Fooled by Randomness (29 page)

Epilogue

•

SOLON TOLD YOU SO

Beware the London Traffic Jams

A
couple of years after we left him looking at John smoking a cigarette with a modicum of
schadenfreude,
Nero’s skepticism ended up paying off. Simultaneously as he beat the 28% odds, up to the point of complete cure, he made a series of exhilarating personal and professional victories. Not only did he end up sampling the next level of wealth but he got the riches right when other Wall Street hotshots got poor, which could have allowed him to buy the goods they owned at very large discounts, if he wanted to. But he acquired very little, and certainly none of the goods Wall Streeters usually buy. But Nero did engage in occasional excess.

Friday afternoon traffic in London can be dreadful. Nero started spending more time there. He developed an obsession with traffic jams. One day he spent five hours moving west from his office in the city of London toward a cottage in the Cotswolds, where he stayed most weekends. The frustration prompted Nero to get a helicopter-flying license, through a crash course in Cambridgeshire. He realized that the train was probably an easier solution to get out of town for the weekend, but he felt the urge for a pet extravagance. The other result of his frustration was his no less dangerous commuting on a bicycle between his flat in Kensington and his office in the city.

Nero’s excessive probability-consciousness in his profession somehow did not register fully into his treatment of physical risk. For Nero’s helicopter crashed as he was landing it near Battersea Park on a windy day. He was alone in it. In the end the black swan got its man.

ACKNOWLEDGMENTS
FOR THE UPDATED SECOND EDITION

Out of the Library

T
he book helped me break out of my intellectual isolation (not being a full-time academic offers plenty of benefits, such as independence and the avoidance of the dull parts of the process, but it comes at the cost of seclusion). I made many interesting dinner companions and pen pals among lucid thinkers through the first edition, and, thanks to them, I was able to make a second pass on some of the topics. In addition, I have gotten closer to my dream life thanks to the stimulation of discussion with people who share my interests; I feel that I need to pay the book back for that. There seems to be some evidence that conversations and correspondence with intelligent people is a better engine for personal edification than plain library-ratting (human warmth: Something in our nature may help us grow ideas while dealing and socializing with other people). Somehow there was the
pre-
and
post-Fooled
life. While the acknowledgments for the first edition hold more than ever, I would like to add here my newly incurred debt.

Shrinking the World

I first met Robert Shiller in person as we were seated next to each other at a breakfast panel discussion. I found myself inadvertently eating all the fruits on his plate and drinking his coffee and water, leaving him with the muffins and other unfashionable food (and nothing to drink). He did not complain (he may have not noticed). I did not know Shiller when I featured him in the first edition and was surprised by his accessibility, his humility, and his charm (by some heuristic one does not expect people who have vision to be also personable). He later drove me to a bookstore in New Haven, showed me
Flatland,
a scientific parable dealing with physics that he read when he was in high school, and told me to keep this book as it was in the first edition: short, personal, as close to a novel as possible, something I kept in mind throughout the exercise of this reworking (he tried to convince me to not do this second edition, I begged him to do a second one of his own
Irrational Exuberance,
be it only for my own consumption; I think that I won both points). Books have bubble dynamics of the type discussed in
Chapter 10
, a matter that makes an extra edition of an existing book far more likely to break through the critical point than a new one (network externalities make religions and fads fare incrementally better in their second editions than brand-new ones). The physicist and crash theorist Didier Sornette provided me with convincing arguments for the effectiveness of a second version; we are surprised that book publishers who thrive on informational cascades are not conscious of the point.

