I have a trick to know if something real in the world is taking place. I have set up my Bloomberg monitor to display the price and percentage change of all relevant prices in the world: currencies, stocks, interest rates, and commodities. By dint of looking at the same setup for years, as I keep the currencies in the upper left corner and the various stock markets on the right, I managed to build an instinctive way of knowing if something serious is going on. The trick is to look only at the large percentage changes. Unless something moves by more than its usual daily percentage change, the event is deemed to be noise. Percentage moves are the size of the headlines. In addition, the interpretation is not linear; a 2% move is not twice as significant an event as 1%, it is rather like four to ten times. A 7% move can be several billion times more relevant than a 1% move! The headline of the Dow moving by 1.3 points on my screen today has less than one billionth of the significance of the serious 7% drop of October 1997. People might ask me: Why do I want everybody to learn some statistics? The answer is that too many people read explanations. We cannot instinctively understand the nonlinear aspect of probability.
Filtering Methods
Engineers use methods to clean up the noise from the signal in the data. Did it ever occur to you while talking to your cousin in Australia or the South Pole that the static on the telephone line could be distinguished from the voice of your correspondent? The method is to consider that when a change in amplitude is small, it is more likely to result from noise—with its likelihood of being a signal increasing exponentially as its magnitude increases. The method is called a smoothing kernel, which has been applied in Figures 11.1 and 11.2. But our auditory system is incapable of performing such a function by itself. Likewise our brain cannot see the difference between a significant price change and mere noise, particularly when it is pounded with unsmoothed journalistic noise.
We Do Not Understand Confidence Levels
Figure 11.1 Unfiltered Data Containing Signal and Noise
Figure 11.2 Same Data with Its Noise Removed
Professionals forget the following reality. It is not the estimate or the forecast that matters so much as the degree of confidence with the opinion. Consider that you are going on a trip one fall morning and need to formulate an idea about the weather conditions prior to packing your luggage. If you expect the temperature to be 60 degrees, plus or minus 10 degrees (say in Arizona), then you would take no snow clothes and no portable electric fan. Now, what if you were going to Chicago, where you are told that the weather, while being 60 degrees, will nevertheless vary by about 30 degrees? You would have to pack winter and summer clothes. Here the expectation of the temperature carries little importance concerning the choice of clothing; it is the variance that matters. Your decision to pack is markedly different now that you are told that the variability would be around 30 degrees. Now let us push the point further; what if you were going to a planet where the expectation is also going to be around 60 degrees, but plus or minus 500 degrees? What would you pack?
We can see that my activity in the market (and other random variables) depends far less on where I think the market or the random variable is going so much as it does on the degree of error I allow around such a confidence level.
An Admission
We close this chapter with the following information: I consider myself as prone to foolishness as anyone I know, in spite of my profession and the time spent building my expertise on the subject. But here is the exception; I know that I am very, very weak on that score. My humanity will try to foil me; I have to stay on my guard. I was born to be fooled by randomness. That will be explored in Part III.
Part III
•
WAX IN MY EARS
Living with Randomitis
Odysseus, the Homerian hero, had the reputation of using guile to overcome stronger opponents. I find the most spectacular use of such guile was against no other opponent than himself.
In Book 12 of the Odyssey, the hero encounters the sirens, on an island not far from the rocks of Charybdis and Scylla. Their songs are known to charm the sailors into madness, causing them irresistibly to cast themselves into the sea off the sirens’ coast, and perish. The indescribable beauty of the sirens’ songs is contrasted with the moldering corpses of sailors who strayed into the area around them. Odysseus, forewarned by Circe, contrives the following ruse. He fills the ears of all his men with wax, to the point of total deafness, and has himself tied to the mast. The sailors are under strict instructions not to release him. As they approach the sirens’ island, the sea is calm and over the water comes the sound of a music so ravishing that Odysseus struggles to get loose, expending an inordinate amount of energy to unrestrain himself. His men tie him even further, until they are safely past the poisoned sounds.
The first lesson I took from the story is not to even attempt to be Odysseus. He is a mythological character and I am not. He can be tied to the mast; I can merely reach the rank of a sailor who needs to have his ears filled with wax.
I AM NOT SO INTELLIGENT
The epiphany I had in my career in randomness came when I understood that I was not intelligent enough, nor strong enough, to even try to fight my emotions. Besides, I believe that I need my emotions to formulate my ideas and get the energy to execute them.
I am just intelligent enough to understand that I have a predisposition to be fooled by randomness—and to accept the fact that I am rather emotional. I am dominated by my emotions—but as an aesthete, I am happy about that fact. I am just like every single character whom I ridiculed in this book. Not only that, but I may be even worse than them because there may be a negative correlation between beliefs and behavior (recall Popper the man). The difference between me and those I ridicule is that I try to be aware of it. No matter how long I study and try to understand probability, my emotions will respond to a different set of calculations, those that my unintelligent genes want me to handle. If my brain can tell the difference between noise and signal, my heart cannot.
