This article is an excerpt from the Shortform book guide to "Fooled By Randomness" by Nassim Nicholas Taleb. Shortform has the world's best summaries and analyses of books you should be reading.
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Are you a good judge of risk? What factors do you take into account when trying to anticipate risks involved in a project or an endeavor?
According to Nassim Nicholas Taleb, the author of Fooled by Randomness, most people are poor judges of risk because they do not fully comprehend the power of randomness. As a result, they harbor misguided beliefs about risk that lead them to make poor decisions.
In this article, we’ll look at the characteristics of people who fail to anticipate risk properly and discuss specific things you can do to anticipate risk mindfully.
How Our Misguided Beliefs Lead to Failure
Traders—and others in fields affected greatly by randomness, such as economics or politics—often have the same set of qualities that lead them to misevaluate risk and make poor decisions:
- They are overconfident in their beliefs: They don’t see that what worked for them in the past may have worked because of coincidence. They don’t see that analysis of past events obscures the random element of it. Traders who blow up typically think that they were such experts that the risk of failure was non-existent. When traders take risks under such a misbelief, it’s ignorance, not courage, that drives them.
- They don’t think ahead: They don’t plan for their strategy to fail and they act emotionally to pressure. If the market falls, they may start buying more stocks simply because they panic, not because of a predetermined strategy.
- They don’t stay the course, or they stay too long: Sometimes traders vacillate between short-term and long-term strategies because they react emotionally to noise they should ignore. Other times they stubbornly ignore noise that has turned into meaning, choosing to ride out a sinking market instead of cutting their losses.
- They think too simply: Trained to boil arguments down to their most simplistic forms, they are unprepared for the greater complexity that governs the randomness and probabilities of the market. Simplicity works for many business matters like the logistics of bringing a product to market, but it does not work for matters that have more mathematical complexity and cannot be simplified.
How to Avoid Failure in a Random World
To avoid developing the misguided beliefs above and thus avoid failure, remember that success built on hard work and smart choices is more lasting than that built on luck. Therefore, try to avoid accumulating success that relies on luck. Be aware of the ways your instincts and emotions blind you to the roulette wheel. Prepare for risks and don’t expose yourself to losses you wouldn’t be able to handle.
Some specific thoughts on how to develop this mindset follow.
Anticipate Your Emotional Reactions
It is hard to act rationally when we have irrational biases driving us, even when we know better. We often know how we’re supposed to act, but we act impulsively anyway. The problem is not lack of knowledge, it’s poor execution.
As humans, we are pre-programmed to react emotionally to stimuli. The best—and often only—way to prevent our emotions from clouding our judgment is to eliminate the triggers that activate them. For example, if you can’t control your cravings for chocolate, your best strategy would be to simply not keep it in your desk. In the same way, limit your exposure to market triggers.
To prevent unnecessary emotional reactions to noise, limit your exposure to the daily barrage of information available to you: Don’t read the market reports, don’t watch television, and don’t scroll through online finance analyses. Insulate yourself from small shifts that might grab you emotionally and cause you to make rash moves.
Set some parameters for your data so that you are only alerted when the market makes relatively large moves, the size of which you specify in advance. (Keep in mind that changes are not linear in their significance. A 2 percent change is not just twice a 1 percent change; it is more like 4 to 10 times, depending on the specifics of the numbers. Determine your threshold for significance with this in mind.)
Essentially, filter noise the way an engineer filters background static from a phone call. A phone’s technology detects sounds that have small changes in amplitude, pegs them as noise, and filters them out so that only sounds with significant changes in amplitude are delivered to the listener. Without such technological help, our ears have trouble picking out the voices from the noise. In the same way, our brains have trouble picking out important changes from noise, especially when we are also being bombarded with “expert” advice.
Don’t Think Like a Bull or a Bear
Don’t focus on whether the market will rise (as in a bullish market) or fall (as in a bearish one); focus instead on the impact that either movement will have on your results. Correctly predicting small market movements might earn you small gains, but hedging against large drops or rises can be much more profitable.
