Fooled by Randomness

by Nassim Nicholas Taleb

  Listening to the media, mostly because I am not used to it, can cause me on occasion to jump out of my seat and become emotional in front of the moving image (I grew up with no television and was in my late twenties when I learned to operate a TV set). One illustration of a dangerous refusal to consider alternative histories is provided by the interview that media person George Will, a “commentator” of the extensively commenting variety, conducted with Professor Robert Shiller, a man known to the public for his bestselling book Irrational Exuberance, but known to the connoisseur for his remarkable insights about the structure of market randomness and volatility (expressed in the precision of mathematics).

  The interview is illustrative of the destructive aspect of the media, in catering to our heavily warped common sense and biases. I was told that George Will was very famous and extremely respected (that is, for a journalist). He might even be someone of the utmost intellectual integrity; his profession, however, is merely to sound smart and intelligent to the hordes. Shiller, on the other hand, understands the ins and outs of randomness; he is trained to deal with rigorous argumentation, but does sound less smart in public because his subject matter is highly counterintuitive. Shiller had been pronouncing the stock market to be overpriced for a long time. George Will indicated to Shiller that had people listened to him in the past they would have lost money, as the market has more than doubled since he started pronouncing it overvalued. To such a journalistic and well-sounding (but senseless) argument, Shiller was unable to respond except to explain that the fact that he was wrong in one single market call should not carry undue significance. Shiller, as a scientist, did not claim to be a prophet or one of the entertainers who comment on the markets on the evening news. Yogi Berra would have had a better time with his confident comment on the fat lady not having sung yet.

  I could not understand what Shiller, untrained to compress his ideas into vapid sound bites, was doing on such a TV show. Clearly, it is foolish to think that an irrational market cannot become even more irrational; Shiller’s views on the rationality of the market are not invalidated by the argument that he was wrong in the past. Here I could not help seeing in the person of George Will the representative of so many nightmares in my career; my attempting to prevent someone from playing Russian roulette for $10 million and seeing journalist George Will humiliating me in public by saying that had the person listened to me it would have cost him a considerable fortune. In addition, Will’s comment was not an off-the-cuff remark; he wrote an article on the matter discussing Shiller’s bad “prophecy.” Such tendency to make and unmake prophets based on the fate of the roulette wheel is symptomatic of our ingrained inability to cope with the complex structure of randomness prevailing in the modern world. Mixing forecast and prophecy is symptomatic of randomness-foolishness (prophecy belongs to the right column; forecast is its mere left-column equivalent).

  Humiliated in Debates

  Clearly, this idea of alternative history does not make intuitive sense, which is where the fun begins. For starters, we are not wired in a way to understand probability, a point that we will examine backward and forward in this book. I will just say at this point that researchers of the brain believe that mathematical truths make little sense to our mind, particularly when it comes to the examination of random outcomes. Most results in probability are entirely counterintuitive;we will see plenty of them. Then why argue with a mere journalist whose paycheck comes from playing on the conventional wisdom of the hordes? I recall that every time I have been humiliated in a public discussion on markets by someone (of the George Will variety) who seemed to present more palatable and easier-to-understand arguments, I turned out (much later) to be right. I do not dispute that arguments should be simplified to their maximum potential; but people often confuse complex ideas that cannot be simplified into a media-friendly statement as symptomatic of a confused mind. MBAs learn the concept of clarity and simplicity—the five-minute-manager take on things. The concept may apply to the business plan for a fertilizer plant, but not to highly probabilistic arguments—which is the reason I have anecdotal evidence in my business that MBAs tend to blow up in financial markets, as they are trained to simplify matters a couple of steps beyond their requirement. (I beg the MBA reader not to take offense; I am myself the unhappy holder of the degree.)

  A Different Kind of Earthquake

  Try the following experiment. Go to the airport and ask travelers en route to some remote destination how much they would pay for an insurance policy paying, say, a million tugrits (the currency of Mongolia) if they died during the trip (for any reason).Then ask another collection of travelers how much they would pay for insurance that pays the same in the event of death from a terrorist act (and only a terrorist act). Guess which one would command a higher price? Odds are that people would rather pay for the second policy (although the former includes death from terrorism). The psychologists Daniel Kahneman and Amos Tversky figured this out several decades ago. The irony is that one of the sampled populations did not include people on the street, but professional predictors attending some society of forecasters’ annual meeting. In a now famous experiment they found that the majority of people, whether predictors or nonpredictors, will judge a deadly flood (causing thousands of deaths) caused by a California earthquake to be more likely than a fatal flood (causing thousands of deaths) occurring somewhere in North America (which happens to include California). As a derivatives trader I noticed that people do not like to insure against something abstract; the risk that merits their attention is always something vivid.

