Fooled by randomness

As I have briefly mentioned before, I have just finished reading Fooled by Randomness, by Nassim Taleb.

Taleb's take on the investing world is that in the spectrum of skill verses luck, many people attribute the success of successful traders, including the traders themselves, down to skill, whereas Taleb mostly attributes it to luck.  Even if the traders have demonstrated "long running" success, Taleb attributes this to survivorship bias rather than skill.  He believes that many traders essentially follow a well masked "increase risk until you blow up" strategy, he says that it's only a matter of time until they actually blow up, and there is no point praising those that are yet reach that point.

Taleb's investing "skill" is essentially to play odds arbitrage. He has spotted a situation where most other traders mis-price the odds of rare "black swan" events, and so takes advantage of this situation. Betting on mis-priced black swan events means that Taleb loses more often than he wins.  This strategy leads to him losing small amounts often, and occasionally winning large amounts.  The psychological cost of losing often causes the mis-price, despite the occasional wins being so large as to more than makes up for the previous losses.

When I was younger, a friend's father once told me secret strategy to roulette, and that was simply to double your bet of you lose, thus winning back your loses, plus a profit.  When I told my father - a professional punter, and thus had some experience with gambling - that I had the secret to roulette, and told him what it was, he took his time before simply explaining that "the problem with that strategy is that no-one has infinitely deep pockets".  Being a budding programmer, I knew that I could simply write a program to discover exactly how deep my pockets needed to be before I was guaranteed to be able to cover all cases.  I can't remember the exact numbers, but it was something like $5,000, assuming an initial bet of $1, to ensure that I couldn't lose, in the time it took me to ran the program, and not get completely bored of waiting.  With the answer now locked in, I told my father that I had the answer, and, again he pointed out the folly: "So, you going to the casino with $5,000 to place a $1 bet, and eventually you might be betting the whole $5,000 just to win another $1, and you haven't even considered that the board has a zero on it".

Apparently the idea of simulating gambling games has a name - the Monte Carlo method.  Taleb talked about it rather fondly but I couldn't really get excited about it, given how obvious it was to me as a youngster.

An appealing aspect of the book is the lifestyle that Taleb claims to live.  To me, it's the dream lifestyle, spending most of his timing reading and traveling slowly, and enjoying life.  He doesn't pay much attention to the news of the day. Instead, he simply waits for the arbitrage opportunities to come along, and only plays the game when the odds are in his favor.

I've always believed that it is better to invest rather than trade, as investing, done right, is a positive some game, whereas trading is a zero sum game. I've never been completely anti trading, just that one needs to be sure that one has an edge of skill, and can therefore ensure that the money flows from the other players to him, rather than from him to the the other players.  I think that Taleb has nailed this.