Sunday, 30 November 2008

Fooled By Randomness


I am currently reading "Fooled By Randomness", sub-titled "The Hidden Role of Chance in Life and in the Markets" by Nassim Nicholas Taleb. It's not exactly light reading, and I have to say the author has a very high opinion of himself which is a little grating, but within its pages are some nuggets that might well be of interest to followers of this blog.

I accompanied my beautiful girlfriend to the hairstylist yesterday morning (since her appointment would only take an hour), and waited for her whilst enjoying my book and a cup of coffee in Munch. (They need the business).

Six coffees and three hours later she showed up (looking extra gorgeous I must say, very apologetic and no doubt somewhat lighter in the purse), but I'd at least had the time to read 103 pages even if I may need to re-visit some of them since I was on a caffeine high for the last 37 of them (and also by this time well acquainted with the toilet facilities).

Anyway, I digress, but one example he gives is of a bet which will win you £1 999 times out of 1000, but the one loss will set you back £10,000. This is similar to how the Unders / Overs market seems to work, although in the book the numbers are exaggerated to make the point that the bet is not a good idea, even though you will often win. This is why the idea of nicking a little money isn't a long-term strategy. He mentions how it is human nature to think that we are somehow special, and that we are somehow immune from that 1/1000 chance, but of course we are not.

The stock market works the same way. It seldom goes up big in a short time period, crawling up slowly but surely during a bull market; but when it crashes, it crashes big and fast. Look at the chart above to see how big the falls are. It's not surprising that the world and his grandmother thought that buying stocks in the late 90s was a sure-fire winning strategy. It was, for a while, but even though history is littered with examples of similar bubbles ending in crashes, the prevailing mood was that "this time it is different". It wasn't.

The author gives several examples of traders who made money year after year and were considered almost invincible, but when the black swan event hit them, (as they ultimately will), they lost all they had made and more (and not just money - but careers and reputations too).

As an aside, he mentions how one trader went from a net worth of $16m to $1m (still a total that 99.9% of the planet would envy), but that "there is a difference between a wealth level reached from above and a wealth level reached from below. The road from $16m to $1m is not as pleasant as the one from 0 to $1m".

7 comments:

John said...

That book completely changed the way I traded. I used to make a loss most of the time and it helped me realise the reason why (mainly as you say, nicking small wins is pointless if the risk is such that you could wipe out your pot). Now I have a much better understanding of what’s needed to make a LONG-TERM profit and it seems to be working – the downside of the book from a physiological viewpoint is you will always question what you do! How do you know if you are winning because you have a good strategy or because you’ve just been lucky? The upside is it keeps you on your toes because I’m now constantly checking my risk levels just in case everything I’ve done up until now has been luck – and that’s what keeps me in profit!

I wonder how many people try to nick ticks on 2.5 goals and have so far made profits. Through pure luck one of them could have done it for years and never suffered a loss. It doesn’t make him/her a better trader than any of the others. It reminds me of the betting program Derren Brown done on C4 (for those in the UK) which was completely miss-understood by the Betfair forum posters.

Anyway, I’ve been busy over the last week or so but I’ve tried to read your comments on value when I could. I’m a value believer – without having an idea of the value of a bet, how can you possibly access the risk and know when to exit. I don’t think value is of a concern to scalpers/momentum traders because of the nature of their trade – but then they are far more likely to be fooled by randomness than a value trader.

Cassini said...

Thanks for thecomment John. I shall press on with the book, especially since you recommend it so highly! I have posted before on the futility of the under / over markets with no game plan, and have completely abandoned the nicking a tick or two strategy. Derren Brown is great - he's from the same home town as me too!

Anonymous said...

Cassini, the over/unders markets CAN actually be beaten in the long term. However, your meaning/point of this post I absolutely agree with. The short term consecutive winners can fool people into believing they have found an edge (or proof they are "special" like the book suggests). From experience though, Ive found that as long as you genuinely accept & respect the prospects of big losses (not to mention planning your exit strategy in these circumstances) it is possible to extract long term value.

I can only speak for myself but Ive found that by adopting these posibilities and options as part of your process when opening your position, it actually leads myself to only get involved in the "juicy" parts that these markets offer up, even though I might not be aware of it at the time.

You mention that the big losses wipe out your profits plus some more. Id hazzard a guess that the "plus some more" probably equates to the comission paid over the relevant period on these markets. Put in that light, I reckon you probably are able to "crack" these markets but for various reasons (and probably very good and legitmate reasons) you are turning down.

Even if all of what I say is true & correct, it still doesnt invalidate the points raised in your post and the content of the book that relates to this. Keep it up mate, I wish I had the will to do a blog like this!

JPG

Cassini said...

Thanks JPG. My problem with the Unders/Overs markets was always that I had no strategy for exiting. I would jump in, watch my position get in the money, and then for no good reason jump out. Then I'd get bored, jump in again, nick a few more quid, and exit again. But ultimately I would get caught out, and that market doesn't allow a gentle stop-loss strategy! 1.2 suddenly becomes 3.0 or worse, the market is closed.

Anonymous said...

"Thanks JPG. My problem with the Unders/Overs markets was always that I had no strategy for exiting. I would jump in, watch my position get in the money, and then for no good reason jump out. Then I'd get bored, jump in again, nick a few more quid, and exit again. But ultimately I would get caught out, and that market doesn't allow a gentle stop-loss strategy! 1.2 suddenly becomes 3.0 or worse, the market is closed."

It's 1.01 the reason why you arent making long term profits is purely because of the "bored" word youve mentioned.

I dont think its your exit point that you are going wrong on, more the other part....

JPG

saperduper said...

"one example he gives is of a bet which will win you £1 999 times out of 1000, but the one loss will set you back £10,000"

As Taleb says:Option sellers, it is said, eat like chickens and go to the bathroom like elephants

Cassini said...

Yes, I liked that quote!