- Nassim Taleb has written a book about how we mistake skill from randomness, chance and luck. Though the ‘success stories’ go to great lengths to justify their wins, they’re most likely fooled by randomness; probabilistically some have to win, and these ‘winners’ fail to make allowance for the role of luck in their performance due to the attribution bias: “You attribute your successes to skills, but your failures to randomness.”
- Hindsight bias is another hindrance in terms of appreciating the role of luck and randomness. Investors fail to recognize that the story that did happen was merely one of many alternative stories that could have played out. Instead, they’re ‘victims’ of the “I knew it all along” effect.
- Quote of the book: “A mistake is not something to be determined after the fact, but in the light of the information until that point.”
The author of The Black Swan, Nassim Taleb, has written a book on randomness, chance and luck. Namely, how we mistake skill from luck in matters of succes and failures. This theme is explored via theories, calculations, narratives and common sense. Let’s explore!
Are you a skillful investor, or a lucky fool?
“Can we judge the success of people by their raw performance and their personal wealth?”, Nassim asks. In the eyes of these high net worth individuals who have succeeded, the answer is clear: yes. People who have been successful in their fields, i.e. portfolio managers, will go to great lengths to outline their unique secrets that paved their way to financial riches.
The truth, however, is that they’re most likely fooled by randomness, or “lucky fools” to quote Nassim. He substantiates that claim by saying that probabilistically someone has to come out on top. He goes on to ask the reader to imagine a population of 10,000 investment managers, each of whom starts out with $10,000. Each manager’s success for the year is determined by a coin toss. If it comes out heads, she looses her $10,000; tails, she wins $10,000. There’s thus a 50% probability he/she will succeed. At the beginning of year two, we’re down to 5,000 managers with $20,000 each. A year later, 2,500 managers with $40,000 each remain. Another year, 1,250 managers. In year 4, we’re left with 625 managers before finally reaching 313 in year 5. “We have now, simply in a fair game, 313 managers who made money for five years in a row. Out of pure luck.” (p. 153)
You see, someone has to be part of the – in this instance – top ~3%. When asked about their investment strategies they’ll surely rant and rave about their superior insights, analytical abilities and determination. But Nassim reminds us that “a large section of businessmen with outstanding track records will be no better than randomly thrown darts. […] However, they will fail to make an allowance for the role of luck in their performance. Lucky fools do not bear the slightest suspicion that they may be lucky fools – by definition, they do not know that they belong to such a category. They will act as if they deserved the money.” (p. 18)
Nassim goes on to say that nobody accepts randomness in one’s successes, only in one’s failures. That’s the essence of the attribution bias: We take credit for our successes, but point fingers at external factors when reflecting upon our failures: “You attribute your successes to skills, but your failures to randomness.” (p. 243) If you can’t repeat your successes year in and year out, you’re not skilled, you were lucky. Inspired by this book, Guy Spier, the author of The Education of a Value Investor, said in this Google Talk that he can’t be sure whether his 20-year track record of outperformance is due to luck or skill. Though Guy is famous for his humble nature, there is a lesson to extract from his statement and Nassim’s book: stay humble, and appreciate the role of luck and probabilities.
Hindsights Bias and Alternative Narratives
As we saw in afore illustration, a rather small segment of our original population of 10,000 investment managers were still standing in year 5. Let’s say that the investment managers are to be judged by their investment performance, and not a coin toss. What if a manager made an otherwise intelligent investment in year 1, which simply didn’t pan out, is he or she to be labelled as a failure? And what about the “lucky fool” who made a stupid bet, which happened to wrench off a neat profit, is he to be considered a succes?
Well, sure, the lucky fool did outperform, but he might as well have lost everything had another narrative played out. Let’s say our lucky fool invested in a biotech stock that competed to be the first company to launch a product to cure a given disease. Had one of the many competitors won the race, thus making his investment worthless, he would be the failure. On the other hand, our failure’s “intelligent investment”, which turned out to be a “mistake”, could have worked out. In length, Nassim has a refreshing perspective:
“When you look at the past, the past will always be deterministic, since only one single observation took place. […] Psychologists call this overestimation of what one knew at the time of the event due to subsequent information the hindsight bias, the “I knew it all along” effect.” Now the civil servant called the trades that ended up as losers “gross mistakes”. […] I will repeat this point until I get hoarse: A mistake is not something to be determined after the fact, but in the light of the information until that point.” (p. 56)
A mistake is not something to be determined after the fact, but in the light of the information until that point. What an absolutely profound comment – and a great comfort to those of us who have tried being convinced of an investment idea’s merits, just to witness said idea turning sour because of some information that wasn’t available at the time of the investment decision. In afore scenario, our “lucky fool” happened to be rewarded for a poor decision. That it turned out profitably doesn’t suddenly change the fact that it was indeed a poor decision; no, it was a stupid bet, which happened to pan out – because of luck. Hence, bad decisions may result in profits, and good decisions in losses.
The lesson? Appreciate the stories that did happen when your investment thesis plays out, and be aware that others could just as easily have been realized. Nassim’s take-away is this: he’s aware that he’s a “mistake-prone idiot”, but “happens to be endowed with the rare privilege of knowing it” (p. 243), and acts accordingly. Namely, at the time an investment decision is made there’s an array of stories that may play out, but you have to act based on the decision you believe most strongly (based on probabilities, perhaps?) will take place.
Randomness, chance and luck are crucial elements to succes. Yet, Nassim acknowledges that success and chance favors those who are skillful and work hard. “Mild successes” are especially dependent on skills and energetic work efforts. “Wild successes”, however, are heavily dependent of luck and chance.
Let’s end this book summary with a quote from the preface to come full circle: “There is one world in which I believe the habit of mistaking luck for skill is most prevalent – and most conspicuous – and that is the world of markets.” (p. xlii)