We Study Billionaires - The Investor’s Podcast Network - TIP609: Fooled by Randomness by Nassim Taleb

Starting point is 00:00:00 You're listening to TIP. Hey, everyone, welcome to the Investors Podcast. I'm your host, Clay Fink, and today I'm so excited to share what I learned from reading this wonderful book called Fooled by Randomness by Nassim Taleb. Teleb is a well-known author and Options Trader, and we actually discussed his investment approach in detail with Scott Patterson back on episode 558. Teleb is also fairly well known for his books titled The Black Swan, Anti-Fragile, and Skin in the Game.

Starting point is 00:00:28 and Teleb, he's really essentially devoted his entire life to immersing himself in these problems of luck, uncertainty, probability, and knowledge. So during this episode, I'll be touching on the role of luck in investing, biases that get investors into trouble such as survivorship bias and the endowment effect, why we should develop a sense of skepticism and humility, the need to understand alternative histories, Teleb's personal trading strategy, distinguishing a good process, from a good outcome and much more. I really enjoyed going through this book and I'm so excited to share these lessons with you today. With that, I hope you enjoy today's episode. Celebrating 10 years and more than 150 million downloads. You are listening to the Investors Podcast Network. Since 2014, we studied the financial markets and read the books that influence self-made

Starting point is 00:01:24 billionaires the most. We keep you informed and prepared for the unexpected. Now, for your host, Claythink. All right, so diving right in here, as the title suggests, fooled by randomness, it really gave me an appreciation for the amount of randomness in financial markets and how markets might be a little bit noisier than we might realize. It's also a great read to really better understand investor psychology and how we can fool ourselves into making bad bets in the markets. Teleb has watched many traders get blown up due to overconfidence,

Starting point is 00:02:06 taking excess risk, and ignoring what the, market is trying to tell them. The tricky thing about financial markets is that it's really difficult, if not impossible, to distinguish luck from skill. If you have 100,000 people trying to invest successfully, it's no wonder that one of them will happen to turn out like Warren Buffett. Teleb isn't really trying to make the case that there are no skilled investors out there. Of course there are, because Teleb himself has made a living from trading in the markets.

Starting point is 00:02:34 The case he's really trying to make in the book is that a substantial amount of success, and investing is primarily driven by luck or factors totally outside of our control. The key idea he's trying to convey in the book is that things are a bit more random than we tend to think rather than things are entirely random. To be honest, it's actually pretty daunting to consider the massive role that luck plays into our lives. One common theme in the investment world is for people to turn to macro forecasters to hear their predictions and, you know, they seem to be quite confident in.

Starting point is 00:03:06 These experts are prone to not learn from their past failures of predicting market moves, and despite being wrong time and time again, they still seem to trick themselves into thinking that the next call is going to be correct. This also ties into hindsight bias and how past events almost always seem obvious and look less random with the benefit of hindsight. It's easy to think that markets would skyrocket after COVID and the Fed printed all that money, but zoom back to April of 2020, very important. few of us would have been so certain of such an outcome. Just think about your view of markets

Starting point is 00:03:41 today and how uncertain things feel. However, in the year ahead, however it plays out, it's going to be obvious however it does play out with the benefit of hindsight. Consider also the fact that people tend to underplay the role of luck when they're successful and overplay the role of luck when they fail. Teleb explains that this is largely emotions at play in the absence of deep critical thinking. A big lesson that Teleb shares in this book is to remain skeptical. He writes in the preface here, it certainly takes bravery to remain skeptical. It takes inordinate courage to introspect, to confront oneself, to accept one's limitations. Scientists are seeing more and more evidence that we are specifically designed by Mother Nature to fool ourselves, end quote.

Starting point is 00:04:28 So the reason to remain skeptical is because we live in an uncertain world. There are infinite number of different scenarios that can play out in the future, and we need to be humble enough to accept that the world is fundamentally uncertain. Taleb encourages us to think probabilistically. Instead of just thinking about how things turned out in reality, we must also consider the alternative outcomes that could have occurred, and as investors, prevent the risk of getting blown up or taken totally out of the game. Simple ways to have this happen is doing things like taking on leverage or even over-concentrating into one or two positions. He also has this great table in the prologue that shares the key themes of the book that he

Starting point is 00:05:10 really wanted to address. And you have the words on the left column that are being mistaken by the words in the right column. So noise is being mistaken by signal. Luck is being mistaken by skill. Randomness is being mistaken by determinism. Probability is being mistaken by certainty. A lucky idiot is being mistaken by a skilled investor.

Starting point is 00:05:31 survivorship bias is being mistaken by market outperformance, among a host of other examples he lists here. It's a good reminder that the world is pretty messy, and it isn't as simple as we'd like it to be. Teleb writes, I quote, as much as you believe in the keep it simple stupid, it is the simplification that is dangerous, end quote. Financial markets is one of the most prevalent places where people mistake luck for skill, because it's just so difficult to distinguish between the two. Let's take basketball, for example, to try and compare that to how things work in the world or in investing. So, Steph Curry, many of you might know him if you watch basketball. He might get lucky when he makes his first or second shot against these massive defenders that are all over him. But when you see Steph Curry just make shot after shot year after year and he goes on and wins multiple championships,

Starting point is 00:06:25 you can say with a pretty high level of certainty that he isn't a fraud or isn't just lucky and making all these shots. But in investing, someone who has a great five or 10-year track record might just be on a lucky streak, or they might be in the right sectors in the market at the right time. For example, they might be in value during the 2000s when value was hot, or writing tech stocks throughout much of the 2010s to today. So before we get to the content here in Chapter 1, I wanted to share one point to Lev made in the prologue.