  This brings us to a more dangerous dimension of journalism. We just saw how the scientifically hideous George Will and his colleagues can twist arguments to sound right without being right. But there is a more general impact by information providers in biasing the representation of the world one gets from the delivered information. It is a fact that our brain tends to go for superficial clues when it comes to risk and probability, these clues being largely determined by what emotions they elicit or the ease with which they come to mind. In addition to such problems with the perception of risk, it is also a scientific fact, and a shocking one, that both risk detection and risk avoidance are not mediated in the “thinking” part of the brain but largely in the emotional one (the “risk as feelings” theory). The consequences are not trivial: It means that rational thinking has little, very little, to do with risk avoidance. Much of what rational thinking seems to do is rationalize one’s actions by fitting some logic to them.

  In that sense the description coming from journalism is certainly not just an unrealistic representation of the world but rather the one that can fool you the most by grabbing your attention via your emotional apparatus—the cheapest to deliver sensation. Take the mad cow “threat” for example: Over a decade of hype, it only killed people (in the highest estimates) in the hundreds as compared to car accidents (several hundred thousands!)—except that the journalistic description of the latter would not be commercially fruitful. (Note that the risk of dying from food poisoning or in a car accident on the way to a restaurant is greater than dying from mad cow disease.) This sensationalism can divert empathy toward wrong causes: cancer and malnutrition being the ones that suffer the most from the lack of such attention. Malnutrition in Africa and Southeast Asia no longer causes the emotional impact—so it literally dropped out of the picture. In that sense the mental probabilistic map in one’s mind is so geared toward the sensational that one would realize informational gains by dispensing with the news. Another example concerns the volatility of markets. In people’s minds lower prices are far more “volatile” than sharply higher moves. In addition, volatility seems to be determined not by the actual moves but by the tone of the media. The market movements in the eighteen months after September 11, 2001, were far smaller than the ones that we faced in the eighteen months prior—but somehow in the mind of investors they were very volatile. The discussions in the media of the “terrorist threats” magnified
the effect of these market moves in people’s heads. This is one of the many reasons that journalism may be the greatest plague we face today—as the world becomes more and more complicated and our minds are trained for more and more simplification.

  Proverbs Galore

  Beware the confusion between correctness and intelligibility. Part of conventional wisdom favors things that can be explained rather instantly and “in a nutshell”—in many circles it is considered law. Having attended a French elementary school, a lycée primaire, I was trained to rehash Boileau’s adage:

  Ce qui se conçoit bien s’énonce clairement

  Et les mots pour le dire viennent aisément

  What is easy to conceive is clear to express / Words to say it would come effortlessly.

  The reader can imagine my disappointment at realizing, while growing up as a practitioner of randomness, that most poetic sounding adages are plain wrong. Borrowed wisdom can be vicious. I need to make a huge effort not to be swayed by well-sounding remarks. I remind myself of Einstein’s remark that common sense is nothing but a collection of misconceptions acquired by age eighteen. Furthermore, What sounds intelligent in a conversation or a meeting, or, particularly, in the media, is suspicious.

  Any reading of the history of science would show that almost all the smart things that have been proven by science appeared like lunacies at the time they were first discovered. Try to explain to a Times (of London) journalist in 1905 that time slows down when one travels (even the Nobel committee never granted Einstein the prize on account of his insight on special relativity). Or to someone with no exposure to physics that there are places in our universe where time does not exist. Try to explain to Kenny that, although his star trader “proved” to be extremely successful, I have enough arguments to convince him that he is a dangerous idiot.

  Risk Managers

  Corporations and financial institutions have recently created the strange position of risk manager, someone who is supposed to monitor the institution and verify that it is not too deeply involved in the business of playing Russian roulette. Clearly, having been burned a few times, the incentive is there to have someone take a look at the generator, the roulette that produces the profits and losses. Although it is more fun to trade, many extremely smart people among my friends (including Jean-Patrice) felt attracted by such positions. It is an important and attractive fact that the average risk manager earns more than the average trader (particularly when we take into account the number of traders thrown out of the business: While a ten-year survival rate for a trader is in the single digits, that of a risk manager is close to 100%). “Traders come and go; risk managers are here to stay.” I keep thinking of taking such a position both on economic grounds (as it is probabilistically more profitable) and because the job offers more intellectual content than the one consisting in just buying and selling, and allows one to integrate research and execution. Finally, a risk manager’s blood has smaller quantities of the harmful kind of stress hormones. But something has held me back, aside from the irrationality of wanting the pains and entertainment from the emotions of speculation. The risk managers’ job feels strange: As we said, the generator of reality is not observable. They are limited in their power to stop profitable traders from taking risks, given that they would, ex post, be accused by the George Wills around of costing the shareholder some precious opportunity shekels. On the other hand, the occurrence of a blowup would cause them to be responsible for it. What to do in such circumstances?

