Fooled by Randomness (28 page)

COMPUTING INSTEAD OF THINKING

There is another story of probability other than the one I introduced with Carneades and Cicero. Probability entered mathematics with gambling theory, and stayed there as a mere computational device. Recently, an entire industry of “risk measurers” emerged, specializing in the application of these probability methods to assess risks in the social sciences. Certainly, the odds in games where the rules are clearly and explicitly defined are computable and the risks consequently measured. But not in the real world. For mother nature did not endow us with clear rules. The game is not a deck of cards (we do not even know how many colors there are). But somehow people “measure” risks, particularly if they are paid for it. I have already discussed Hume’s problem of induction and the occurrence of black swans. Here I introduce the scientific perpetrators.

Recall that I have waged a war against the charlatanism of some prominent financial economists for a long time. The points are as follows. One Harry Markowitz received something called the Nobel Memorial Prize in Economics (which in fact is not even a Nobel Prize, as it is granted by the Swedish Central Bank in honor of Alfred Nobel—it was never in the will of the famous man). What is his achievement? Creating an elaborate method of computing
future
risk if one knows
future
uncertainty; in other words, if the world had clearly defined rules one picks up in a rulebook of the kind one finds in a Monopoly package. Now, I explained the point to a cab driver who laughed at the fact that someone ever thought that there was any scientific method to understanding markets and predicting their attributes. Somehow when one gets involved in financial economics, owing to the culture of the field, one becomes likely to forget these basic facts (pressure to publish to keep one’s standing among the other academics).

An immediate result of Dr. Markowitz’s theory was the near collapse of the financial system in the summer of 1998 (as we saw in Chapters
1
and
5
) by Long Term Capital Management (“LTCM”), a Greenwich, Connecticut, fund that had for principals two of Dr. Markowitz’s colleagues,“Nobels”as well. They are Drs. Robert Merton (the one in
Chapter 3
trouncing Shiller) and Myron Scholes. Somehow they thought they could scientifically “measure” their risks. They made absolutely no allowance in the LTCM episode for the possibility of their not understanding markets and their methods being wrong. That was not a hypothesis to be considered. I happen to specialize in black swans. Suddenly I started getting some irritating fawning respect. Drs. Merton and Scholes helped put your humble author on the map and caused interest in his ideas. The fact that these “scientists” pronounced the catastrophic losses a “ten sigma” event reveals a Wittgenstein’s ruler problem: Someone saying this is a ten sigma either (a) knows what he is talking about with near perfection (the prior assumption is that it has one possibility of being unqualified in several billion billions), knows his probabilities, and it is an event that happens once every several times the history of the universe; or (b) just does not know what he is talking about when he talks about probability (with a high degree of certainty), and it is an event that has a probability higher than once every several times the history of the universe. I will let the reader pick from these two mutually exclusive interpretations which one is more plausible.

Note that the conclusions also reflect on the Nobel committee who sanctified the ideas of the gentlemen involved: Conditional on these events, did they make a mistake or were these events unusual? Is the Nobel committee composed of infallible judges? Where is Charles Sanders Peirce to talk to us about papal infallibilism? Where is Karl Popper to warn us against taking science—and scientific institutions—seriously? In a few decades will we look upon the Nobel economics committee with the same smirk as when we look at the respected “scientific” establishments of the Middle Ages that promoted (against all observational evidence) the idea that the heart was a center of heat? We have been getting things wrong in the past and we laugh at our past institutions; it is time to figure out that we should avoid enshrining the present ones.

One would think that when scientists make a mistake, they develop a new science that incorporates what has been learned from it. When academics blow up trading, one would expect them to integrate such information in their theories and make some heroic statement to the effect that they were wrong, but that now they have learned something about the real world. Nothing of the sort. Instead they complain about the behavior of their counterparts in the market who pounced on them like vultures, thus exacerbating their downfall. Accepting what has happened, clearly the courageous thing to do, would invalidate the ideas they have built throughout an entire academic career. All of the principals who engaged in a discussion of the LTCM events partook of a masquerade of science by adducing
ad hoc
explanations and putting the blame on a rare event (problem of induction: How did they know it was a rare event?). They spent their energy defending themselves rather than trying to make a buck with what they learned. Again, compare them with Soros, who walks around telling whoever has the patience to listen to him that he is fallible. My lesson from Soros is to start every meeting at my boutique by convincing everyone that we are a bunch of idiots who know nothing and are mistake-prone, but happen to be endowed with the rare privilege of knowing it.

