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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Can you think of a rare event—that happened either in history or in your personal life? Looking back, how likely is it to it happen again? More generally, do you think people under- or overestimate the likelihood of rare events?
Rare events happen infrequently enough that we sometimes are lulled into believing they’re rarer than they actually are so that when they do happen, we are more surprised than we should be. According to Nassim Taleb, the author of Fooled by Randomness, people tend underestimate the likelihood of rare events for these reasons: 1) we don’t properly interpret the past, 2) we can’t predict the future.
We’ll explore these two concepts below.
We Don’t Properly Interpret the Past
One reason we’re bad at assessing and preparing for risk and random events is that we are not good at learning from the past. We mistakenly believe that because something has never happened before, it can’t happen now. We then defend our lack of planning accordingly: “That had never happened before!”
A longer-term examination of history shows that rare events of all kinds do, indeed, happen. The very definition of a rare event is its unpredictability. History is littered with examples of events that never happened before. If history’s past brought surprises, why shouldn’t our own past do the same?
Even when we do remember a past rare event, we tend to falsely believe that we now understand the events that led up to it, and we therefore think we can “predict” it; that is, if it were to happen again, we wouldn’t be taken by surprise. We’d be more prepared for, and therefore less exposed to, any negative fallout from a similar rare event.
We also tend to falsely believe that mistakes of the past that led to these events have been resolved, making it even more unlikely that they would happen again. For example, people know that 1929 proved that stock markets can crash, but they often chalk that up to specific causes of that time. They believe, in other words, that the event is contained and non-repeatable.
We thus like to imagine that if we were to live through certain historical events, such as the stock market crash of 1929, we would recognize the signs and wouldn’t be taken by surprise in the way that people at the time were. This is the “hindsight bias,” otherwise known as the “I knew it all along” claim. However, seeing something clearly after the fact is much easier than seeing it clearly in real time.
In the same way, a manager taking over a trading department might do an analysis and find that only a small percentage of the trades made that past year were profitable. She might then point out that the solution is to simply make more of the profitable trades, and less of the losers. Unfortunately, such a statement of the obvious doesn’t provide any usable guidance for future trading decisions.
We Can’t Predict the Future
Not only do we incorrectly interpret the past, but we also have trouble using lessons of the past to predict future rare events—no matter how hard we try—for three primary reasons:
- Noise prevents clarity: Only the passage of time allows us to properly judge which pieces of information end up being consequential.
- Structures change: The structure of the past can be so different from the structure of the future that lessons learned from history might fit today’s world only clumsily.
- The future is changeable: If everyone could predict the future, the future would then change, and would once again become unpredictable.
These three reasons are explored further below.
Reason #1: Noise Prevents Clarity
When people think they could have correctly predicted past rare events, they think that they can also correctly predict contemporary or future rare events. However, we can typically only have clarity on an event through the lens of time passed; in real time, there’s usually too much “noise” to be able to judge what’s consequential and what’s not.
“Noise” is the overwhelming deluge of facts that bombards us from newspapers, television, online outlets, and so on. It includes up-to-the-minute stock fluctuations, daily explanations of market moves, and endless analyses of companies—most of which will be out of business within a decade.
Small changes in the market are most likely random, and paying close attention to them can lead you astray, convincing you that unimportant things have larger consequences than they actually do. This means that noise is not just useless, but can be actively harmful, if it leads you to make bad decisions, such as selling a stock abruptly because of minor movements, when it would have been wiser to hang onto it. Only the passage of time reveals what is important and what is noise: Time filters out the inconsequential changes and allows you to see what matters, since it reveals which changes ultimately prove unimportant and which change the direction of history.
This is especially true for stock prices. Looking at the minutiae of constant price changes means you are focusing on the variance but not the returns. It’s unhelpful, and the negative moments may even convince you to act prematurely. Imagine an investor is sitting on a portfolio that has a 90 percent chance of increasing over the course of a year. If she checks the stock prices every minute, she might experience 250 happy minutes each day as prices rise and 240 unhappy minutes as prices fall.
Because a person reacts more strongly to negative news than positive, she’ll end each day exhausted. She’ll also have 240 instances during which she’ll question her strategy and consider changing course. However, if she only checks her balance yearly, she’ll experience 9 happy moments for every one unhappy one, if that 90 percent chance of increase means she’ll have good news 9 out of 10 years. Time will have filtered out the unhelpful noise.
This idea also holds for world events. The daily news covers all events, consequential or not, while historians can see, with the benefit of hindsight, which events turned out to be transformative.
Reason #2: Structures Change
Often when studying history to apply it to today, we look at one or two narrowly-framed past events and believe their lessons apply to the future as a whole—at least as it relates to that general type of event—without taking into account all the ways in which the world constantly changes on a fundamental level.
So many details change in the way things work that it calls into question the usefulness of studying history at all—except, of course, to acknowledge its ability to serve up surprises. Lessons from previous eras may not apply to today. For example, the Asian markets of the 1990s bear little resemblance to the ones of today now that the structure of the world economy has changed so dramatically, so market strategies that worked back then might not work now.
Likewise, because the structure of the past can be so different from the structure of the future, we can only see similarities between the two from a distance, after the events have passed. In the moment, we’re too close to judge. This is true for connections between specific past and future events as well as between broader past and future landscapes.
Reason #3: The Future Is Changeable
The future eludes us in another way, too: It is affected not just by outside influences but also by our own understanding of those influences. Our predictions of the future can themselves change it.
For example, if traders as a whole notice that the market always rises in March, they would all buy stocks in February in anticipation of the rise. Consequently, the market would no longer rise in March; it would rise in February.
Because of this, even if we could fully and properly understand the past, if everyone did so, our predictions would no longer hold true because the preparations people would make for a future event would prevent the event from happening as expected. The tendency of the future to repeat the past depends upon our being driven by the same invisible forces that drove past events. Thus, rare events like stock sell-offs exist because they are unexpected; if they were expected, people would prepare for them and consequently, they wouldn’t happen.
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Here's what you'll find in our full Fooled By Randomness summary :
- 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