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Fooled by Randomness by Nassim Taleb - Nassim Nicholas Taleb has written a mind-blowing book! Totally contrarian and terrifically clear in explaining the fallacies followed by journalist, investors, traders and, sadly, many scientists.

Example: Failing to notice the difference between probability and expectation, famous commodity trader/investor Jim Rogers made this astounding statement.

"I don't buy options....90 percent of all long options lost money." ~ Jim Rogers

Rogers confused probability with expectation.

By itself, the 90 percent number means very little. What you need to know before making a decision is the expectation. If that winning 10 percent of options yielded a lot of money, then options might actually carry a VERY good expectation of making money. See chart below:

EventProbabilityOutcomeExpectation
Option Lost $90%-$1-$0.90
Option Gain $10%$100+$10.00
  TOTAL+$9.90

But don't let the numbers delude you into thinking such a scenario can be predicted. The chart illustrates the idea. Does the idea exactly match reality? Never. So what is one to do?

The best description of my lifelong business in the market is "skewed bets," that is, I try to benefit from rare events, events that do not tend to repeat themselves frequently, but, accordingly, present a large payoff when they occur.

I try to make money infrequently, as infrequently as possible, simply because I believe that rare events are not fairly valued, and that the rarer the event, the more undervalued it will be in price."

~ Nassim Taleb, FBR, p.103

So Taleb goes beyond defending himself against negative Black Swan events. Instead, he actually tries to benefit from the rare events by placing bets with a large payoff when those rare event occur. But how? He's not very specific, but it almost certainly (pun?) involves derivative options.

In the book he illustrated the point by describing a meeting he attended where they asked him where the market was going. Though he generally doesn't answer such questions, he ultimately said he believed it was going up--that the probability it would go up was high. But the traders countered that he placed bets that would only payoff if the market went down (put options on S&P 500); how can you say it's going up yet bet it's going down?

Because of expectation. Yes, at that time, most estimates (meaningless?) would declare high probability of the market going up. But IF it went down--if that rare event occurred--Taleb's bet would payoff big. So while he may have thought the market would probably go up, he placed bets to benefit huge if it went down. That's betting on expectation and not probabilities.

This bet, presumably, took the form of some long-term derivatives (put options). With such an investment(?), the potential (and likely) losses are relatively small (the cost of the option) but the payoff potentially huge. The idea is that you expect to lose most of the time, but when you win, you expect to win big.

So as long as your numerous losses are small, and the unexpected event does in fact occur, you can get win big. Of course, there are no guarantees. You could bleed to death (hold lots of expired options) while waiting for the black swan, which is why Taleb stresses to keep most of you money in the safest investments possible (Government securities?).

Only use a small portion of your nest egg for chasing black swans.

So Nassim Taleb's best investment advice is to keep most of your money absolutely safe, but for a small percentage, chase black swans.

Nassim Nicholas Taleb - Investment Advice

In Fooled by Randomness, Nassim Taleb offers some compelling, counter-intuitive ideas on what action to take. Absolutely riveting.

Fooled by Randomness - Amazon Reviews

I really liked these reviews I found on Amazon. Hits the book's highlights.

If the prescriptions for getting rich that are outlined in books such as The Millionaire Next Door and Rich Dad Poor Dad are successful enough to make the books bestsellers, then one must ask, Why aren't there more millionaires?

In Fooled by Randomness, Nassim Nicholas Taleb, a professional trader and mathematics professor, examines what randomness means in business and in life and why human beings are so prone to mistake dumb luck for consummate skill.

This eccentric and highly personal exploration of the nature of randomness meanders from the court of Croesus and trading rooms in New York and London to Russian roulette, Monte Carlo engines, and the philosophy of Karl Popper.

Part of what makes this book so good is Taleb's ability to make seemingly arcane mathematical concepts (at least to this reviewer) entirely relevant in evaluating and understanding everything from the stock market to the success of those millionaires cited in the aforementioned bestsellers.

Here's an articulate, wise, and humorous meditation on the nature of success and failure that anyone who wants a little more of the former would do well to consider. Highly recommended. ~ Harry C. Edwards

This one is wonderfully critical of Taleb's approach. I found it quite enlightening.

Read the other reviews to get the flavour of the book. I'll only add a few points that haven't been mentioned.