The scientist’s behavior while facing the refutation of his ideas has been studied in depth as part of the so-called attribution bias. You attribute your successes to skills, but your failures to randomness. This explains why these scientists attributed their failures to the “ten sigma” rare event, indicative of the thought that they were right but that luck played against them. Why? It is a human heuristic that makes us actually believe so in order not to kill our self-esteem and keep us going against adversity.

We have known about this wedge between performance and self-assessment since 1954, with Meehl’s study of experts comparing their perceived abilities to their statistical ones. It shows a substantial discrepancy between the objective record of people’s success in prediction tasks and the sincere beliefs of these people about the quality of their performance. The attribution bias has another effect: It gives people the illusion of being better at what they do, which explains the findings that 80 to 90% of people think that they are above the average (and the median) in many things.

FROM FUNERAL TO FUNERAL

I conclude with the following saddening remark about scientists in the soft sciences. People confuse science and scientists. Science is great, but individual scientists are dangerous. They are human; they are marred by the biases humans have. Perhaps even more. For most scientists are hard-headed, otherwise they would not derive the patience and energy to perform the Herculean tasks asked of them, like spending eighteen hours a day perfecting their doctoral thesis.

A scientist may be forced to act like a cheap defense lawyer rather than a pure seeker of the truth. A doctoral thesis is “defended” by the applicant; it would be a rare situation to see the student change his mind upon being supplied with a convincing argument. But science is better than scientists. It was said that science evolves from funeral to funeral. After the LTCM collapse, a new financial economist will emerge, who will integrate such knowledge into his science. He will be resisted by the older ones, but, again, they will be much closer to their funeral date than he.

Fourteen

•

BACCHUS ABANDONS ANTONY

W
hen the classicist aristocratic French writer Henry de Montherlant was told that he was about to lose his eyesight to a degenerative disease, he found it most appropriate to take his own life. Such is the end that becomes a classicist. Why? Because the stoic’s prescription was precisely to elect what one can do to control one’s destiny in front of a random outcome. At the end, one is allowed to choose between no life at all and what one is given by destiny; we always have an option against uncertainty. But such an attitude is not limited to stoics; both competing sects in the ancient world, stoicism and Epicureanism, recommended such control (the difference between the two resides in minor technicalities—neither philosophies meant then what is commonly accepted today in middlebrow culture).

Being a hero does not necessarily mean such an extreme act as getting killed in battle or taking one’s life—the latter is only recommended in a narrow set of circumstances and considered cowardly otherwise. Having control over randomness can be expressed in the manner in which one acts in the small and the large. Recall that epic heroes were judged by their actions, not by the results. No matter how sophisticated our choices, how good we are at dominating the odds, randomness will have the last word. We are left only with dignity as a solution—dignity defined as the execution of a protocol of behavior that does not depend on the immediate circumstance. It may not be the optimal one, but it certainly is the one that makes us feel best.
Grace under pressure,
for example. Or in deciding not to toady up to someone, whatever the reward. Or in fighting a duel to save face. Or in signaling to a prospective mate during courtship: “Listen, I have a crush on you; I am obsessed with you, but I will not do a thing to compromise my dignity. Accordingly, the slightest snub and you will never see me again.”

This last chapter will discuss randomness from a totally new angle; philosophical but not the
hard
philosophy of science and epistemology as we saw in Part I with the
black swan problem.
It is a more archaic,
softer
type of philosophy, the various guidelines that the ancients had concerning the manner in which a man of virtue and dignity deals with randomness—there was no real
religion
at the time (in the modern sense). It is worthy of note that before the spread of what can be best called Mediterranean monotheism, the ancients did not believe enough in their prayers to influence the course of destiny. Their world was dangerous, fraught with invasions and reversals of fortune. They needed substantial prescriptions in dealing with randomness. It is such beliefs that we will outline next.

