Friday 26 June 2009

Randomness

If you wonder why you lost all your money in the financial crisis or why people get it wrong when it comes to statistics, here is what could read: Fooled by Randomness and The Black Swan by Nassim Nicholas Taleb. The first one is about how we are unable to understand chance intuitively and the second one particularly about the rare event that may compensate everything that came before it. And he has a really nice writing style.

According to the "narrative fallacy" you are more likely to believe my point if I tell you a story, alright: Let's say you are playing "Mensch ärgere dich nicht" or some other game with a die. For many rounds now you have not been able to get a 6. Are you more likely to get a 6 in the next round? "Next time it really has to be a 6!" But of course the chance is still 1/6. Or to apply Taleb's street smarts logic: Someone is probably cheating and the chance for a 6 is even lower.

To stay with games, there is also what Taleb calls the "ludic fallacy": People tend to think that the kind of randomness that matters is the one that follows a known statistical distribution. But it is the events that no-one thought about that matter, or the ones that do not happen in "ten billion times the age of the universe according to our model" ... the Black Swans.

So what is the problem: of course evolution. Our rational thinking (or "Reflective System") is fairly new in evolutionary terms and it does not really play a role when it comes to making decisions (at least not as much we would think it does). What really drives us is intuition (or the "Automatic System"). And statistics in the Automatic System come in the sense of heuristics.[1] The problem is that these heuristics only really apply to Stone Age conditions. For example they don't take into account that the person on whose clothes you just spilled your coffee cup is a complete stranger that will be 5000 miles across the ocean within a few hours. So you will apologize and try to help even though this behavior is probably nicer than what would be purely rational. In this case it was good but the problem is that our intuitive heuristics fail in many cases.

Actually this brings me to another nice point which is interesting, at least from a slightly academic point of view. A major question in trading is if it is possible to be on average better than someone who buys purely at random.[2] Let's assume some stock is lower in value than it should be according to some economic considerations. If there is a way to find out, people will buy the stock and the price will go up until the stock is not cheap anymore. Therefore it is very difficult to get rich in the stock market through information unless you are either very smart or very quick. But in our real world stock prices are not ideal but biased by humanness (e.g. because of people that think that they are very smart or very quick, or generally herding phenomena, and so on). So stock prices will reflect the real value with a bias by human (Stone Age) intuition. All you have to do to get rich, is counter-intuitive trades. I like the thought but the problem in economics is always that oversimplified theories lead to elegant results but to the destruction of trillion dollar hedge funds. Anyway in essence my point is similar to what Taleb says only that he gives the examples.

[1] Some of these things are nicely explained in the first part of "Nudge" by Thaler and Sunstein. In the second part they will probably explain how to nudge people to do the right thing but I am not there yet. "Nudge" is also a nice book but it is a bit too academic to be an easy read ...

[2] Here the point is average. You can (and should) affect the deviation by diversification. In case we are talking about your funds you should keep the deviation low. If it is someone else's money, you should gamble. If it goes up use the hype to get rich. And when it crashes, you should disappear or take the settlement, depending on your contract.