bullish view and the 500 a bearish view. This time the market turns to be bearish. Great. 500 of them got it right the second time as well. The third time, he sends bullish to 250 and bearish to 250 of the 500 that got it right last time. This time again, 250 of them get it right. In principle, these 250 people got his advice right all three times and that is a good statistical record. Beware you subscribe to anonymous mailers
Nonlinaerity: Our brain is not quite comfortable with non-linearity. It is tuned to the cause and effect model. It needs connections. This happened because of that or because of this, which needs to happen and when that “that” does not happen, we are confused. Most of the events are non linear in nature. Eg.one may own a security that benefits from benefits from lower market prices, but may not react at all until some critical point. Most people give up before the rewards.
Noise: & Finance Sites:
· Dow is up 1.03 on lower interest rates
· Dollar down 0.12 yen on higher Japanese surplus.
The first one is noise. 1.03 points on dow is like less than 0.1% . This has happened because of lower interest rates!!! The 1 point move on an index close to 11000.??
· Dow is up 1.03 on lower interest rates
· Dollar down 0.12 yen on higher Japanese surplus.
The first one is noise. 1.03 points on dow is like less than 0.1% . This has happened because of lower interest rates!!! The 1 point move on an index close to 11000.??
Gist: Most of us like "Neo" - the hero in matrix would not like to believe that we dont have control over our destiny. Neverthess..let us not ignore the importance to randomness in the events and not getting carried away by our previous/historical success, as if we have found the secret formula for perpetual success .The idea is not to bring in the philosophy of fate, but the understanding of the fact that rare events are not predictable and no amount of the post mortem studies and analysis can make a black swan easily prdictable. We will keep having unexpected and rare events. So..it is important to be aware of this tuth and be prepared and perhaps even take advantage of these, like Nassim Nicholas Taleb, who makes his millions betting on these kind of events. So lets behave like mere mortals allowing ourselves the ability to contradict ourselves. It’s ok, if you thought something today and something changes then your opinion could change. Start everyday on a clean slate, like George Soros. and be prepared for the rare event which might have never occured before, but can occur in the future.
