Fooled by Randomness (9 page)

If the tone of this book seems steeped in the culture of Darwinism and evolutionary thinking, it does not come from any remotely formal training in the natural sciences, but from the evolutionary way of thinking taught by my Monte Carlo simulators.

I reckon that I outgrew the desire to generate random runs every time I want to explore an idea—but by dint of playing with a Monte Carlo engine for years I can no longer visualize a realized outcome without reference to the nonrealized ones. I call that “summing under histories,” borrowing the expression from the colorful physicist Richard Feynman who applied such methods to examine the dynamics of subatomic particles.

Using my Monte Carlo to make and remake history reminded me of the experimental novels (the so-called new novels) by such writers as Alain Robbe-Grillet, popular in the 1960s and 1970s. There the same chapter would be written and revised, the writer each time changing the plot like a new sample path. Somehow the author was freed from the past situation he helped create and allowed himself the indulgence to change the plot retroactively.

Denigration of History

One more word on history seen from a Monte Carlo perspective. The wisdom of such classical stories as Solon’s prods me to spend even more time in the company of the classical historians, even if the stories, like Solon’s warning, have benefited from the patina of time. However, this goes against the grain: Learning from history does not come naturally to us humans, a fact that is so visible in the endless repetitions of identically configured booms and busts in modern markets. By history I refer to the anecdotes, not the historical theorizing, the grand-scale historicism that aims to interpret events with theories based on uncovering some laws in the evolution of history—the sort of Hegelianism and pseudoscientific historicism leading to such calls as the end of history (it is pseudoscientific because it draws theories from past events without allowing for the fact that such combinations of events might have arisen from randomness; there is no way to verify the claims in a controlled experiment). For me, history is of use merely at the level of my desired sensibility, affecting the way I would wish to think by reference to past events, by being able to better steal the ideas of others and leverage them, correct the mental defect that seems to block my ability to learn from others. It is the respect of the elders that I would like to develop, reinforcing the awe I instinctively feel for people with gray hair, but that has eroded in my life as a trader where age and success are somewhat divorced. Indeed, I have two ways of learning from history: from the past, by reading the elders; and from the future, thanks to my Monte Carlo toy.

The Stove Is Hot

As I mentioned above, it is not natural for us to learn from history. We have enough clues to believe that our human endowment does not favor transfers of experience in a cultural way but through selection of those who bear some favorable traits. It is a platitude that children learn only from their own mistakes; they will cease to touch a burning stove only when they are themselves burned; no possible warning by others can lead to developing the smallest form of cautiousness. Adults, too, suffer from such a condition. This point has been examined by behavioral economics pioneers Daniel Kahneman and Amos Tversky with regard to the choices people make in selecting risky medical treatments—I myself have seen it in my being extremely lax in the area of detection and prevention (i.e., I refuse to derive my risks from the probabilities computed on others, feeling that I am somewhat special) yet extremely aggressive in the treatment of medical conditions (I overreact when I am burned), which is not coherent with rational behavior under uncertainty. This congenital denigration of the experience of others is not limited to children or to people like myself; it affects business decision makers and investors on a grand scale.

If you think that merely reading history books would help you learn “from other’s mistakes,” consider the following nineteenth-century experiment. In a well-known psychology case the Swiss doctor Claparède had an amnesic patient completely crippled with her ailment. Her condition was so bad that he would have to reintroduce himself to her at a frequency of once per fifteen minutes for her to remember who he was. One day he secreted a pin in his hand before shaking hers. The next day she quickly withdrew her hand as he tried to greet her,
but still did not recognize him.
Since then plenty of discussions of amnesic patients show some form of learning on the part of people without their being aware of it and without it being stored in conscious memory. The scientific name of the distinction between the two memories, the conscious and the nonconscious, is declarative and nondeclarative. Much of the risk avoidance that comes from experiences is part of the second. The only way I developed a respect for history is by making myself aware of the fact that I was not programmed to learn from it in a textbook format.

Actually, things can be worse than that: In some respects we do not learn from our own history. Several branches of research have been examining our inability to learn from our own reactions to past events: For example, people fail to learn that their emotional reactions to past experiences (positive or negative) were short-lived—yet they continuously retain the bias of thinking that the purchase of an object will bring long-lasting, possibly permanent, happiness or that a setback will cause severe and prolonged distress (when in the past similar setbacks did not affect them for very long and the joy of the purchase was short-lived).

All of my colleagues who I have known to denigrate history blew up spectacularly—and I have yet to encounter some such person who has not blown up. But the truly interesting point lies in the remarkable similarities in their approaches. The blowup, I will repeat, is different from merely incurring a monetary loss; it is losing money when one does not believe that such fact is possible at all. There is nothing wrong with a risk taker taking a hit provided one declares that one is a risk taker rather than that the risk being taken is small or nonexistent. Characteristically, blown-up traders think that they knew enough about the world to reject the possibility of the adverse event taking place: There was no courage in their taking such risks, just ignorance. I have noticed plenty of analogies between those who blew up in the stock market crash of 1987, those who blew up in the Japan meltdown of 1990, those who blew up in the bond market débâcle of 1994, those who blew up in Russia in 1998, and those who blew up shorting Nasdaq stocks. They all made claims to the effect that “these times are different” or that “their market was different,” and offered seemingly well-constructed, intellectual arguments (of an economic nature) to justify their claims; they were unable to accept that the experience of others was out there, in the open, freely available to all, with books detailing crashes in every bookstore. Aside from these generalized systemic blowups, I have seen hundreds of option traders forced to leave the business after blowing up in a stupid manner, in spite of warnings by the veterans, similar to a child’s touching the stove. This I find to resemble my own personal attitude with respect to the detection and prevention of the variety of ailments I may be subjected to. Every man believes himself to be quite different, a matter that amplifies the “why me?” shock upon a diagnosis.