During much of the rewriting of this book I was under the energizing influence of two intense dinner conversations in Italy with Daniel Kahneman, which had the effect of “pushing” me to the next critical point of intellectual drive, after I saw that his work went so much deeper than mere rational choice under uncertainty. I am certain that his influence on economics (including the Nobel medal) focused people away from the breadth and depth and the general applicability of his discoveries. Economics is boring stuff, but
His work matters
I kept telling myself, not just because he is an empiricist, not just because of the contrast of the relevance of his work (and personality) with those of the other recent Nobel economists, but because of its far-reaching implications on far worthier questions: (a) He and Amos Tversky helped stand on its head the notion of man that we owe to the dogmatic rationalism of the Hellenistic age and which held for twenty-three centuries, with all the damaging consequences that we know of now; (b) Kahneman’s important work is on utility theory (in its different stages) with consequences on such significant things as happiness. Now understanding happiness is a
real
pursuit.

I had lengthy discussions with Terry Burnham, the biologist and evolutionary economist and co-author of
Mean Genes,
that unpretentious introduction to evolutionary psychology, who coincidentally turned out to be best friends with Jamil Baz, the childhood friend who was my sounding board with my early introspections on randomness two decades ago. Peter McBurney got me involved with the Artificial Intelligence community, which seems to fuse together the fields of philosophy, cognitive neuroscience, mathematics, economics, and logic. He and I started a voluminous correspondence on the various theories of rationality. Michael Schrage, one of my reviewers, is the epitome of the modern (hence scientific) intellectual—he has a knack of reading everything that seems to matter. He offers the conversation of a true intellectual, shielded from the straitjacket of academic pressures. Ramaswami Ambarish and Lester Siegel showed me (with their suspiciously unnoticed work) that if we are fooled by randomness with respect to plain performance, then performance differential is even harder to pin down. The writer Malcolm Gladwell sent me into some interesting parts of the literature on intuition and self-knowledge. Art De Vany, the insightful and brilliantly colorful economist who specializes in nonlinearities and rare events, started his introductory letter to me with the shibboleth “I despise textbooks.” It is encouraging to see someone with such depth in his thinking who can also have fun in life. The economist William Easterly showed me that randomness contributed to illusionary causes in economic development. He liked the link between being a skeptical empiricist and disliking monopolies on knowledge by institutions like governments and universities. I am grateful to Hollywood agent Jeff Berg, an enthusiastic reader, for his insights on the wild type of uncertainty that prevails in the media business. I have to thank the book for allowing me to have insightful dinner discussions with Jack Schwager, who seems to have thought of some of the problems longer than anybody alive.

Thank You, Google

The following people have provided me with help on this text. I was very fortunate to have Andreea Munteanu as an incisive reader and valuable sounding board; she spent hours away from her impressive derivatives job checking the integrity of the references on Google. Amanda Gharghour also helped with the search. I was also lucky to have Gianluca Monaco as the Italian translator; he found mistakes in the text that it would have taken me a century to detect (a cognitive scientist and book-translator-turned-student-of-mathematical-finance, he called up the publisher and appointed himself the translator). My collaborator, the philosopher of science Avital Pilpel, provided me with invaluable help with technical probability discussions. Elie Ayache, another Levantine-tradder-mathematician-physicist-turned-philosopher-of-science-probability-markets (though without the neurobiology), made me spend numerous hours at Borders Books in both the philosophy section and the science section. Flavia Cymbalista, Sole Marittimi (now Riley), Paul Wilmott, Mark Spitznagel, Gur Huberman, Tony Glickman, Winn Martin, Alexander Reisz, Ted Zink, Andrei Pokrovsky, Shep Davis, Guy Riviere, Eric Schoenberg, and Marco Di Martino provided comments on the text. George Martin was, as usual, an invaluable sounding board. The readers Carine Chichereau, Bruce Bellner, and Illias Katsounis, gracefully e-mailed me extensive errata. I thank Cindy, Sarah, and Alexander for support and the reminder that there are other things than probability and uncertainty.

I also have to thank my second home, the Courant Institute of Mathematical Sciences, for providing me with the right atmosphere to pursue my interests and teach and coach students while retaining my intellectual independence, particularly Jim Gatheral, who took the habit of heckling me while co-teaching the class. I am indebted to Paloma’s Donald Sussman and Tom Witz for their unusual insights; I am truly impressed by their heroic ability to understand the “black swan.” I also thank the Empirica members (we ban the use of the word
employees
) for fostering a climate of fierce and ruthless, truly cut-throat intellectual debate in the office. My coworkers make sure that not a single comment on my part can go without some sort of challenge.