Such unintelligent behavior does not just cover probability and randomness. I do not think I am reasonable enough to avoid getting angry when a discourteous driver blows his horn at me for being one nanosecond late after a traffic light turns green. I am fully aware that such anger is self-destructive and offers no benefit, and that if I were to develop anger for every idiot around me doing something of the sort, I would be long dead. These small daily emotions are not rational. But we need them to function properly. We are designed to respond to hostility with hostility. I have enough enemies to add some spice to my life, but I sometimes wish I had a few more (I rarely go to the movies and need the entertainment). Life would be unbearably bland if we had no enemies on whom to waste efforts and energy.
The good news is that there are tricks. One such trick is to avoid eye contact (through the rearview mirror) with other persons in such traffic encounters. Why? Because when you gaze into someone’s eyes, a different part of your brain, the more emotional one, is activated and engaged as the result of the interaction. I try to imagine that the other person is a Martian, rather than a human being. It works sometimes—but it works best when the person presents the appearance of being from a different species. How? I am an avid road cyclist. Recently, as I was riding along with other cyclists, slowing down traffic in a rural area, a small woman in a giant sports utility vehicle opened her window and heaped curses at us. Not only did it not upset me but I did not even interrupt my thoughts to pay attention. When I am on my bicycle, people in large trucks become a variety of dangerous animals, capable of threatening me but incapable of making me angry.
I have, like anyone with strong opinions, a collection of critics among finance academics and economists, annoyed by my attacks on their misuse of probability and unhappy about my branding them as pseudoscientists. I am incapable of taming my emotions when reading their comments. The best I can do is just not read them. Likewise with journalists. Not reading their discussions of markets spares me plen
ty of emotional expenditure. I will do the same with unsolicited comments on this book. Wax in my ears.
WITTGENSTEIN’S RULER
What is the mechanism that should convince authors to avoid reading comments on their work, except for those they solicit from specified persons for whom they have intellectual respect? The mechanism is a probabilistic method called conditional information: Unless the source of the statement has extremely high qualifications, the statement will be more revealing of the author than the information intended by him. This applies, of course, to matters of judgment. A book review, good or bad, can be far more descriptive of the reviewer than informational about the book itself. This mechanism I also call Wittgenstein’s ruler: Unless you have confidence in the ruler’s reliability, if you use a ruler to measure a table you may also be using the table to measure the ruler. The less you trust the ruler‘s reliability (in probability called the prior),the more information you are getting about the ruler and the less about the table. The point extends way beyond information and probability. This conditionality of information is central in epistemology, probability, even in studies of consciousness. We will see later extensions with “ten sigma” problems.
The point carries practical implications: The information from an anonymous reader on Amazon.com is all about the person, while that of a qualified person, is going to be all about the book. This plays equally in court: Take the O. J. Simpson trial once again. One of the jurors said, “There was not enough blood,” meaning to assess the statistical evidence of what was offered: Such statement reveals very little about the statistical evidence as compared with what it shows about the author of the statement’s ability to make a valid inference. Had the juror been a forensic expert, the ratio of information would have tilted the other way.
The problem is that while such reasoning is central to my thinking, my brain knows it though not my heart: My emotional system does not understand Wittgenstein’s ruler. I can offer the following evidence: A compliment is always pleasant, regardless of its authorship—something manipulators know rather well. Likewise with book reviews or comments on my risk-management strategy.
THE ODYSSEAN MUTE COMMAND
Recall that the accomplishment from which I derive the most pride is my weaning myself from television and the news media. I am currently so weaned that it actually costs me more energy to watch television than to perform any other activity, like, say, writing this book. But this did not come without tricks. Without tricks I would not escape the toxicity of the information age. In the trading room of my company, I have the television set turned on all day with the financial news channel CNBC staging commentator after commentator and CEO after CEO murdering rigor all day long. What is the trick? I have the volume turned completely off. Why? Because when the television set is silent, the babbling person looks ridiculous, exactly the opposite effect as when the sound is on. One sees a person with moving lips and contortions in his facial muscles, taking themselves seriously—but no sound comes out. We are visually but not auditorily intimidated, which causes a dissonance. The speaker’s face expresses some excitement, but since no sound comes out, the exact opposite is conveyed. This is the sort of contrast the philosopher Henri Bergson had in mind in his Treatise on Laughter, with his famous description of the gap between the seriousness of a gentleman about to walk on a banana skin and the comical aspect of the situation. Television pundits lose their intimidating effect;they even look ridiculous. They seem to be excited about something terribly unimportant. Suddenly pundits become clowns, which is a reason the writer Graham Greene refused to go on television.
I had this idea of stripping people of language while, on a trip, I listened (while brutally jet-lagged) to a speech in Cantonese, a language I do not understand, without the benefit of translation. Since I had no possible clue about his subject, the animated orator lost a large share of his dignity. The idea came to me that perhaps I could use a built-in bias, here prejudice, to offset another built-in bias, our predisposition to take information seriously. It seems to work.
