Despite recent developments, I will focus on my niche of telling you about things that happened 15 years ago. Around 2005, I met a unique trader / investor for whom I continue to have great respect. Let's call him Bruce Wayne. I asked Bruce about his strategies and he said the book Fooled by Randomness by Nassim Nicholas Taleb was the best encapsulation of his thinking. Nassim, who subsequently wrote The Black Swan and Antifragile is definitely having a moment. On January 26, he co-wrote a paper warning about the systemic risk of coronavirus. And ever since, he has been vocal about the dangers of under-reacting, often by calling others idiots, as is his style.
What I connected with most in Fooled by Randomness is Nassim's belief that many market participants fool themselves about what is knowable. The only trader Nassim respected was George Soros, who maintained a very flexible trading strategy. At the time, I was also big on Soros and finding trading tricks to compensate for the fact that very little is knowable. Bruce Wayne had said he was so impressed with the book that he almost called Nassim. Around 2007, I was raising money for a US fund and talking to people who could help me. I actually did cold call Nassim. Be warned that all my phone call stories are lame, since, by definition, I did not meet the person. When I reached him, Nassim answered from a place that sounded like a bar. He said something like "I cannot speak with you, sir". He did not call me an idiot or ask whether I had skin in the game. He was very curious about how I had gotten his number. But as you know, I don't discuss sources or methods. That was the entirety of the call.
Nassim has been affiliated with a tail risk hedging operation run by Mark Spitznagel, called Universa Investments. After 2008, there had been lots of interest in tail risk hedging strategies. Since then, I had assumed Universa had fizzled given 10 years of relatively low vol. But it turns out, the firm has prospered and was recently managing $4 billion. The fund is reported to have been up by about a 1,000% in February and a multiple of that in March. At last, my quest for a fund with respectable performance is over.
Here's my summary of Fooled by Randomness:
Title: Fooled by Randomness, The Hidden Role of Chance in Life and in the Markets
Author: Nassim Nicholas Taleb (NNT)
The most basic point of Fooled is that the human mind is not very good at dealing with probability. Examples of probability mishandling / oddities of perception
-Cites a study that found that the majority of people will judge "a deadly flood (causing thousand 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)
-Birthday paradox: what’s the chance that someone you meet shares your birthday? 1/365.25. What’s the chance that at least 2 people will share a birthday in a dinner of 23? 50%. In the first case, two specified people are testing the hypothesis “We have the same birthday”. In the second, any birthday coincidence suffices.
The distinction is helpful in understanding the “data mining” problem. Data mining: if you look at enough data without any specific aim, you can find all types of spurious correlations, such as women’s hemlines and the economy.
On the difference between noise and signal
-Time scale is important in judging the historical significance of an event. For example, suppose you’re a trader with a 15% expected return with a 10% volatility: this translates into a 93% probability of success in a year but only slightly over 50% if measured in increments of one second. So even though you are bound to be profitable most years, you will experience losses from one second to the next half the time. Further, because psychologists estimate that the pain of loss is 2.5x the magnitude of the joy of a win, if you pay attention to short-term fluctuations, you will get drained.
Traits of "fools of randomness" (traders who blow up)
- overestimation of the accuracy of their beliefs in some measure, either economic or statistical
- a tendency to get married to their positions/beliefs
- the tendency to change their stories: becoming "investors for the long haul" when they are losing money, switching back and forth between being traders and investors to fit the latest reversal of fortune
- no precise game plan ahead of time as to what to do in the event of a loss
- unwillingness to critically reassess the situation...no allowance for the possibility that the original analysis was flawed
- denial: not accepting the message of the market, hanging on to some abstract "value"
NNT presents the idea of skewness or the shape of a probability distribution curve: how traders might forget the distinction between probability and expectation. For example, if a trader told you he sees a 70% probability that the market will go up in 3 months and that he's short the market, how would you reconcile the two statements? The trader expects that if the market falls it will fall big.
-A classic mistake of the type above is the common wisdom that “80% of options expire worthless”. This statement is misleading on many levels, including the fact that it doesn’t say anything about the magnitude of profits generated by options that are worth something.
-NNT cautions against strategies subject to skewness, e.g. a small chance of large losses and a large chance of a small win. "If you engaged in a Russian-roulette-type strategy with a low probability of a large loss, one that bankrupts you every several years, you are likely to show up as the winner in almost all samples except in the year when you are dead.”
The problem of induction, aka the black swan problem
-Has been haunting science for a long time and NNT says it’s very relevant to trading but largely ignored...as posed by philosopher David Hume: “no amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion"
-The problem of induction is a caution against naive empiricism. For example, take the well-known fact that car accidents happen closer to home....a naive empiricist might conclude that you're safer driving in remote places, when the only reasonable conclusion is that people spend more time driving closer to home.
-To use an example closer to the trading world, the fact that the market has never fallen 30% in a 3 month period does not mean that it will never happen. If you think that's a gimme, he gives the example of Victor Niederhoffer selling naked options based on his backtesting and blowing up an otherwise excellent track record spanning close to twenty years.
-Cautions against the “it never happened before” line of thinking. The worst that happened before cannot be equated with your maximum downside. Remember that the worst previous scenario displaced another previous worst scenario, so there’s nothing to say that a worse yet scenario might not be lurking in the future.
-NNT himself runs a trading shop where he tries to profit from rare events that give a large payoff when they do occur...he believes that rare events are not accurately priced. He constantly buys out-of-the-money options, accepting small losses frequently until one day when he makes a killing, when there’s a “black swan” event.
On George Soros
-Speaks admiringly of Soros: "he walked around calling himself fallible, but was so potent because he knew it while others had loftier ideas about themselves"
-Talks about Karl Popper (a seminal influence on Soros the philosopher) and his philosophies: verification is not possible...have you noticed how Soros keeps harping about something called an "Open Society"? An open society is one in which no permanent truth is held to exist, allowing counter-ideas to emerge.
-Says that Soros and other great speculators like him are devoid of “path dependency”...ie their decisions are not governed by past actions...they don’t mind switching to a faster horse, even if it means having to take a loss in the current position...they can sell something today and buy it higher tomorrow...every day is a clean slate.
On survivorship bias
Monkeys on typewriters: you might have seen the picture of a large (infinite) number of monkeys typing away on typewriters...if one of them happens to type the Illiad, would you sign a book deal with it?
How much faith can you put in past performance?
-For example it's well known that hedge fund databases with historical performance overstate the average performance of the entire hedge fund universe, since only managers with at least a passable track record will report their results.
-If you launch 10,000 imaginary investment managers with the condition that whether they are profitable or unprofitable in a given year is decided by the flip of a coin, 313 will have been profitable every year after five years, purely out of luck. Even with only a 45% chance of making money, the number is 184 (managers that might be called “spurious survivors”). In other words, even a population composed entirely of bad managers will produce a small amount of great track records.
-"Judging an investment proposal that comes to you requires more stringent standards than judging an investment you seek out, owing to adverse selection." Adverse selection: people who want to manage your money will have good track records to sell, otherwise they wouldn’t bother. By proactively going to a cohort composed of 10,000 managers, there's a 2% chance of finding a spurious (ie merely lucky) survivor...by answering calls, the chance of the caller being a spurious survivor is closer to 100%.
-In summary, always count the monkeys. The problem is that in real life, the losing monkeys fade away, you don't hear about them.
Other random quotes
-“Mild success can be explained by skill and labour. Wild success is attributable to variance.”
-"Option sellers eat like chicken and go to the bathroom like elephants"
-"The only article Lady Fortuna has no control over is your behavior. Good luck."