Aim to make money from rare events rather than from slow and steady bets; rare events—either positive or negative—tend to be more profitable in the long run. Act like a crisis hunter: someone who keeps alert for unusual opportunities or unlikely threats, and plans to profit off either accordingly. Crisis hunters are the ones shorting the market to anticipate a large drop, or buying options in the hopes of an unlikely price jump. Even if those scenarios are less likely than market stability, they can pay much more handsomely and are therefore worth seeking out.
For example, if you judge the market has an 80 percent chance of rising, but would only rise by two percent, but if it falls, would fall by 20 percent, you’re better off shorting the market and betting on the fall, as doing so will earn you higher returns.
Be Aware of Your Superstitions
Superstitions are an innate part of the human psyche: People instinctively look for connections between unrelated objects, events, or patterns and tend to be more primed to accept a hypothesis than to reject it. Therefore, if we are presented with a hypothetical possibility that our good fortune is caused by something like what we ate for breakfast that morning or a quirky market strategy we used, we are more likely to consider it than to dismiss it outright.
Though you may associate superstitions with cultural myths passed down from your grandparents, most people harbor at least a few superstitions that lead them to find causal links between two unrelated phenomena—like a certain pair of shoes bringing you a good trading day. These are sometimes referred to as “gambler’s ticks.”
Avoid being driven by such meaningless superstitions. Don’t look for connections where there are none—accept the random nature of your profession and resist attaching importance to unimportant things. Examine your attachment to your lucky pair of shoes or to an odd strategy, neither of which is actually lucky.
Don’t Stay Wedded to Your Positions
One trait common in traders who stay successful over the course of years is their willingness to change their positions at any moment. George Soros is renowned for it; he’ll talk bearishly about the market and then suddenly buy bullishly.
We referred to “path dependence” earlier when discussing how early success affects later success. To refresh, path dependence describes when a series of events unfolds in response to an initial, dominant event. In practice, it means that unless we consciously choose otherwise, we tend to be driven by the decisions we’ve already made, such as a decision to take a particular trading position.
This trait probably evolved to ensure a continuous society instead of one where people wake up every day and choose a different spouse, job, and kids. In the negative, though, it can mean a person does not question her emotional investment to a decision even when evidence shows she should.
This problem runs strongly in industries outside investing. For example, a scholar rarely suddenly contradicts all of her previous research. In fact, we say she “defends” her thesis; it would be unusual for her to change her position in the middle of her doctoral interview.
In the world of trading, this can be seen when traders continue to double down on losing positions, insisting that their strategy will one day be proven correct. It often leads to a blow up and an exit from the industry.
Instead of admitting they were wrong and incorporating the lessons they’ve learned into their understanding of the world, the trader blames market forces. It’s hard to admit that everything we’ve believed in and worked for up to this point has been wrong. But a better strategy is to acknowledge that you sometimes make mistakes and then incorporate the lessons you learn from those mistakes into your future decisions. Once you become comfortable accepting your fallibility, you’ll be better able to change your position if signs indicate it’s the wrong one.
Some Final Notes on Randomness
Sometimes randomness is an acceptable—even desirable—part of the human experience. Outside of matters of survival, such as making a living through investing or other means, randomness can enhance a person’s life. For example, poetry is constructed of random-sounding phrases, and in fact, a computer-generated poem can often sound just as lyrical as a human-generated one. But within the world of business, minimizing—or on occasion, harnessing—randomness is a crucial element to building lasting success.
We don’t have control over the random events that happen to us. The best we can do is plan for them and react appropriately when they inevitably happen. Anticipate the risks you can predict, and allow room in your plans for those you can’t. Keep in mind that no matter how much you plan, randomness will always be ready to strike. Bear this in mind and react with dignity to the rare events that inevitably hit you:
- Greet misfortune with stoicism: a combination of wisdom and courage.
- Face the future with an optimistic yet accepting attitude.
- Don’t act like a victim. Don’t show self-pity.
- Be courteous to those below you; be forgiving of those who contributed to your misfortune.
- Remember that the only thing luck does not control is your attitude.
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- The outsized role luck plays in success
- How we’re fooled by randomness in many aspects of our lives
- How we can accommodate randomness in our lives once we’re aware of it