NOTES ON JACKIE O.’S FUNERAL

If a stoic were to visit us, he would feel represented by the following poem. To many (sophisticated) lovers of poetry, one of the greatest poets who ever breathed is C. P. Cavafy. Cavafy was an Alexandrian Greek civil servant with a Turkish or Arabic last name who wrote almost a century ago in a combination of classical and modern Greek a lean poetry that seems to have eluded the last fifteen centuries of Western literature. Greeks treasure him like their national monument. Most of his poems take place in Syria (his Grecosyrian poems initially drew me to him), Asia Minor, and Alexandria. Many people believe it worth learning formal semi-classical Greek just to savor his poems. Somehow their acute aestheticism stripped of sentimentality provides a relief from centuries of mawkishness in poetry and drama. He provides a classical relief for those of us who were subjected to the middle-class-valued melodrama as represented by Dickens’s novels, romantic poetry, and Verdi’s operas.

I was surprised to hear that Maurice Tempelsman, last consort of Jackie Kennedy Onassis, read Cavafy’s valedictory “Apoleipein o Theos Antonion” (“The God Abandons Antony”) at her funeral. The poem addresses Marc Antony, who has just lost the battle against Octavius and was forsaken by Bacchus, the god who until then had protected him. It is one of the most elevating poems I have ever read, beautiful because it was the epitome of such dignified aestheticism—and because of the gentle but edifying tone of the voice of the narrator advising a man who had just received a crushing reversal of fortune.

The poem addresses Antony, now defeated and betrayed (according to legend, even his horse deserted him to go to his enemy Octavius). It asks him to just bid her farewell, Alexandria the city that is leaving him. It tells him not to mourn his luck, not to enter denial, not to believe that his ears and eyes are deceiving him. Antony, do not degrade yourself with empty hopes. Antony,

While shaken with emotion. No stiff upper lip. There is nothing wrong and undignified with emotions—we are cut to have them. What is wrong is not following the heroic or, at least, the dignified path. That is what
stoicism
truly means. It is the attempt by man to get even with probability. I need not be nasty at all and break the spell of the poem and its message, but I cannot resist some cynicism. A couple of decades later, Cavafy, while dying of throat cancer, did not quite follow the prescription. Deprived of his voice by the surgeons, he used to randomly enter undignified spells of crying and cling to his visitors, preventing them from leaving his death room.

Some history. I said that stoicism has rather little to do with the stiff-upper-lip notion that we believe it means. Started as an intellectual movement in antiquity by a Phoenician Cypriot, Zeno of Kition, it developed by Roman time into a life based on a system of virtues—in the ancient sense when virtue meant
virtu,
the sort of belief in which virtue is its own reward. There developed a social model for a stoic person, like the gentlemen in Victorian England. Its tenets can be summarized as follows: The stoic is a person who combines the qualities of wisdom, upright dealing, and courage. The stoic will thus be immune from life’s gyrations as he will be superior to the wounds from some of life’s dirty tricks. But things can be carried to the extreme; the stern Cato found it beneath him to have human feelings. A more human version can be read in Seneca’s
Letters from a Stoic,
a soothing and surprisingly readable book that I distribute to my trader friends (Seneca also took his own life when cornered by destiny).

RANDOMNESS AND PERSONAL ELEGANCE

The reader knows my opinion on unsolicited advice and sermons on how to behave in life. Recall that ideas do not truly sink in when emotions come into play; we do not use our rational brain outside of classrooms. Self-help books (even when they are not written by charlatans) are largely ineffectual. Good, enlightened (and “friendly”) advice and eloquent sermons do not register for more than a few moments when they go against our wiring. The interesting thing about stoicism is that it plays on dignity and personal aesthetics, which are part of our genes. Start stressing personal elegance at your next misfortune. Exhibit
sapere vivere
(“know how to live”) in all circumstances.

Dress at your best on your execution day (shave carefully); try to leave a good impression on the death squad by standing erect and proud. Try not to play victim when diagnosed with cancer (hide it from others and only share the information with the doctor—it will avert the platitudes and nobody will treat you like a victim worthy of their pity; in addition, the dignified attitude will make both defeat and victory feel equally heroic). Be extremely courteous to your assistant when you lose money (instead of taking it out on him as many of the traders whom I scorn routinely do). Try not to blame others for your fate, even if they deserve blame. Never exhibit any self-pity, even if your significant other bolts with the handsome ski instructor or the younger aspiring model. Do not complain. If you suffer from a benign version of the “attitude problem,” like one of my childhood friends, do not start playing nice guy if your business dries up (he sent a heroic e-mail to his colleagues informing them “less business, but same attitude”). The only article Lady Fortuna has no control over is your behavior. Good luck.