Starting point is 00:06:57 He talks about how circumstances that are brought about primarily. through luck, could also be taken away by luck or randomness as well. So in the example of the investor that got lucky over a 10-year time frame, he's going to need more luck to keep that street going. However, had his performance primarily been driven by skill, then it's much more resistant to the randomness of markets. It reminds me of the point that Morgan Housel made in his book same as ever in the chapter title, Too Fast, Too Soon. I'd much rather take consistently good results over a long period of time, than a tremendous burst of success over a very short period of time. The success gained over long periods is much more enduring, and it's resistant to outside

Starting point is 00:07:41 forces and randomness. So in Chapter 1 here, Teleb outlines a story of a character named Nero. Narrow was a conservative trader that just wanted to consistently have good years and avoid the risk of ruin and avoid virtually any bad years. Nero made a pretty good living in the markets trading. His trading style was really risk-averse, partly because of his previous career. It wasn't nearly as lucrative, and it really wasn't nearly as fun either. Every time he thought about maximizing profits or increasing risk, he remembered what it was

Starting point is 00:08:18 like in his previous career. So he's really optimizing for longevity, and he's also seen many traders get blown up or lose all their money, and he doesn't want that to be him. So this story was based in the 1990s that Teleb shares here, and he inserts another character named John, who actually lived across the street from Narrow. So John had a larger house, and he was a high-yield trader. So from an outsider's perspective, John was much more successful than Narrow. He had the bigger house, he had two top-line German cars and many other fancy toys and things in his life. In no way did Nero want to be like John, you know, trade like him, live a life that he lived,

Starting point is 00:09:03 but he couldn't help but feel the social pressure. John would just keep adding onto his house and continually let Nero know that he was doing quite well in life. John wasn't as well educated, wasn't as physically fit, and likely wasn't as intelligent as narrow. Teleb points to the research that shows that most people would prefer to make $70,000 a year when others around them are making $60,000, rather than make $80,000 in a year when others around them are making $90,000. Most people naturally don't care about how much they make. They care more about how much others make relative to them. So Nero had an idea of what was at play here for John.

Starting point is 00:09:44 He didn't agree with the methods that John used to trade, and he said that it resembles taking a nap on a railway track. Toleb, writes, you make money every month for a long time, then lose a multiple of your cumulative performance in a few hours. He has seen it with option sellers in 1987, 1989, 1992, and 1998. It was in September of 1998 that it was time for John's wake-up call. Nero felt vindicated as he got up for work and he saw John out in his front yard smoking a cigarette, a site that he probably hasn't seen before. When Narrow saw that, he knew immediately that John had been fired from his job, and it turns out that he lost almost everything he had. And this is a great example of the emotions at play for great investors. Narrow was a great investor. He had found a way

Starting point is 00:10:38 to consistently make money, a method that was rational, and it really made sense to him. It might not have been too hard to keep doing what worked. The hard part is watching others become rich. than you are by doing really stupid things. To make this more applicable to times our audience might be aware of, think of those in your social group getting rich on tech stocks in 1999, in real estate in 2006, or in cryptocurrencies and profitless tech companies in 2021. Just because something is working really well doesn't mean you need to jump on board. Narrow in this story is a prime example of keeping your emotions in check and sticking with a good strategy, even when it's out of favor. Teleb would have referred to John as a lucky fool that got rich because he didn't understand

Starting point is 00:11:25 randomness in market cycles. There's another lesson in the story, which is really to think probabilistically. Had narrow lived out his life a thousand times using the strategy he did, he likely would have become rich in the vast majority of those scenarios. And as for John, he was putting himself in a vastly different situation, and he likely would have been blown up in a decent amount of the thousand cases. For the vast majority of people, ending up with an above average result is enough. You know, in the case of Nero, he lived a very comfortable life, and it offered him pretty much everything he could have ever needed or wanted. When you shoot for that top 1% type of life, you risk potentially exposing yourself to the rare event. And when you

Starting point is 00:12:11 expose yourself to the rare black swans enough times, it's really bound to catch up with you. And that's really what happened with John here. Teleb encourages us to think about both the observed and the unobserved outcomes. For example, say you were looking to get into a career as a trader. You might look at John when he was doing well and saying that trading is a really great profession. You don't want to get led to stray though by the outliers, thinking that you're also going to be an outlier. You'll want to also consider how well the average trader does and how long people are able to last in the profession. If your typical trader ends up exiting the field after two years, then you may have your work cut out for you.

Starting point is 00:12:54 Related to the unobserved observations, consider the idea of looking at someone extremely successful. You know, you look at Elon Musk, LeBron James, Tom Brady, Steph Curry, you name it. We see the people at the very top, but we don't see all the people that supposedly did all the right things and didn't make it to the top. For every Elon Musk, there are countless other people out. there who didn't see the fruits of their labor the way they like it to pan out. Teleb also uses the example of Bill Gates in the book and he shares this idea of path dependency. So how one outcome leads to another outcome which leads to another outcome so it's very path dependent. So you have the one outcome because of what happened before it. Computer keyboards

Starting point is 00:13:40 were designed for example in a very suboptimal way but we never ended up optimizing the the layout of a keyboard because we started training people typing on the version that existed and people didn't want to have to learn a new type. So it's very similar to languages in a way. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year bringing together activists,

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Starting point is 00:17:58 Go to Shopify.com slash WSB. That's Shopify. All right, back to the show. Path dependency also plays out when it comes to network effects, and this is where Bill Gates was brought into the book. To Lab writes, I quote, while it is hard to deny that Gates is a man of high personal standards, work ethic, and above average intelligence, is he the best? Does he deserve it?