1) There is good advice on avoiding some common mistakes that lead to "blowing up", which will prove useful to inexperienced market practitioners.

2) Taleb's own (claimed) trading methodology (buying OTM options) could easily fall victim to the "black swan" problem. A regime change to persistently higher implied than actual volatility would result in extended losses for his fund (unless he is bluffing us about its methodology).

3) Taleb only focuses on cases where volatility is underpriced - but some of the best opportunities come when it is overpriced, during market panics. Yet according to what he says in the book, one should continue buying such overpriced volatility! As someone whose bread and butter trade is fading market panics, I can confirm that premium selling can be highly profitable - the trick is to sell at the right time, and to employ risk control. Just because some practitioners are incapable of this, does not invalidate the method, any more than OTM options buying is invalidated because many naive speculators buy in a panic just before the VIX is about to collapse.

4) Taleb lumps MBA and businessmen types into the "fool" category. This misses the point. 99% of business is not about risk-assessment, dazzling insight, or grand strategic thought, but about successful *execution* of obvious ideas, and hard work. How many eggheads have had great ideas, but never done anything to put them into action? There is no point knowing that a beach bar in the Bahamas might be destroyed every 10 years by a hurricane, if you aren't even capable of raising capital, employing people, or working 16 hour days getting it off the ground. Good MBAs and CEOs will in any case employ people like Taleb to assess risk for them.

5) Taleb ignores the possiblity of using praxeological analysis (i.e. taking a set of demonstrable a priori truths, then using a logical train of deduction to discover what those truths necessarily imply about reality) to avoid the survivorship bias & noise problems. E.g. you can predict the effect of supply and demand on price without having to test it in the real world. This technique has been used by Murray Rothbard in economics (which has an even greater "non-falsifiability" problem than trading), and Warren Buffett in investing. As an example, you *can* judge if a good track record is "skill" or "luck", by examining the methodology of the trader/investor. If they operated solely during a period favourable to their style, it is probably luck e.g. if they made money buying emerging market bonds from 1994-1998. If they made a bucketload trading a style that was *against* the market regime, then it is almost certainly skill e.g. someone who made good returns as a shortseller of tech stocks from 1997-2000; or someone who has successfully sold premium during market panics. Since Taleb is a follower of Popper, and a hardened quant, it should come as no surprise that he is ignorant of praxeology, but it is a huge oversight all the same.

6) Taleb's scorning of Buffett as a lucky fool is ignorant in the extreme. Buffett clearly did *not* use naive analysis of past data to make his investment decisions, or rely on luck (he did well from 1969-82, a terrible period for equities). Rather he deduced highly probably consequences from demonstrable truths about investment (i.e. firms with pricing power, high barriers to entry, and low working capital requirements are likely to perform very well), and then saw that the market was not pricing these factors efficiently. Anyone reading his writings can see this. And Buffett's approach is ironically more rigorous and less dependent on luck than Taleb's professed trading methods. To elaborate - Taleb is relying on "black swan" events happening more often than people think. Therefore EITHER a reduction in the frequency of these events, OR an increase in people's expectation of them, would be enough to invalidate Taleb's approach - clearly neither can be ruled out. Taleb thinks he is betting on black swan events occuring, whilst ignoring the possibility of the "black swan" of major regime change making his own system unprofitable. Whereas with Buffet, the laws of supply and demand, and basic investment/economics, ensure that certain business methods will *always* work better than others.

To conclude - Taleb thinks he has a great idea, but it was already well known by most experienced market practitioners (see the Market Wizards books etc where multiple traders continually bang on about rare event risk and fat tailed probability distributions). He then goes on as if this idea is the only important thing, which is clearly not the case. Finally, he critiques some people, such as Buffett, who use totally rigorous methodologies, whilst himself employing a strategy that is by no means foolproof, and relies largely on past observation (data-mining!) to form its conclusions. All I can say is that he better watch out for the black swan of long-term declining volatility over the next decade!

Finally, I would just say that I found the book enjoyable, it's just that (luckily for future my P&L) Taleb hasn't got everything worked out just yet :) Looking forward to the follow-up Nassim!

Nassim Nicholas Taleb - On Human Memory

Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets by Nassim Nicholas Taleb
The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb

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