About the author assim Nicholas Taleb is the founder of Empirica Capital LLC, a crisis-hunting hedge fund operator, and a fellow at the Courant Institute of Mathematical Sciences of New York University. He has held a variety of derivative trading positions in New York and London and worked as an independent floor trader in Chicago. Taleb was inducted in February 2001 in the Derivatives Strategy Hall of Fame. Taleb received an MBA from the Wharton School and a Ph.D. from University Paris-Dauphine. He is the author of Dynamic Hedging: Managing Vanilla and Exotic Options (Wiley, 1997). BY The Hidden Role of Chance in the Markets and in Life NASSIM NICHOLAS TALEE eg • TEXE RE New York • London CONTENTS Preface and Acknowledgments xiii Chapter Summaries xvii Prologue 1 Mosques in the Clouds 1 PART I: SOLON'S WARNING - SKEWNESS, ASYMMETRY, INDUCTION 7 One: If You're So Rich Why Aren't You So Smart? 11 Nero Tulip 11 Hit by Lightning 11 Temporary Sanity 12 Modus Operandi 14 No Work Ethics 16 There Are Always Secrets 17 John the High-Yield Trader 17 An Overpaid Hick 19 viii CONTENTS The Red-Hot Summer 21 Serotonin and Randomness 22 Your Dentist Is Rich, Very Rich - 24 Two: A Bizarre Accounting Method 26 Alternative History 26 Russian Roulette 27 An Even More Vicious Roulette 28 Smooth Peer Relations 29 Salvation Via Aeroflot 30 Solon Visits Regine's Night Club 32 George Will Is No Solon: On Counterintuitive Truths 34 Humiliated in Debates 37 Risk Managers 38 Three: A Mathematical Meditation on History 40 Europlayboy Mathematics 40 The Tools 41 Monte Carlo Mathematics 43 Fun in My Attic 45 Making History 45 Zorglubs Crowding the Attic 46 Denigration of History 47 The Stove Is Hot 48 My Solon 50 Distilled Thinking on Your PalmPilot 51 Breaking News 51 Shiller Redux 53 Gerontocracy 55 Philostratus in Monte Carlo: On the Difference Between Noise and Information 56 Four: Randomness, Nonsense, and the Scientific Intellectual 60 Randomness and the Verb 60 Reverse Turing Test 62 CONTENTS ix The Father of All Pseudothinkers 64 Monte Carlo Poetry 64 Five: Survival of the Least Fit - Can Evolution Be Fooled by Randomness? 68 Carlos the Emerging Markets Wizard 68 The Good Years 71 Averaging Down 72 Lines in the Sand 72 John the High-Yield Trader 74 The Quant Who Knew Computers and Equations 75 The Traits They Shared 78 A Review of Market Fools of Randomness Constants 78 Naive Evolutionary Theories 81 Can Evolution be Fooled by Randomness? 82 Six: Skewness and Asymmetry 84 The Median Is Not the Message 84 Bull and Bear Zoology 86 An Arrogant 29-Year-Old Son 88 Rare Events 89 Symmetry and Science 90 The Rare Event Fallacy 93 The Mother of All Deceptions 93 Why Don't Statisticians Detect Rare Events? 96 A Mischievous Child Replaces the Black Balls 97 Seven: The Problem of Induction 99 From Bacon to Hume 99 Cygnus Atratus 100 Niederhoffer, Victorian Gentleman 100 Sir Karl's Promoting Agent i03 Location, Location 105 Popper's Answer 106 Open Society 108 vii CONTENTS Nobody Is Perfect 108 Pascal's Wager 109 Thank You Solon _ 110 PART lis MONKEYS ON TYPEWRITERS - SURVIVORSHIP AND OTHER BIASES 111 It Depends On the Number of Monkeys 114 Vicious Real Life 115 This Section 115 Eight: Too Many Millionaires Next Door 117 How To Stop the Sting of Failure 117 Somewhat Happy 117 Too Much Work 118 You're a Failure 119 Double Survivorship Biases 120 More Experts 120 Visibility Winners 122 It's a Bull Market 122 A Guru's Opinion 123 Nine: It Is Easier To Buy and Sell Than Fry an Egg 125 Fooled by Numbers 127 Placebo Investors 127 Nobody Has To Be Competent 128 Ergodicity 129 Life Is Coincidental 131 The Mysterious Letter 131 An Interrupted Tennis Game 132 The Birthday Paradox 132 It's a Small World! 