Starting point is 00:18:27 Clearly not. Most people are equipped with his software because other people are equipped with his software, a purely circular effect. Nobody ever claimed that it was the best software product. Most of Gates's rivals have an obsessive jealousy of his success. They're maddened by the fact that he managed to win so big, while many of them are struggling to make their companies survive, end quote. So in the case of Bill Gates, his success is due to his own efforts,

Starting point is 00:18:56 in addition to just being at the right place at the right time and all these other factors that are totally outside of his control. And in better understanding the unobserved outcomes, Telebd oftentimes refers to the example of Amoni Carlos simulation, which I essentially think of a computer program that runs through various scenarios for you after you set up your model and put these specific inputs and assumptions in. But life is even more complex than a Monte Carlo simulation. He lists two reasons for why this is.

Starting point is 00:19:28 In the example of John, life didn't feel random to him. He saw that he could make a lot of money in the markets, but he couldn't really see the risk. It's similar to playing with a revolver where five of the chambers are empty, but one chamber contains a bullet. When all you've seen in your life are the empty chambers being let go, it's easy to forget that there's a bullet in one of them. It can give people a false sense of security when they fall back on experiences and only looking at the things that they've encountered in their own lives. To make matters even more complex, we can envision the odds, but we can't know for certain what the true odds are in markets or in many things in life. While in the revolver example, rational players can see there's a bullet in one chamber, but in life, we don't observe the barrel of reality. We can only make educated guesses, which can really lead us to becoming delusional, ignoring the risk of ruin, ignoring the potential black swans on the horizon.

Starting point is 00:20:27 and this really leads to some people playing carelessly, being tricked into thinking that the game is terribly easy. Another key theme in the book is alternative histories. People tend to fixate on the outcomes and not the randomness that was associated with that outcome and also the alternative histories. I was really trying to think of some sports examples here. And one that really came to mind was a game I watched when I was a kid. It was a game with Eli Manning in the New York Giants versus the New England Patriots during the Super Bowl 42 in 2008. It's funny. I think about in the interview with Morgan Housel, how we can be told things when we're young.

Starting point is 00:21:08 You know, we can be taught math. We just totally forget it. But it's stories that really stick with us for life. And it's funny that this was one of the first examples that came to mind. So for those of you who might not remember that game, if you watched it, with about a minute left, it was third down. And Eli Manning was in trouble. I believe they were down three or four points. And Manning, he evades these giant defenders and he throws the ball deep downfield. And David Tyree jumped and caught it. And he almost lost it right after he caught it. But he ended up managing to pin it against his helmet. So he caught it,

Starting point is 00:21:45 pinned it, and got the first down. And that was really a key play. And it was sort of the highlight of the game. And to me, when I go back and watch that play, the catch, it really felt quite lucky. It isn't hard to imagine these alternative histories on that just one play. You know, think about what if the defender reacted a split second quicker? What if Eli Manning got taken down for a sack when these massive defenders were grabbing at his jersey? What if David Tyree happened to wear a different, you know, his other style of gloves that day? What if some totally random thing caused the Giants to run a different play? There are so many alternative histories just on that one play.

Starting point is 00:22:29 And randomness and luck just happened to play to the Giants advantage. And they went down and they ended up scoring the winning touchdown to take down Tom Brady and the Patriots. Now, of course, I'm not saying there was no skill involved in that catch. He's obviously a great wide receiver, great quarterback on that team. And, you know, there's obviously skill in winning that game. as well. So my point is that in so many things, randomness and things we can't control play a huge role in the ultimate outcome that ends up impacting us tremendously. When you look at the history books, it's going to show the New York Giants as the winner of Super Bowl 42. And it's not going to

Starting point is 00:23:11 really bring into consideration how randomness, luck, or alternative histories played into that game. It's just going to show the score and the Giants as the winner. And then those who bet money on the Giants that game, they're going to be considered geniuses that hit it big. They're going to think they're really smart for making that bet. And those who bet on the Patriots, they were considered fools. And they're going to be like, why did I pick the Patriots? I should have picked the Giants.

Starting point is 00:23:36 Teleb writes, such tendency to make and unmake profits based on the fate of the roulette wheel is symptomatic in our ungrained inability to cope with the complex structure of randomness prevailing in the modern world, end quote. So it's so important to understand that the human brain is not wired to think in terms of probabilities in these alternative histories. And he helps drive home this point by giving an example of selling an insurance policy. If we were to go to an airport and ask travelers en route to some remote destination, how much they would pay for an insurance policy that pays a million dollars if they died on the trip,

Starting point is 00:24:16 and this is for any reason, then ask another collection of travelers how much they would pay for an insurance policy that pays the same amount in the event of death from a terrorist attack and only for a terrorist attack. Odds are that people would pay more for the second policy, even though a terrorist threat is included in the first policy by definition. He writes, as a derivatives trader, I notice that people do not like to insure against something abstract, the risk that merits their attention is always something vivid, end quote. And Taleb is really pointing to the fact that human beings, they tend to be very emotional creatures. I quote, it is also a scientific fact and a shocking one that both risk detection

Starting point is 00:25:00 and risk avoidance are not mediated in the thinking part of the brain, but largely in the emotional one. The consequences are not trivial. It means that rational thinking has very very, little to do with risk avoidance. Much of what rational thinking seems to do is rationalize one actions by fitting some logic to them." So this is why so much of the media and journalism space, they aren't trying to deliver news or deliver information that's truly helpful, but rather they're really tapping into the emotions the best they can. The media really can play into the psyche of the mindset of investors. We tend to naturally assume that downmarked, markets are more volatile than up markets.