I insist once again that without David Wilson and Myles Thompson this book would have never been initially published. But without Will Murphy, Daniel Menaker, and Ed Klagsbrun, who revived this book, it would have been dead. I thank Janet Wygal for her thoroughness (and patience) and Fleetwood Robbins for his assistance. Given their zeal, I doubt that many mistakes are left; however, those that remain are mine.

Postscript

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THREE AFTERTHOUGHTS IN THE SHOWER

O
wing to the subject’s tentacles and its author’s ruminating nature, this book keeps growing like a living object. I will add in this section a few post-thoughts I’ve had in the shower and in the few boring philosophy lectures I’ve attended (without wanting to offend my new colleagues in the thinking business, I discovered that listening to a speaker reciting
verbatim
his lecture notes makes me invariably daydream).

FIRST THOUGHT:
THE INVERSE SKILLS PROBLEM

The higher up the corporate ladder, the higher the compensation to the individual. This might be justified, as it makes plenty of sense to pay individuals according to their contributions. However, and in general (provided we exclude risk-bearing entrepreneurs), the higher up the corporate ladder, the
lower
the evidence of such contribution. I call this the
inverse rule.

I will be deriving the point by mere logical arguments.
Chapter 2
made the distinction between those skills that are visible (like the abilities of a dentist) and those that present more difficulty in nailing down, especially when the subject belongs to a randomness-laden profession (say, one that includes the occasional practice of Russian roulette). The degree of randomness in such an activity and our ability to isolate the contribution of the individual determine the visibility of the skills content. Accordingly, the cook at the company headquarters or the factory worker will exhibit their direct abilities with minimal uncertainty. These contributions may be modest but they are clearly definable. A patently incompetent professional cook who cannot distinguish salt from sugar or who tends to systematically overcook the meat would be easily caught, provided the diners have functioning taste buds. And if he gets it right by luck once, it also will be hard for him to get it right by sheer chance a second, third, and a thousandth time.

Repetitiveness is key for the revelation of skills because of what I called
ergodicity
in
Chapter 8
—the detection of long-term properties, particularly when these exist. If you bang one million dollars at your next visit to Las Vegas at the roulette table in one single shot, you will not be able to ascertain from this single outcome whether the house has the advantage or if you were particularly out of the gods’ favor. If you slice your gamble into a series of one million bets of one dollar each, the amount you recover will systematically show the casino’s advantage. This is the core of sampling theory, traditionally called the
law of large numbers.

To view it in another way, consider the difference between judging
on process
and judging
on results.
Lower-ranking persons in the enterprise are judged on both process and results—in fact, owing to the repetitive aspect of their efforts, their process converges rapidly to results. But top management is only paid on result—no matter the process. There seems to be no such thing as a foolish decision if it results in profits. “Money talks,” we are often told. The rest is supposed to be philosophy.

Now take a peek inside the chief executive suite. Clearly, the decisions there are not repeatable. CEOs take a small number of large decisions, more like the person walking into the casino with a single million-dollar bet. External factors, such as the environment, play a considerably larger role than with the cook. The link between the skill of the CEO and the results of the company are tenuous. By some argument, the boss of the company may be unskilled labor but one who presents the necessary attributes of charisma and the package that makes for good MBA talk. In other words, he may be subjected to the monkey-on-the-typewriter problem. There are so many companies doing all kinds of things that some of them are bound to make “the right decision.”

It is a very old problem. It is just that, with the acceleration of the power law–style winner-takes-all effects in our environment, such differences in outcomes are more accentuated, more visible, and more offensive to people’s sense of fairness. In the old days, the CEO was getting ten to twenty times what the janitor earned. Today, he can get several thousand times that.

