How Randomness Masquerades as Luck and Skill
Nassim Taleb explores how traders confuse chance with skill, offering lessons on controlling emotion, avoiding excuses, and resisting crowd-driven errors.
Many events in our lives are decided by chance, even if we believe we made them happen singlehandedly. Financial traders can be especially prone to this mental defect. The feeling of turning a deposit into a 10x payout is a thrilling endorsement of a trader’s intelligence.
At least, that’s how it feels. That trader could’ve just been lucky. After all, social media accounts claiming to have foolproof trading strategies don’t show off the many other traders who bankrupted themselves by replicating the lucky trader’s strategy.
Former options trader Nassim Taleb wrote Fooled by Randomness to show the many ways we confuse random chance with an outcome caused by our own special brand of genius. He offers concrete ways to step back and view the world more clearly instead of assuming we have a special power to control reality lost to lesser creatures.
Daily Fluctuations Hide Annual Successes
Financial portfolios rise and fall every day. Watching an investment flip from 10% up to 5% down can be a source of panic for even experienced traders. However, Taleb points out that focusing on daily changes hides growth that can occur each month or year.
“Our emotions are not designed to understand the point,” Taleb wrote. “The dentist [an earlier example] did better when he dealt with monthly statements rather than more frequent ones. Perhaps it would be even better for him if he limited himself to yearly statements. (If you think that you can control your emotions, think that some peopole also believe that they can control their heartbeat or hair growth.)”
We can save ourselves a lot of heartbreak if we focus on the incremental gains we make in our lives instead of how similar we are to the previous day’s version of ourselves. However, being aware of this cognitive shortcoming doesn’t neutralize the intensity of negative feelings. Taleb explains:
“Regardless of what people claim, a negative pang is not offset by a postive one (some psychologists estimate the negative effect for an average loss to be up to 2.5 the magnitude of a postive one); it will lead to an emotional deficit.”
Misery Loves Company—And Excuses
Many of Taleb’s examples come from his experience as a professional options trader. One was a trader who amassed great losses, but managed to point the finger at an arbitrary industry benchmark, if only for a little while:
“His losses were mounting, but he kept telling his management rumors about very large losses among other banks—larger than his. He felt justified to show that ‘he fared well relative to the industry.’ This is a symptom of systemic troubles; it shows that there was an entire community of traders who were conducting the exact same activity. Such statemnts, that other traders had also gotten into trouble, are self-incriminating. A trader’s mental construction should direct him to do precisely what other people do not do.”
It’s one thing to look to other people for guidance. But when a large enough group of people makes the same mistakes, even smart people can justify them.
This mistake is especially devastating for traders. The whole point of trading is to make returns that outpace the market. It’s a risky profession, because mistakes lead to losses that also outpace the market.
If you’re acting the same way as everyone else, then you can and should expect the same or similar outcomes as they experience. Their failures may justify your own, but do you really want to perform the same as everyone else?
Justifying is a Major Mistake
Much of the advice in Fooled by Randomness boils down to avoiding changing one’s story to justify mistakes that are incorrectly attributed to chance. Taleb wrote:
“They [investors] 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…There is abolutely 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.”
The stories we tell ourselves can free us, as every proponent of fiction celebrates, but stories can also trap us. We can sell lies to ourselves instead of taking difficult steps to reverse or mitigate our mistakes.
Fooled by Randomness often invokes examples from finance, but its lessons apply well beyond it.