Starting point is 00:25:45 He gives an example in the book that market movements in the 18 months after 9-11 were less volatile than the 18 months prior, but in the minds of investors, it was very volatile. So the media really magnified the terrorist threats and their impact on financial markets. Unfortunately, in a world full of noise, people want the simple solution that sounds good, but following such simple adages that you hear can sometimes get you into the most trouble. Teleb has certain parts of the book here that are just hilarious. There were so many times when I was reading it where I just laughed out loud because he has quite an interesting and unique personality and writing style.

Starting point is 00:26:28 There was one amusing remark where he mentioned that because of how he is a contrarian traitor that bets on people's underestimation of randomness, he needs most people in the most people in the markets to be fools of randomness, but not everybody because he needs people to invest with him or hire his services because if everyone were fools, then no one would appreciate the work that he does and how he invests and such. In Chapter 3, Teleb gets into more detail on the Monte Carlo simulations that I mentioned. And I thought it was funny. He mentioned that he became addicted to these the minute he became a traitor. And Monte Carlo simulations, they really shaped his thinking in matters related to randomness.

Starting point is 00:27:11 He writes, mathematics is principally a tool to meditate rather than compute. So he's partly obsessed with them because they can really be programmed to simulate just about anything. And while Taleb's colleagues, they were immersed in news stories, central bank announcements and whatnot. Taleb was just obsessed with tinkering with simulations and doing these things like simulating the populations of fast mutating. animals. And it's also interesting. He mentions the connection between evolutionary biology and markets.

Starting point is 00:27:45 And it's funny he mentions this because I'm currently reading what I learned about investing from Darwin by Poulac Prasad. And this is just an absolutely phenomenal book. I'm really happy that Kyle covered it on the show. Poulac Prasad, he has beaten the market for more than the past decade. And Kyle covered his book back on episode 597. And we also discussed his book in our TIP Master my community as it's been one of my very favorite books of 2024. And at the end of February, Poolock Prasad is going to be joining us for a Q&A. So if you'd like to join that Q&A and join our community, you can shoot me an email at Clayant at the investorspodcast.com if you'd like to sit in on that discussion. Because Poolock, he actually doesn't do public appearances. So with Taleb's extensive

Starting point is 00:28:32 experience with Monte Carlo's, he could no longer visualize a realized outcome. without reference to the unrealized ones. So for everyone that is upset that they missed out investing in Tesla, remember that there are plenty of unrealized scenarios where Tesla wouldn't exist in 2024 and they ended up going bankrupt. And for everyone who's upset for not buying Amazon in 2001, remember that there are thousands of internet companies that ended up going to zero. We want to position our portfolios in a way where if we ran forward the future 1,000 times,

Starting point is 00:29:08 we want to achieve sufficient investment returns in nearly all of them. We don't want luck to end up playing a major role in how our life ends up panning out. Teleb also highlights the importance of studying history and how it can be quite difficult for us to learn from history. Sometimes the best lessons are learned from painful experiences, but ideally we're able to learn from the mistakes of others in studying history. Investor Michael Battenick has this wonderful quote that I wanted to share here on learning from our mistakes. Some lessons have to be experienced before they can be understood. And I can just

Starting point is 00:29:43 totally resonate with that quote where some of my biggest lessons from investing have been from the mistakes I've made along the way. And I actually reviewed Michael Batnik's book. It's titled Big Mistakes back on episode 579, where he really just walks through all these great investors and all the big mistakes they make. It's a great read and I highly recommend tuning into that episode as well. Teleb is definitely well aware of our natural, inferior ability to assess risk, and he's really watched other traders just ignore history and just get blown up spectacularly. It seems to be really common in the world he's in.

Starting point is 00:30:22 He writes, characteristically, blown up traders think 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 in 1987, those who blew up in the Japan meltdown in 1990, the bond market debacle in 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 their market was different, and offered seemingly well-constructed intellectual arguments to justify their claims,

Starting point is 00:31:02 end quote. So we either can be students of history and learn from the mistakes of others, or we probably end up learning the painful lesson ourselves and taking too much risk, or getting caught up in a market bubble, or whatnot. With many of these traders, I'm sure that greed just blinds them to so many of the risks. If you can make a killing year after year, it's just so easy to believe that you've cracked the code that no one else has found and that the game is now easy. When investing feels easy, that's probably a good time to check in and ensure you aren't taking excess risk, and you aren't letting your emotions take over. We can look back at the past with hindsight bias knowing that tech stocks were far overvalued in 1999, for example,

Starting point is 00:31:48 but once we're in a bubble ourselves, it's very difficult not to get carried away, especially if it's your first time experiencing such an emotional train ride. The same people who get caught up in a bubble are the same ones who say after the fact they knew it all along. Remember that the easiest person to fool is ironically ourselves. Although Teleb is a trader, I think there are so many great points in this book related to investing more broadly. He gives the example of a portfolio that returns 15% per year with 10% levels of volatility. So you can generally think most outcomes end up between 5% and 25% of returns. So over one year, the probability of a positive return is 93%.