I am excluding entrepreneurs from this discussion for the obvious reason: These are people who stuck their necks out for some idea, and risked belonging to the vast cemetery of those who did not make it. But CEOs are not entrepreneurs. As a matter a fact, they are often
empty suits.
In the “quant” world, the designation
empty suit
applies to the category of persons who are good at looking the part but nothing more. More appropriately, what they have is skill in getting promoted within a company rather than pure skills in making optimal decisions—we call that “corporate political skill.” These are people mostly trained at using PowerPoint presentations.

There is an asymmetry, as these executives have almost nothing to lose. Assume that two equally charismatic, empty-suit-style twin brothers manage to climb the corporate ladder to get two different jobs in two different corporations. Assume that they own good-looking suits, that they have MBAs, and that they are tall (the only truly visible predictor of corporate success is to be taller than average). They flip coins in secret and randomly take completely opposite actions, leading to great failure for one and great success for the other. We end up with a mildly wealthy, but fired, executive and his extremely wealthy, and still operating, twin brother. The shareholder bore the risk; the executives got the reward.

The problem is as old as leadership. Our attribution of heroism to those who took crazy decisions but were lucky enough to win shows the aberration—we continue to worship those who won battles and despise those who lost, no matter the reason. I wonder how many historians use luck in their interpretation of success—or how many are conscious of the difference between process and result.

I insist that it is not society’s problem but that of the investors. If shareholders are foolish enough to pay someone $200 million to just wear a good-looking suit and ring a bell, as they did with the New York Stock Exchange’s Richard Grasso in 2003, it is their own money they part with, not yours and mine. It is a corporate governance issue.

The situation is not much better in a bureaucratic economy. Outside the capitalistic system, presumed talent flows to the governmental positions, where the currency is prestige, power, and social rank. There, too, it is distributed disproportionately. The contributions of civil servants might be even more difficult to judge than those of the executives of a corporation—and the scrutiny is smaller. The central banker lowers interest rates, a recovery ensues, but we do not know whether he caused it or if he slowed it down. We can’t even know that he didn’t destabilize the economy by increasing the risk of future inflation. He can always fit a theoretical explanation, but economics is a narrative discipline, and explanations are easy to fit retrospectively.

The problem may not be incurable. It is just that we need to drill into the heads of those who measure the contribution of executives that what they see is not necessarily what is there. Shareholders, in the end, are the ones who are fooled by randomness.

SECOND THOUGHT: ON SOME ADDITIONAL
BENEFITS OF RANDOMNESS

Uncertainty and Happiness

Have you ever had a weeknight dinner in New York City with a suburban commuter? Odds are that the shadow of the schedule will be imprinted in his consciousness. He will be tightly aware of the clock, pacing his meal in such a way that he does not miss the 7:08 because after that one, there are no more express trains and he would be reduced to taking the 7:42 local, something that appears to be very undesirable. He will cut the conversation short around 6:58, offer a quick handshake, then zoom out of the restaurant to catch his train with maximal efficiency. You will also be stuck with the bill. Since the meal is not finished, and the bill is not ready, your manners will force you to tell him that it’s on you. You will also finish the cup of decaffeinated skim cappuccino all alone while staring at his empty seat and wondering why people get trapped by choice into such a life.

Now deprive him of his schedule—or randomize the time of departures of the trains so they no longer obey a fixed and known timetable. Given that what is random and what you do not know are functionally the same, you do not have to ask the New York area Metropolitan Transit Authority to randomize their trains for the purpose of the experiment: Just assume that he is deprived of knowledge of the various departure times. All he would know is that they operate about every, say, thirty-five minutes. What would he do under such a scenario? Although you might still end up paying for dinner, he would let the meal follow its natural course, then leisurely walk to the nearby station, where he would have to wait for the next train to show up. The time difference between the two situations will be a little more than a quarter of an hour. Another way to see the contrast between a known and an unknown schedule is to compare his condition to that of another diner who has to use the subway to go home, for an equivalent distance, but without a known and fixed schedule. Subway riders are freer of their schedule, and not just because of the higher frequency of trains. Uncertainty protects them from themselves.

