Despite recent developments, I will stick to my specialty of telling you about events that occurred 15 years ago. Around 2005, I met a one-of-a-kind trader/investor for whom I continue to have great admiration. Let us refer to him as Bruce Wayne.
When I asked Bruce about his strategies, he said that Nassim Nicholas Taleb’s book Fooled by Randomness was the best encapsulation of his thinking. Nassim Taleb, who went on to write The Black Swan and Antifragile, is clearly having a moment. On January 26, he co-wrote a paper warning about the coronavirus’s systemic risk. And, as is his wont, he has been outspoken about the dangers of underreacting, often by labeling others as idiots.
What struck me the most in Fooled by Randomness was Nassim’s conviction that many market participants delude themselves about what is knowable. Nassim admired only one trader: George Soros, who used a very flexible trading strategy.
I was also a big fan of Soros and devising trading strategies to compensate for the fact that very little is known at the time. Bruce Wayne had stated that he was so taken with the book that he almost phoned Nassim. Around 2007, I was raising funds for a US fund and contacting people who could assist me. I did make a cold call to Nassim. Be warned: all of my phone call stories are ridiculous because, by definition, I did not meet the person.
When I called him, he answered from what sounded like a bar. He said something to the effect of “I cannot speak with you, sir.” He didn’t call me an idiot or ask if I had any stake in the game. He was intrigued by how I had obtained his phone number. However, as you are aware, I do not discuss sources or methods. That was the end of the phone call.
Nassim has been associated with Universa Investments, a tail risk hedging operation run by Mark Spitznagel. There was a lot of interest in tail risk hedging strategies after 2008. Given 10 years of relatively low vol, I assumed Universa had fizzled. However, the firm has thrived and was recently managing $4 billion. According to reports, the fund gained about 1,000% in February and a multiple of that in March. Finally, my search for a fund with a good track record is over.
Here’s a synopsis of Fooled by Randomness:
Fooled by Chance: The Hidden Role of Chance in Life and the Markets
Nassim Nicholas Taleb is the author (NNT)
The central theme of Fooled is that the human mind is terrible at dealing with probability. Examples of probability blunders / perceptual anomalies
-References a study that found that “a deadly flood (causing thousands of deaths) caused by a California earthquake is more likely than a fatal flood (causing thousands of deaths) occurring somewhere in North America” (which happens to include California)
-Birthday paradox: what are the chances that someone you meet has the same birthday as you? 1/365.25. In a dinner of 23, there is a 50% chance that at least two people will share a birthday. In the first case, two people are putting the hypothesis “We have the same birthday” to the test. In the second case, any birthday coincidence will do.
The distinction is useful in comprehending the “data mining” issue. Data mining: if you look at enough data without a specific goal in mind, you can find all kinds of erroneous correlations, such as a correlation between women’s hemlines and the economy.
On the distinction between noise and signal
-The time scale is important in determining an event’s historical significance. Assume you’re a trader with a 15% expected return and 10% volatility: this translates to a 93% chance of success in a year, but only slightly more than 50% if measured in one-second increments.
So, while you will almost certainly be profitable most of the time, you will lose money from one second to the next half of the time. Furthermore, because psychologists estimate that the pain of loss is 2.5 times greater than the joy of victory, paying attention to short-term fluctuations will drain you.
Characteristics of “randomness fools” (traders who blow up)
overestimation of their beliefs’ accuracy in some measure, either economic or statistical a tendency to get married to their positions/beliefs a tendency to change their stories: When they are losing money, they become “investors for the long haul,” switching back and forth between being traders and investors to accommodate the latest turn of fortune.
No specific game plan for what to do in the event of a loss unwillingness to critically reassess the situation…no allowance for the possibility that the original analysis was flawed denial: refusing to accept the market’s message, clinging to some abstract “value”
In terms of skewness
NNT discusses skewness, or the shape of a probability distribution curve: how traders can lose sight of the difference between probability and expectation. For example, if a trader told you that he believes the market will rise in three months and that he is short the market, how would you reconcile the two statements? The trader anticipates that if the market falls, it will fall dramatically.
-A classic example of the above error is the common belief that “80% of options expire worthless.” This statement is deceptive on several levels, including the fact that it says nothing about the magnitude of profits generated by options worth something.
-NNT warns against skewness in strategies, such as a small chance of large losses and a large chance of a small win. “If you engaged in a Russian-roulette-style strategy with a low probability of a large loss, one that bankrupts you every few years, you are likely to come out on top in almost all samples except the year you die.”
The induction problem, also known as the black swan problem
-As posed by philosopher David Hume: “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”
-The induction problem serves as a warning against naive empiricism. Consider the well-known fact that car accidents occur closer to home….a naive empiricist might conclude that driving in remote places is safer, when the only reasonable conclusion is that people spend more time driving closer to home.
-To use a more practical example, just because the market has never fallen 30% in three months does not mean it will never happen. If you think that’s a given, consider Victor Niederhoffer, who sold naked options based on his backtesting, destroying an otherwise stellar track record spanning nearly two decades.
-Warns against the “it’s never happened before” school of thought. The worst that has previously happened cannot be equated with your maximum downside. Remember that the worst previous worst scenario displaced another worst previous worst scenario, so there’s no guarantee that a worse yet scenario won’t emerge in the future.
-NNT runs a trading shop in which he attempts to profit from rare events that provide a large payoff when they occur…he believes that rare events are not accurately priced. He constantly buys out-of-the-money options, accepting small losses on a regular basis, until one day he makes a killing, when a “black swan” event occurs.
Regarding George Soros
-Speaks highly of Soros: “he walked around calling himself fallible, but was so powerful because he knew it, whereas others had loftier ideas about themselves.”
-Discusses Karl Popper (a seminal influence on Soros the philosopher) and his philosophies: verification is impossible…have you noticed how Soros keeps harping on the concept of a “Open Society”? An open society is one in which no absolute truth is held to exist, allowing for the emergence of opposing ideas.
-Says that Soros and other great speculators like him are free of “path dependency,” that is, their decisions are not influenced by previous actions…they don’t mind switching to a faster horse, even if it means taking a loss in the current position…they can sell something today and buy it higher tomorrow…every day is a new day.
Concerning the survivorship bias
Monkeys on typewriters: you’ve probably seen the image of a large (infinite) number of monkeys typing away on typewriters…would you sign a book deal with one of them if they typed the Iliad?
How much confidence can you place in past performance?
-For example, it is well known that hedge fund databases with historical performance overstate the average performance of the entire hedge fund universe, because only managers with a passable track record report their results.
-If you launch 10,000 hypothetical investment managers with the condition that whether they are profitable or unprofitable in a given year is determined by a coin flip, 313 will have been profitable every year after five years, purely by chance. Even with a 45% chance of profit, the number is 184 (managers who could be described as “spurious survivors”). In other words, even a population of bad managers will produce a small number of great track records.
-“Because of adverse selection, judging an investment proposal that comes to you requires more stringent standards than judging an investment that you seek.” People who want to manage your money will have a good track record to sell; otherwise, they would not bother. There is a 2% chance of finding a spurious (ie merely lucky) survivor by proactively going to a cohort of 10,000 managers…by answering calls, the chance of the caller being a spurious survivor is closer to 100%.
-In conclusion, always count the monkeys. The problem is that in real life, you don’t hear about the missing monkeys.
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