Starting point is 00:32:33 Over any given month, the probability of a positive return is 67%. But when you zoom in to just one day, it's 54%. And one hour, it's 51%. So the more you compress the time frame, the more random your returns are, or the higher chance of a negative outcome. And for those of you who are aware of the loss aversion bias, naturally losses hurt more than the gains feel good from a psychological perspective. So the more you check your portfolio in this situation, the more pain you're going to feel. So for many of you in the audience who check your stocks or portfolios daily, I'm guilty as charged,

Starting point is 00:33:14 just remember that you're not only looking at the returns on a day-to-day basis, but you're really looking at the volatility and the randomness of your returns. So many days, you can simply attribute stock price movements simply to randomness and not anything we should really apply sound logic to. Teleb makes the funny joke that when he sees an investor monitoring his portfolio really closely looking at the live prices on their phone or their tablet, he smiles because he knows that there are still investors out there getting caught up in the randomness and letting their emotions flow watching that randomness with a close eye.

Starting point is 00:33:48 Taleb also recommends tuning out of the news as the news tends to be full of noise and information that offers you no predictive power or ability. So if the news is important enough, it's really just going to find a way to get to you without you having to check on it constantly. Teleb writes, I quote, My problem is that I am not rational and I am extremely prone to drown in randomness and to incur emotional torture. I am aware of my need to ruminate on park benches and in cafes away from information,

Starting point is 00:34:24 but I can only do so if I am somewhat deprived of it. My sole advantage in life is that I know some of my weaknesses, mostly that I am incapable of taming my emotions facing news, and incapable of seeing a performance with a clear head. Silence is far better, end quote. So to see him stay again and again in this book, how even though he's aware of the randomness at play in the world, he's just as susceptible as anyone to fall prey to it.

Starting point is 00:34:53 Jumping ahead to chapter five here, Taleb tells an interesting story about a trader that got caught on the wrong side of a trade. So he describes this trader as named Carlos. And Carlos was an emerging markets trader and he traded bonds from all these emerging markets. And throughout the 1990s, these bonds were really in a bull market. And he had a big tailwind at his back and this greatly benefited traders like Carlos. So, Taleb was skeptical of traders of Carlos's type. He was very well dressed up, well spoken.

Starting point is 00:35:29 And he was really, really smart, probably had a, you know, went to the nice school, had an MBA, had all the credentials he needed. And Taleb, he jokes that he believed that true traders, they dress sloppily and they're really the mere opposite of the Carlos's of the world. So Carlos did exceptionally well during his career, not only because he was in the right sector, writing the right trend, but also because he was buying dips along the way. So whenever there was a momentary panic, Carlos would step in with confidence during that bull market and the trend would resume. Being right about the reversals time and time again really made Carlos feel invincible. So this strategy worked really well until the

Starting point is 00:36:13 summer of 1998, and this is when the dip that happened didn't end up translating into a rally. That summer in 1998 would be his first bad summer. It was actually so bad that it should be considered catastrophic. Up until that point, he had earned $80 million cumulatively in those previous years, and in that one summer, he lost his firm $300 million. So he talks about how this happened. So the market dropped and Carlos had started to average down as he'd habitually done. It's what's always worked in his experience. So, and, you know, he was plenty confident that the market was going to bounce as I always did before. And Carlos knew that some other firms were going through some liquidity issues and they were, there was really forced selling at play.

Starting point is 00:37:04 So this was really a common sign that bargains were available. He bought in at $52 and he stated that the bonds would never trade below 48. So he was actually at this time, he was betting big on Russian bonds saying that Russia was just too big to fail or too big to default on their debt obligations. So he continued to double down as the bonds traded down to $43 in July. And he ended up wagering half of his own net worth or around $5 million in the Russia principal bond thinking that the profits from it are going to have them set for life. The market had other plans for him. By the middle of August, they were trading down in the 20s. Carlos understood that there was a difference between price and value, so he continued to hold

Starting point is 00:37:51 on as he believed that the true value was substantially higher than the price that was shown on the screen. Everyone in Carlos' circle agreed that the sell-off was far overdone. But by the end of August, the bonds kept falling and they dropped below $10. Now the board members at Carlos' firm wanted to understand why in the world, the company had so much exposure to a government that wasn't paying their own employees or their soldiers. Veteran trader Marty O'Connell refers to what was happening around here as the firehouse effect.

Starting point is 00:38:25 And the firehouse effect is when you have a bunch of firemen with a lot of downtime, they're talking to each other, you know, they're doing so for far too long, and it ends up being an eco chamber where they all agree on many of the same things, and an outside observer would just deemed them to be ludicrous. We can also refer to this really as an eco-chamber where the same talking points are repeated again and again by the same people that think the same way. This trader hadn't considered the possibility of the low probability event happening because he'd never seen such a thing happen in his own experience before, and it ended up costing Carlos a lot of money in his job. He also ended up switching careers because of the damage that it ended up doing to him.

Starting point is 00:39:08 What's also interesting is that before this collapse of Russian bonds, a trader like Carlos would have been considered the top of his field because his returns were probably really, really good relative to other traders. But Teleb wisely points out that the best traders, or the way I think of it, the best investors at any given point in time, may actually be the worst traders or worst investors. Teleb writes here, at a given time in the market, the most successful trades, the most successful traders are likely to be those that are best fit to the latest cycle. This does not happen too often with Dennis or pianists because these professions are more immune to randomness, end quote.

Starting point is 00:39:51 So if a trader has a really hot streak, odds are it may solely be due to randomness, being at the right place, at the right time, or maybe taking too much risk. People tend to assume that traders that had a hot streak are successful because they're skilled or they're good at what they do. But we must remember survivorship bias. For every successful trader, there are a host of unsuccessful ones who may be just as skilled. Over short time periods, a successful trader does not make a good trader or a successful investor does not necessarily make for a good investor. It's also important to not get married to your positions. When something goes against you, putting the majority of your net worth into it probably isn't a sound practice of risk management.