  Their focus becomes to play politics, cover themselves by issuing vaguely phrased internal memoranda that warn against risk-taking activities yet stop short of completely condemning it, lest they lose their job. Like a doctor torn 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 inherently need some margin of error in their business.

  Epiphenomena

  From the standpoint of an institution, the existence of a risk manager has less to do with actual risk reduction than it has to do with the impression of risk reduction. Philosophers since Hume and modern psychologists have been studying the concept of epiphenomenalism, or when one has the illusion of cause-and-effect. Does the compass move the boat? By “watching” your risks, are you effectively reducing them or are you giving yourself the feeling that you are doing your duty? Are you like a chief executive officer or just an observing press officer? Is such illusion of control harmful?

  I conclude the chapter with a presentation of the central paradox of my career in financial randomness. By definition, I go against the grain, so it should come as no surprise that my style and methods are neither popular nor easy to understand. But I have a dilemma: On the one hand, I work with others in the real world, and the real world is not just populated with babbling but ultimately inconsequential journalists. So my wish is for people in general to remain fools of randomness (so I can trade against them), yet for there to remain a minority intelligent enough to value my methods and hire my services. In other words, I need people to remain fools of randomness, but not all of them. I was fortunate to meet Donald Sussman, who corresponds to such an ideal partner; he helped me in the second stage of my career by freeing me from the ills of employment. My greatest risk is to become successful, as it would mean that my business is about to disappear; strange business, ours.

  Three

  •

  A MATHEMATICAL MEDITATION ON HISTORY

  On Monte Carlo simulation as a metaphor for understanding a sequence of random historical events. On randomness and artificial history. Age is beauty, almost always, and the new and the young are generally toxic. Send your history professor to an introductory class on sampling theory.

  Europlayboy Mathematics

  The stereotype of a pure mathematician presents an anemic man with a shaggy beard and grimy and uncut fingernails silently laboring on a Spartan but disorganized desk. With thin shoulders and a pot belly, he sits in a grubby office, totally absorbed in his work, oblivious to the grunginess of his surroundings. He grew up in a communist regime and speaks English with an astringent and throaty Eastern European accent. When he eats, crumbs of food accumulate in his beard. With time he becomes more and more absorbed in his subject matter of pure theorems, reaching levels of ever increasing abstraction. The American public was recently exposed to one of these characters with the Unabomber, the bearded and recluse mathematician who lived in a hut and took to murdering people who promoted modern technology. No journalist was capable of even coming close to describing the subject matter of his thesis, “Complex Boundaries,” as it has no intelligible equivalent—a complex number being an entirely abstract and imaginary number that includes the square root of minus one, an object that has no analog outside of the world of mathematics.

  The name Monte Carlo conjures up the image of a suntanned urbane man of the Europlayboy variety entering a casino under a whiff of the Mediterranean breeze. He is an apt skier and tennis player, but also can hold his own in chess and bridge. He drives a gray sports car, dresses in a well-ironed Italian handmade suit, and speaks carefully and smoothly about mundane, but real, matters, those a journalist can easily describe to the public in compact sentences. Inside the casino he astutely counts the cards, mastering the odds, and bets in a studied manner, his mind producing precise calculations of his optimal betting size. He could be James Bond’s smarter lost brother.

  Now when I think of Monte Carlo mathematics, I think of a happy combination of the two: The Monte Carlo man’s realism without the shallowness, combined with the mathematician’s intuitions without the excessive abstraction. For indeed this branch of mathematics is of immense practical use—it does not present the same dryness commonly associated with mathematics. I became addicted to it the minute I became a trader. It shaped my thinking in most matters related to randomness. Most of the exam
ples used in this book were created with my Monte Carlo generator, which I introduce in this chapter. Yet it is far more a way of thinking than a computational method. Mathematics is principally a tool to meditate, rather than to compute.