This part, the conclusion of this book, presents the human aspect of dealing with uncertainty. I have personally failed in achieving a general insulation from randomness, but I have managed a few tricks.
Twelve
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GAMBLERS’ TICKS AND PIGEONS IN A BOX
On gamblers’ ticks crowding up my life. Why bad taxi-cab English can help you make money. How I am the fool of all fools, except that I am aware of it. Dealing with my genetic unfitness. No boxes of chocolate under my trading desk.
TAXI-CAB ENGLISH AND CAUSALITY
First, a flashback in time to my early days as a trader in New York. Early in my career, I worked at Credit Suisse First Boston, then located in the middle of the block between Fifty-second and Fifty-third streets, between Madison and Park Avenue. It was called a Wall Street firm, in spite of its Midtown location—I used to claim to work “on Wall Street” in spite of having been lucky enough to set foot only twice on the physical Wall Street, one of the most repulsive areas I have visited east of Newark, New Jersey.
Then, in my twenties, I lived in a book-choked (but otherwise rather bare) apartment on Manhattan’s Upper East Side. The bareness was not ideological; it was simply because I never managed to enter a furniture store, as I would eventually stop at a bookstore along the way and haul bags of books instead. As can be expected, the kitchen was devoid of any form of food and utensils, save for a defective espresso machine, as I learned to cook only very recently (even then . . .).
I went to work every morning in a yellow cab, which dropped me off at the corner of Park Avenue and Fifty-third Street. Cab drivers in New York City are known to be rather untamed and universally unfamiliar with the geography of the place, but, on occasion, one can find a cab driver who is both unacquainted with the city and skeptical of the universality of the laws of arithmetic. One day I had the misfortune (or perhaps the fortune, as we will see) to ride with a driver who did not seem capable of handling any language known to me, which includes taxi-cab English. I tried to help him navigate south between Seventy-fourth Street and Fifty-third Street, but he stubbornly continued the journey an additional block south, forcing me to use the Fifty-second Street entrance. That day, my trading portfolio made considerable profits, owing to considerable turmoil in currencies; it was then the best day of my young career.
The next day, as usual, I hailed a cab from the corner of Seventy-fourth Street and Third Avenue. The previous driver was nowhere in sight, perhaps deported back to the old country. Too bad; I was gripped with the unexplainable desire to pay him back for the favor he had done me and surprise him with a gigantic tip. Then I caught myself instructing the new cab driver to take me to the northeast corner of Fifty-second Street and Park Avenue, exactly where I was dropped off the day before. I was taken aback by my own words . . . but it was too late.
When I looked at my reflection in the elevator’s mirror, it dawned on me that I wore the exact same tie as the day before—with the coffee stains from the previous day’s fracas (my only addiction is to coffee). There was someone in me who visibly believed in a strong causal link between my use of the entrance, my choice of tie, and the previous day’s market behavior. I was disturbed for acting like a fake, like an actor playing some role that was not his. I felt that I was an impostor. On the one hand, I talked like someone with strong scientific standards, a probabilist focused on his craft. On the other, I had closed superstitions just like one of these blue-collar pit traders. Would I have to go buy a horoscope next?
A little brooding revealed that my life until then had been governed by mild superstitions, me the expert in options, the dispassionate calculator of probabilities, a rational trader! It was not the first time that I had acted on mild superstitions of a harmless nature, which I believed were instilled in me by my Eastern Mediterranean roots: One does not grab the salt shaker from the hand of another person risking a falling out; one is to knock on wood upon receivi
ng a compliment; plus many other Levantine beliefs passed on for a few dozen centuries. But like many things that brew and spread around the ancient pond, these beliefs I had taken with a fluctuating mixture of solemnity and mistrust. We consider them more like rituals than truly important actions meant to stave off undesirable turns of the goddess Fortuna—superstitions can instill some poetry in daily life.
The worrying part was that it was the first time that I noticed superstitions creeping into my professional life. My profession is to act like an insurance company, stringently computing the odds based on well-defined methods, taking advantage of other people when they are less rigorous, get blinded by some “analysis,” or act with the belief that they are chosen by destiny. But there was too much randomness flooding my occupation.
I detected the rapid accumulation of what are called “gamblers’ ticks” surreptitiously developing in my behavior—though minute and barely detectable. Until then these small ticks had escaped me. My mind seemed to be constantly trying to detect a statistical connection between some of my facial expressions and the outcome of events. For example, my income started to increase after I discovered my slight nearsightedness and started wearing glasses. Although glasses were not quite necessary, nor even useful, except for night driving, I kept them on my nose as I unconsciously acted as if I believed in the association between performance and glasses. To my brain such statistical association was as spurious as it can get, owing to the reduced sample size (here a single instance), yet this native statistical instinct did not seem to benefit from my expertise in hypothesis testing.
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