Starting point is 00:40:40 To LeB writes, there's a saying that bad traders divorce their spouse sooner than abandon their positions. Loyalty to ideas is not a good thing for traders, scientists, or anyone, end quote. I just love that. There's a saying that bad traders divorce their spouse sooner than they abandon their positions. This bias is also known as the endowment effect. The endowment effect is the tendency to hold onto something we own simply because we already own it. Taleb argues that if you buy a painting for $20,000 and the price goes up to $40,000, you should keep it only if you would acquire it at that current price. If you wouldn't acquire the painting at $40,000, then it's said that you're married to your position and it's now become an emotional investment.

Starting point is 00:41:30 This of course ignores the consequences of taxes, but I sort of struggle with this point by Teleb and I kind of disagree a bit because we talk a lot about letting your winners run on the show and not tinkering with your portfolio too much. And part of the game of achieving multi-baggers is hanging on to your winners when they approach intrinsic value or maybe even exceed intrinsic value to some degree. But the bias at play here can be a really useful mental model. Once we buy a stock, something in our brain changes. about how we view it. We likely now have a positive skew towards that stock, and we're now prone

Starting point is 00:42:06 to confirmation bias. And confirmation bias is essentially when we start looking for information that tells us we made a good decision when buying the stock, and it somewhat blinds us to anything that conflicts with our decision to buy. With that said, it's just so important to be open to the idea of changing your mind when the facts change. You shouldn't update your investment thesis just because the price goes against you, and in my opinion, you shouldn't just sell just because the price goes up. If your original investment thesis upon entering the trade doesn't pan out, then odds are that it's best to exit the position no matter how much it hurts psychologically to do so. So in the case of Carlos, he was a trader that entered a position, and he morphed

Starting point is 00:42:51 into a long-term investor when the environment changed. So from what I understand in the story, he had updated his thesis once things changed. And that's just a big red flag and a sign that you've entered a really bad trade. So when we enter a position, we should really have a plan for what we would do in the event of losses. Carlos really wasn't aware of the possibility of losing money here. And all he had done up to that point was really make money. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer

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Starting point is 00:46:36 slash income. This is a paid advertisement. All right, back to the show. I also loved that Teleb had a chapter on skewness and asymmetry. One of my favorite lessons on a asymmetry was from my previous conversation with Godham Bade on episode 583. He explained that if you have two stocks and one is compounding at 26 per year to the upside and the other declining at 26 per year to the downside and then you equal weight those positions from the beginning. At the end of 10 years, your average annual return would still be 17.6%. This shows how your winners can really carry your portfolio, even when you have big losers that fall. by the wayside. So Goddum's point during that episode was really that compounding is convex to the

Starting point is 00:47:24 upside, but concave to the downside. So also remember that humans are wired to think linearly. So we really have to pound these ideas into our heads that really aren't that intuitive. Asymmetry is also why Teleb is able to make money by betting on black swans. Even though the market statistically is likely to go up year after year, it's during the downtime when the market gets hammered that Teleb makes out like a bandit. He generally loses money when the market is going up, but during a month like March 2020 or Black Monday in 1987, he makes all these losses back plus some additional gains on top of it. So although the frequency of profits is low for Teleb, when they do occur, the magnitude of the gains is enormous. So while others perish during chaos,

Starting point is 00:48:18 Teleb thrives in it. I think he referred to himself as a chaos hunter in the book. As Teleb puts it, I try to make money infrequently, as infrequently as possible, simply because I believe that rare events are not fairly valued, and that the rare of the event, the more undervalued it will be in price, end quote. So simply put, Teleb is capitalizing on the asymmetry of down markets. Typically, markets tend to slowly march upward, but when those surprises happen, it just sends the market down much faster than many markets participants expect. Another interesting point I picked up from this piece on asymmetry is not to take stable market prices as a sign of a stable investment. Teleb is really a big skeptic of using past

Starting point is 00:49:06 data to predict future performance. He explains that he needs a lot more than just data. The rare black swan or the rare event has the potential to make all past data irrelevant. And history teaches us that things that have never happened before do happen. I think many people, myself included, can become duped to thinking that we can look at past data and believe that we've somehow increased our knowledge on what the future will look like. But things are just changing all the time. There's some brilliant second level thinking here from Telev that sort of makes my head

Starting point is 00:49:43 spend, he writes, rare events exist precisely because they are unexpected. If the fund manager or trader expected it, he and his like-minded peers would not have invested in it. And the rare event would not have taken place, end quote. So had everyone been prepared for something like the great financial crisis, then there would be more people who would have been in a better position financially and not have their homes foreclosed on, for example. And since there would be less foreclosures, this would have helped prevent so much of that force selling that happened by many people and not made the crisis as bad as it was. So that's the way I sort of interpret that quote there. It's sort of a good reminder that whatever bad outcome is the worst case scenario in your life, in your

Starting point is 00:50:29 portfolio, you know, just in your head, what is the worst case scenario? The reality is that the rare event that could happen in that worst case scenario is likely much worse than you can even imagine or even fathom. In dealing with randomness, we have to keep an open mind and be open to the idea of things happening that we can't even fathom in that moment. So I want to transition here to talk about one of the most important takeaways from the book, and that's the understanding survivorship bias. I've touched on this a little bit during this episode. To let makes the case that if you have an infinite number of monkeys in front of typewriters and you just let them type away, there's certainty that one of them is going to come out with an exact version of the Iliad.