Chapter 10
showed, with the illustration of Buridan’s donkey, that randomness is not always unwelcome. This discussion aims to show how some degree of unpredictability (or lack of knowledge) can be beneficial to our defective species. A slightly random schedule prevents us from optimizing and being exceedingly efficient, particularly in the wrong things. This little bit of uncertainty might make the diner relax and forget the time pressures. He would be forced to act as a
satisficer
instead of a
maximizer
(
Chapter 11
discussed Simon’s satisficing as a blend of satisfying and maximizing)—research on happiness shows that those who live under a self-imposed pressure to be optimal in their enjoyment of things suffer a measure of distress.

The difference between satisficers and optimizers raises a few questions. We know that people of a happy disposition tend to be of the satisficing kind, with a set idea of what they want in life and an ability to stop upon gaining satisfaction. Their goals and desires do not move along with the experiences. They do not tend to experience the internal treadmill effects of constantly trying to improve on their consumption of goods by seeking higher and higher levels of sophistication. In other words, they are neither avaricious nor insatiable. An optimizer, by comparison, is the kind of person who will uproot himself and change his official residence just to reduce his tax bill by a few percentage points. (You would think that the entire point of a higher income is to be free to choose where to live; in fact it seems, for these people, wealth causes them to increase their dependence!) Getting rich results in his seeing flaws in the goods and services he buys. The coffee is not warm enough. The cook no longer deserves the three stars given to him by the Michelin guide (he will write to the editors).The table is too far from the window. People who get promoted to important positions usually suffer from tightness of schedules: Everything has an allotted time. When they travel, everything is “organized” with optimizing intent, including lunch at 12:45 with the president of the company (a table not too far from the window), the Stairmaster at 4:40, and opera at 8:00.

Causality is not clear: The question remains whether optimizers are unhappy because they are constantly seeking a better deal or if unhappy people tend to optimize out of their misery. In any case, randomness seems to operate either as a cure or as Novocain!

I am convinced that we are not made for clear-cut, well-delineated schedules. We are made to live like firemen, with downtime for lounging and meditating between calls, under the protection of protective uncertainty. Regrettably, some people might be involuntarily turned into optimizers, like a suburban child having his weekend minutes squeezed between karate, guitar lessons, and religious education. As I am writing these lines I am on a slow train in the Alps, comfortably shielded from traveling businesspersons. People around me are either students or retired persons, or those who do not have “important appointments,” hence not afraid of what they call wasted time. To go from Munich to Milan, I picked the seven-and-a-half-hour train instead of the plane, which no self-respecting businessperson would do on a weekday, and am enjoying an air unpolluted by persons squeezed by life.

I came to this conclusion when, about a decade ago, I stopped using an alarm clock. I still woke up around the same time, but I followed my own personal clock. A dozen minutes of fuzziness and variability in my schedule made a considerable difference. True, there are some activities that require such dependability that an alarm clock is necessary, but I am free to choose a profession where I am not a slave to external pressure. Living like this, one can also go to bed early and not optimize one’s schedule by squeezing every minute out of one’s evening. At the limit, you can decide whether to be (relatively) poor, but free of your time, or rich but as dependent as a slave.

It took me a while to figure out that we are not designed for schedules. The realization came when I recognized the difference between writing a paper and writing a book. Books are fun to write, papers are painful. I tend to find the activity of writing greatly entertaining, given that I do it without any external constraint. You write, and may interrupt your activity, even in mid-sentence, the second it stops being attractive. After the success of this book, I was asked to write papers by the editors of a variety of professional and scientific journals. Then they asked me how long the piece should be. What? How long? For the first time in my life, I experienced a loss of pleasure in writing! Then I figured out a personal rule: For writing to be agreeable to me,
the length of the piece needs to remain unpredictable.
If I see the end of it, or if I am subjected to the shadow of an outline, I give up. I repeat that our ancestors were not subjected to outlines, schedules, and administrative deadlines.