How Traders/Investors Are Fooled By Randomness | Reading Notes #8

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Originally Posted on My Blog. Click Here to Read This Post on My Website!

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Many of the ideas laid out by Nassim Taleb in "Fooled By Randomness” apply to nearly every field and every person on Earth.

There are so many ways to take these ideas and apply them in your own life and your own occupation and ambitions for the future.

Following a story about 2 different traders (Carlos and John), Taleb goes into some detail in outlining how these 2 traders were fooled by randomness.

These traders were participant in a “right place, right time” scenario.. They made a lot of money and became very “successful” in a short period of time. During this span of time, many events lined up perfectly to make them a hit in their own investment firms.

This allowed them to get more allocations from their firms, make more money, build more confidence, etc. When the time came for randomness to switch directions and bring them misfortune, it took all of what they did away… and then some.

We are all subject to being fooled by randomness. Randomness can strike at any time, in any place and in nearly any field.

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Overestimating:

"An overestimation of the accuracy of their beliefs in some measure, either economic (Carlos) or statistical (John). They never considered that the fact that trading on economic variables has worked in the past may have been merely coincidental, or, perhaps even worse, that economic analysis was fit to past events to mask the random element in it. Consider that of all the possible economic theories available, one can find a plausible one that explains the past, or a portion of it. Carlos entered the market at a time when it worked, but he never tested for periods when markets did the opposite of sound economic analysis. There were periods when economics failed traders, and others when it helped them.” - Nassim Taleb, "Fooled By Randomness”

Overestimating your beliefs and abilities is a common error, especially in the field of investing. What works today is far from guaranteed to work tomorrow.

Just because you were right yesterday, doesn’t mean you can continually expect to be right in the future. Similarly, you can overestimate the validity of the tools and methods at your disposal.

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Loyalty to Ideas:

"A tendency to get married to positions. There is a saying that bad traders divorce their spouse sooner than abandon their positions. Loyalty to ideas is not a good thing for traders, scientists—or anyone.” - Nassim Taleb, "Fooled By Randomness”

I’ve fallen prey to this one more times than I can count. It’s a common error in human thinking. We find something that we believe to be true and then we continue to tell ourselves that it will always ring true.

As an investor, we may find an investment strategy that performs beyond our wildest expectations for months and even years on end. The day will come, however, when that strategy could become irrelevant.

The game could change. Variables can shift. Things can align in a different way.

In early 2018 I was trading on a particular strategy that transacted on a month-to-month basis… The strategy performed well for 4 months in a row. On the 5th month, a few variables changed and the strategy became less profitable. It hit a decline moment and the trades slid into the red.

Thinking that it would eventually go back to the way things were, I held onto this strategy for 2 more months — incurring losses that nearly overpowered all the gains I had made in the first 4 months. I eventually cut the strategy loose. In hindsight, I could have easily cut the strategy the minute I realized that it was no longer profitable and I would have held onto a much larger portion of the gains I saw in those first 4 months.

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Changing Your Story:

"The tendency to change their story. They become investors “for the long haul” when they are losing money, switching back and forth between traders and investors to fit recent reversals of fortune. The difference between a trader and an investor lies in the duration of the bet, and the corresponding size. There is absolutely nothing wrong with investing “for the long haul,” provided one does not mix it with short-term trading—it is just that many people become long-term investors after they lose money, postponing their decision to sell as part of their denial.” - Nassim Taleb, "Fooled By Randomness”

Rationalizing our mistakes and our losses is commonplace in our society. This one again reminds me of that 6 month period of time in 2018 when I was trading on a certain set of variables.

I rationalized in my own head that the losses would be worth it.. That I just had to wait long enough for the strategy to land in the green again. Instead of realizing that the landscape had shifted and it was time to move on to a new form of arbitrage, I believed that I could hold out until it changed back.

Looking back on that period now, I can see that the landscape never returned to what it had been. I would have sat on those positions until I was so deep in the red that all my profits and more wold have been wiped out.

I’ve also come to learn a valuable lesson out of that situation: when you cut 1 arbitrage loose and set your mind to finding something to replace it, you can often find something that is equally as great and oftentimes, even better.

When you’re deeply entrenched in old ideas, it can be hard to spot the new ones that lie just in front of your eyes.

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Q&A

Have you ever been fooled by randomness in your own life/investing?

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