Starting point is 00:51:16 And the probability of this is ridiculously low. For each particular monkey, you know, it's extremely low. But if you did this enough times, he assumes that it would eventually happen. Now, for that monkey, he asked the question of, would you be willing to bet your life savings that the monkey would be able to write the Odyssey next? This is really getting to the question of how relevant, is past performance in forecasting future performance. And this is a trap that many people fall into where they derive conclusions based on a past time series. As Taleb puts it, the more

Starting point is 00:51:53 data we have, the more likely we are to drown in it. So instead of betting on a one-hit wonder, we like to see a long track record. A company that does well in its first year of going public, you know, it might be a great investment, but we're much more likely to have confidence in the company's ability to execute if it has a 10-year track record of solid performance or maybe even 20, 30, 40 years. It's very hard to simply be lucky for 40 years in a row. The predictive ability of past data depends on two factors, the randomness of the data and the number of data points there are. The world of business is full of randomness and, you know, it's just full of a ton of data points as well. If you have millions of people that are trying to start businesses and trying to

Starting point is 00:52:40 make it big, it's no wonder that we have the Elon Musk's and the Jeff Bezos's of the world. Those are the people we constantly see in the headlines, even here on the podcast here, but the people we don't see are the countless data points that didn't get to where they are. This is why Warren Buffett might make it look like it's so easy to beat the market, but the vast majority of fund managers don't beat the market. This really gets to the heart of survivorship bias. We can try and replicate all the tactics that Buffett uses, but for one, we simply aren't Warren Buffett. And two, there are countless people who have tried to use his approach in investing and ended up with a different result. In Buffett's early days, he was buying, you know, cigar butt type businesses. And part of

Starting point is 00:53:26 his investment thesis was that the market price would eventually converge with the intrinsic value. Sometimes that might happen, and sometimes it might take a really long time for it to happen and lead to subpar returns. Or think about when he purchased Coca-Cola in 1989. He needed the company to continue to execute in all these different markets they were in globally, and he was ultimately right in his assessment of the business, but there's almost certainly an alternative scenario where the bet would have looked terrible in hindsight.

Starting point is 00:53:56 Nobody would go out and say that Buffett's success was due to luck, but it certainly played some part of it. Teleb uses another example of a couple that lives in one of the richest areas. areas of Manhattan. I really, really liked this story and wanted to share it. So there's a husband and a wife in Manhattan. And the husband, he worked very demanding hours and he wanted to live close to work. So they stretched their living expenses and they lived in a really expensive area. That way, they had close proximity to get to and from work. And then he could maximize his time at work and not spend, you know, hours commuting. So by any measure, these people were extremely successful and

Starting point is 00:54:35 extremely wealthy. But when you look at the neighborhood they were in, they were actually near the bottom of it in terms of, you know, the size of where they lived, how much the money they made, the things they have. And when the man's wife would look around, she felt like she had next to nothing when she compared herself to her peers. So she was surrounded by, you know, larger diamonds, larger living spaces, and she didn't get the respect that she felt she deserved. And because of this, The wife felt that her husband is a failure by comparison of those around them. But the reality is that they are wildly successful and they're actually better off than 99.5% of Americans. So when you compare the husband to his high school friends and how they turned out, he was certainly near the top.

Starting point is 00:55:24 But when you compared it to his neighbors, he was certainly at the bottom. And this is a perfect example of survivorship bias at play. This couple chose to live in an area full of successful people, which is an area that, by definition, excludes failure. So those who failed don't show up in the sample set or show up in that neighborhood. And this really gets to the heart of why many people never feel satisfied with their life. They get money, they move to a nice neighborhood by their standards, and then they feel poor again. Or they just get used to the nice things that they're now surrounded by. And Taleb also calls out the book The Millionaire Next Door.

Starting point is 00:56:05 And this book explains how a bunch of people became millionaires by saving consistently, investing, among other things. And Taleb points out two flaws in the book. First is that the study only looked at the millionaires, which he equates to the lucky monkeys on typewriters. And the book makes no mention of the people who also invested just like these people in the study. But they happen to invest in the wrong things at the wrong time. or maybe they were in a country where their currency hyperinflated or, you know, they were just in a situation where their assets were seized. Those are excluded from the study is the point he's sort of making.

Starting point is 00:56:40 And then the second flaw, he points out is that there was a massive bull market in asset values in the people they were studying, you know, a few invested from 1980 to 2020. And the book essentially assumes that these asset returns are permanent. So the U.S., you know, like I mentioned, had that exceptional run. from the 1980s, and we shouldn't assume that these level of returns are going to continue forever. And these are the sort of assumptions that led to the Great Crash and the Great Depression after 1929. Another example he gives here in the book is that it's commonly said that successful people are optimistic people. So optimistic people, they tend to take more risk and they're

Starting point is 00:57:24 more confident about their odds. And then those who are successful end up showing. these characteristics of being optimistic and we give them all this praise, but we don't see the optimistic people that ended up making a bad bet. So it's a good reminder to just be careful of the assumptions we make when we're looking at a particular dataset and particularly looking at like winning stocks, for example. I also liked a couple of the concepts here in chapter 10. He mentions chaos theory, which points to how the smallest inputs can lead to a disproportionate response. Morgan Howesel wrote in his book how the U.S., they actually would have lost the Revolutionary War, had the wind been blowing in a certain direction, preventing the opposing army from sailing downstream