Skills in Predicting Past History

We can discuss this point from different angles. Experts call one manifestation of such denigration of history
historical determinism.
In a nutshell we think that we would know when history is made; we believe that people who, say, witnessed the stock market crash of 1929 knew then that they lived an acute historical event and that, should these events repeat themselves, they too would know about such facts. Life for us is made to resemble an adventure movie, as we know ahead of time that something big is about to happen. It is hard to imagine that people who witnessed history did not know at the time how important the moment was. Somehow all respect we may have for history does not translate well into our treatment of the present.

Jean-Patrice of the last chapter was abruptly replaced by an interesting civil servant type who had never been involved in the randomness professions. He just went to the right civil servant schools where people learn to write reports and had some senior managerial position in the institution. As is typical with subjectively assessed positions he tried to make his predecessor look bad: Jean-Patrice was deemed sloppy and unprofessional. The civil servant’s first undertaking was to run a formal analysis of our transactions; he found that we traded a little too much, incurring very large back office expenditure. He analyzed a large segment of foreign exchange traders’ transactions, then wrote a report explaining that only close to 1% of these transactions generated significant profits; the rest generated either losses or small profits. He was shocked that the traders did not do more of the winners and less of the losers. It was obvious to him that we needed to comply with these instructions immediately. If we just doubled the winners, the results for the institution would be so great. How come you highly paid traders did not think about it before?

Things are always obvious after the fact. The civil servant was a very intelligent person, and this mistake is much more prevalent than one would think. It has to do with the way our mind handles historical information. When you look at the past, the past will always be deterministic, since only one single observation took place. Our mind will interpret most events not with the preceding ones in mind, but the following ones. Imagine taking a test knowing the answer. While we know that history flows forward, it is difficult to realize that we envision it backward. Why is it so? We will discuss the point in
Chapter 11
but here is a possible explanation: Our minds are not quite designed to understand how the world works, but, rather, to get out of trouble rapidly and have progeny. If they were made for us to understand things, then we would have a machine in it that would run the past history as in a VCR, with a correct chronology, and it would slow us down so much that we would have trouble operating. 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,” just like journalists call decisions that end up costing a candidate his election a “mistake.” 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.

A more vicious effect of such hindsight bias is that those who are very good at
predicting
the past will think of themselves as good at predicting the future, and feel confident about their ability to do so. This is why events like those of September 11, 2001, never teach us that we live in a world where important events are not predictable—even the Twin Towers’ collapse appears to have been predictable
then.

My Solon

I have another reason to be obsessed with Solon’s warning. I hark back to the very same strip of land in the Eastern Mediterranean where the story took place. My ancestors experienced bouts of extreme opulence and embarrassing penury over the course of a single generation, with abrupt regressions that people around me who have the memory of steady and linear betterment do not think feasible (at least not at the time of writing). Those around me either have (so far) had few family setbacks (except for the Great Depression) or, more generally, are not suffused with enough sense of history to reflect backward. For people of my background, Eastern Mediterranean Greek Orthodox and invaded Eastern Roman citizens, it was as if our soul had been wired with the remembrance of that sad spring day circa 500 years ago when Constantinople, under the invading Turks, fell out of history, leaving us the lost subjects of a dead empire, very prosperous minorities in an Islamic world—but with an extremely fragile wealth. Moreover, I vividly remember the image of my own dignified grandfather, a former deputy prime minister and son of a deputy prime minister (whom I never saw without a suit), residing in a nondescript apartment in Athens, his estate having been blown up during the Lebanese civil war. Incidentally, having experienced the ravages of war, I find undignified impoverishment far harsher than physical danger (somehow dying in full dignity appears to me far preferable to living a janitorial life, which is one of the reasons I dislike financial risks far more than physical ones). I am certain that Croesus worried more about the loss of his Kingdom than the perils to his life.

There is an important and nontrivial aspect of historical thinking, perhaps more applicable to the markets than anything else: Unlike many “hard” sciences, history cannot lend itself to experimentation. But somehow, overall, history is potent enough to deliver, on time, in the medium to long run, most of the possible scenarios, and to eventually bury the bad guy. Bad trades catch up with you, it is frequently said in the markets. Mathematicians of probability give that a fancy name:
ergodicity.
It means, roughly, that (under certain conditions) very long sample paths would end up resembling each other. The properties of a very, very long sample path would be similar to the Monte Carlo properties of an average of shorter ones. The janitor in
Chapter 1
who won the lottery, if he lived one thousand years, cannot be expected to win more lotteries. Those who were unlucky in life in spite of their skills would eventually rise. The lucky fool might have benefited from some luck in life; over the longer run he would slowly converge to the state of a less-lucky idiot. Each one would revert to his long-term properties.

DISTILLED THINKING ON YOUR PALMPILOT

Breaking News

The journalist, my
bête noire,
entered this book with George Will dealing with random outcomes. In the next step I will show how my Monte Carlo toy taught me to favor distilled thinking, by which I mean the thinking based on information around us that is stripped of meaningless but diverting clutter. For the difference between noise and information, the topic of this book (noise has more randomness) has an analog: that between journalism and history. To be competent, a journalist should view matters like a historian, and play down the value of the information he is providing, such as by saying: “Today the market went up, but this information is not too relevant as it emanates mostly from noise.” He would certainly lose his job by trivializing the value of the information in his hands. Not only is it difficult for the journalist to think more like a historian, but it is, alas, the historian who is becoming more like the journalist.