132 Data Mining, Statistics, and Charlatanism 133 The Best Book I Have Ever Read! 134 The Backtester 134 A More Unsettling Extension 136 CONTENTS XI The Earnings Season: Fooled by the Results 136 Cancer Cures 137 Professor Pearson Goes to Monte Carlo (Literally): Randomness Does Not Look Random! 139 The Dog That Did Not Bark: On Biases in Scientific Knowledge 140 I Have No Conclusion 141 Ten: Loser Takes All - On the Nonlinearities of Life 142 The Sandpile Effect 142 Enter Randomness 144 Learning to Type 144 Mathematics Inside and Outside the Real World 146 Buridan's Donkey or the Good Side of Randomness 147 When It Rains, It Pours 148 Eleven: Randomness and Our Brain: We Are Probability Blind 149 Paris or the Bahamas? 149 Some Architectural Considerations 150 From Psychology to Neurobiology 152 Our Natural Habitat 153 Kafka in a Courtroom 154 An Absurd World 156 Kahneman and Tversky 157 Neurobiology 158 Examples of Biases in Understanding Probability 159 We Are Option Blind 160 Probabilities and the Media (More Journalists) 162 CNBC at Lunch Time 163 You Should Be Dead by Now 163 The Bloomberg Explanations 164 Filtering Methods 166 We Do Not Understand Confidence Levels 168 An Admission 168 xii CONTENTS PART Ills WAX IN MY EARS - LIVING WITH RANDOMITIS 169 I Am Not So Intelligent _ 172 The Odyssean Mute Command 173 Twelve: Gamblers' Ticks and Pigeons in a Box 175 Taxi-Cab English and Causality 175 The Skinner Pigeon Experiment 178 Philostratus Redux 179 Thirteen: Carneades Comes to Rome: On Probability and Skepticism 182 Carneades Comes to Rome 183 Probability the Child of Skepticism 184 Monsieur de Norpois's Opinions 185 Path Dependence of Beliefs 187 Computing Instead of Thinking 188 From Funeral to Funeral 190 Fourteen: Bacchus Abandons Antony 191 Notes on Jackie O.'s Funeral 192 Randomness and Personal Elegance 194 Epilogue: Solon Told You So 196 Beware the London Traffic Jams 196 Notes 197 Index 198 About TEXERE 204 PREFACE AND ACKNOWLEDGMENTS his book is the synthesis of, on one hand, the no-nonsense mathematical trader (self-styled "practitioner of uncertainty") who spent his life trying to resist being fooled by randomness and trick the emotions associated with uncertainty and, on the other, the aesthetically obsessed, literature-loving human being willing to be fooled by any form of nonsense that is polished, refined, original, and tasteful. I am not capable of avoiding being the fool of randomness; what I can do is confine it to where it brings some aesthetic gratification. Much has been written about our biases (acquired or genetic) in dealing with randomness over the past decade. My rules while writing this book have been to avoid discussing (a) anything that I did not either personally witness on the topic or develop independently, and (b) anything that I have not distilled well enough to be able to write on the subject with the slightest effort. Everything that remotely felt like work was out. I had to purge the text from passages that seemed to come from a visit to the library, including the scientific name dropping. I tried to use no quote that does not naturally spring from my memory and does not come from a writer whom I have intimately frequented over the years (I detest the practice of random use of borrowed wisdom - much on that, later). Aut tace aut loquere meliora silencio (only when the words outperform silence).