Starting point is 00:58:08 to just finish the war and wipe out the U.S. And had the wind been blowing in the other direction, the outcome of the war would have been entirely different and there would be no United States of America. And Taleb also takes a stab at Bill Gates here saying that he clearly doesn't deserve the level of success he's had to date. And I talked about path dependence earlier. And it's really interesting how in the information age, path dependence and network effects are extremely important. So in the case of Bill Gates and Microsoft, many people were onboarded onto Microsoft and it created that feedback loop of since others were on Microsoft, you now had an incentive to use that

Starting point is 00:58:51 program. You know, sometimes it's just better to be lucky than to be good. There's that saying. Another interesting part about network effects and these networks is the tipping point at which the network takes off and it offers this sort of asymmetric upside. In Malcolm Gladwell's book, The Tipping Point, he shows some of the behaviors of variables such as epidemics that spread extremely fast beyond some unspecified critical level. And it's really the same with book sales. Book sales tend to explode once they reach some sort of tipping point and the word of mouth just takes it everywhere. And these non-linearities are practically impossible to model or predict, and it's just really due to the randomness that's involved. This again links to one of the beauties of investing.

Starting point is 00:59:37 For my own portfolio, I want to spread myself out across bets that I think have limited downside, but I have a lot of potential upside far down the line. And I don't know which bets exactly are going to be the big winners, but I want to expose myself to companies with a lot of room to grow. They're bought at a fair price that I deemed to be sensitive. and I size it enough to be a large enough part of my portfolio where it really makes a difference, and then I just want to leave it alone for many years. Since we can't predict the significance of these non-linearities,

Starting point is 01:00:08 they really aren't going to be obvious beforehand, but it's going to look obvious with the benefit of hindsight like I've talked about today. Just think about most big winners in the markets. I'm sure absolutely nobody 10 years ago envisioned them being as big as they are today, in terms of their size. Our brains really can't fully comprehend the power of these non-linearities. And if we find ourselves with the winner, we generally want to let it run. At least that's my personal approach.

Starting point is 01:00:40 And then we'll have the Nassim Telebs of the world call us lucky after the fact. It's so interesting. He also mentions the idea of when it rains, it pours. Some people just really seem to be inherently lucky. And other people just seem to be inherently lucky. and other people just seem to be inherently unlucky. An author either has a wildly successful book or the author can hardly make a sale at all,

Starting point is 01:01:03 especially with the information age, successful people or books or whatever else. It spreads like wildfire, and then a lot of the others are just left in the dust and can hardly attract a single eyeball. Because there can be so much variability in our world, it can make it quite difficult to forecast anything. For example, people might want to know,

Starting point is 01:01:23 where the S&P 500 is going to be trading one year from now. And since people want that, many firms are happy to try and forecast it. What's maybe more important that I wanted to mention here, more important than the forecast at least, is the variability in the forecast or the degree of confidence in that forecast. So it's one thing if you estimate a 10% increase with a, say, a 5% variability in either direction. And it's a whole different story if you estimate a 10% increase where returns might be as high as 40 or 50% or as low as negative 40%. So, you know, if you have a high degree of certainty within a narrow band, that's totally different than that second scenario I mentioned.

Starting point is 01:02:05 So the variation in the returns matters a lot. But no one really asks about, you know, the variation or the degree of confidence when someone makes a forecast. They usually just share their forecast. One other important takeaway I wanted to mention here is differentiating process, versus outcome. And so much in the stock market and in price movements is just noise. And we need to be mindful of the degree of randomness in markets. So underperforming the market in one year doesn't necessarily make one a bad investor. And outperforming the market in one year doesn't necessarily

Starting point is 01:02:39 make one a good investor. Sometimes terrible stocks skyrocket in price and sometimes great stocks decline in price. And that's just the way markets work. What is more important is honing in, on a process that meshes well with your skill set and your temperament. The best investors focus on a process that is repeatable and they aren't quite as focused as much on the outcome, at least in the short term, because they recognize the role of luck and randomness at play into that short term outcome, and it's oftentimes just simply full of noise. Investors who are focused on the outcome tend to chase things as well. XYZ investment went up a lot recently, so they're going to chase that fad or chase that trend. And this is really an outcome-based approach without considering

Starting point is 01:03:25 the underlying process and the probability of success with that approach. When your process isn't based on luck and it's based on an approach that is sound, logical, and rational, hopefully this will lead to results that you are satisfied with over the long run. All right, so we're getting close to wrapping up this discussion. And in light of all this talk on luck and randomness, Taleb says that he has no conclusion on figuring out when something doesn't have an element of luck in it, which honestly isn't all that helpful. There are, of course, investors who are very skillful and their performance is largely driven by skill and not primarily by luck. And the sort of catch 22 here is that many of the best investors are going to fly under the radar, in my opinion at least,

Starting point is 01:04:13 because they're going to be implementing high levels of risk management. So an investor who's far outpacing the market either has luck going their way or they're taking too much risk. They're going out and marketing themselves, trying to get more investors to invest with them. But eventually, you know, the bad investors, their luck is going to turn. And I'm not going to name any names here, but I'm sure many in the audience can come up with somebody that's been in the headlines. Toleb writes, I am unable to answer the question of who's lucky or unlucky. I can tell that person A seems less lucky than person B.

Starting point is 01:04:49 but the confidence in such knowledge can be so weak as to be meaningless. I prefer to remain a skeptic. I never said that every rich man is an idiot and every unsuccessful person is unlucky, only that in absence of much additional information, it is preferable to reserve one's judgment as it is safer, end quote. All right, that's all I have for today's episode. Thanks for tuning in and I hope to see you again next time. Thank you for listening to TIP.

Starting point is 01:05:20 Make sure to follow We Study Billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only, before making any decision consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP609: Fooled by Randomness by Nassim Taleb

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