Fooled by Randomness Role of Chance in Markets and Life PROPER1

!
"#$% %'( )$%'#*

assim NichoIas TaIeb is lhe founder of Imirica CailaI LLC, a
crisis-hunling hedge fund oeralor, and a feIIov al lhe Couranl
Inslilule of MalhemalicaI Sciences of Nev York Universily. He has heId
a variely of derivalive lrading osilions in Nev York and London and
vorked as an indeendenl fIoor lrader in Chicago. TaIeb vas inducled
in Iebruary 2001 in lhe "#$%&'(%&#) *($'(#+, HaII of Iame.
TaIeb received an MA from lhe Wharlon SchooI and a Ih.D. from
Universily Iaris-Dauhine. He is lhe aulhor of ",-'.%/ 0#1+%-+2
3'-'+%-+ 4'-%55' '-1 678(%/ 9:(%8-) (WiIey, 1997).
BY
The Hidden RoI e of Chance
in lhe Markels and in Life
NASSIM NICHOLAS TALEE
eg

T E X E RE
Ncw Ynrk Lnndnn
CONTINTS
;$#<'/# '-1 =/>-8?5#1+.#-() 7%%%
@A':(#$ *B..'$%#) 7&%%
Prn!nguc 1
38)CB#) %- (A# @58B1) D
I A R T I: SOLON'S WARNING - 5KEWNE55, ASYMMITRY,
INDUCTION 7
Onc: II Ynu'rc 5n Rich Why Arcn't Ynu 5n 5mart? 11
E#$8 FB5%: DD
Hil by Lighlning 11
Temorary Sanily 12
381B) 9:#$'-1% 14
No Work Ilhics 16
There Are AIvays Secrels 17
G8A- (A# 0%+AHI%#51 F$'1#$ DJ
An Overaid Hick 19
viii CONTINTS
FA# K#1H08( *B..#$ LD
Serolonin and Randomness 22
I8B$ "#-(%)( M) K%/AN 4#$, K%/A H LO
Twn: A Bizarrc Accnunting Mcthnd 26
=5(#$-'(%&# 0%)(8$, LP
Russian RouIelle 27
An Iven More Vicious RouIelle 28
*.88(A ;##$ K#5'(%8-) LQ
SaIvalion Via AerofIol 30
SoIon Visils K#+%-#R) Nighl CIub 32
S#8$+# T%55 M) E8 *858-2 9- @8B-(#$%-(B%(%&# F$B(A) UO
HumiIialed in Debales 37
Risk Managers 38
Thrcc: A Mathcmatica! Mcditatinn nn Histnry 40
IuroIayboy Malhemalics 40
The TooIs 41
Monle CarIo Malhemalics 43
VB- %- 3, =((%/ OW
Making Hislory 45
ZorgIubs Crovding lhe Allic 46
Denigralion of Hislory 47
The Slove Is Hol 48
My SoIon 50
"%)(%55#1 FA%->%-+ 8- I8B$ ;'5.;%58( WD
reaking Nevs 51
ShiIIer Redux 53
Geronlocracy 55
;A%58)($'(B) %- 38-(# @'$582 9- (A# "%<<#$#-/# X#(?##- E8%)#
'-1 M-<8$.'(%8- WP
Fnur: Randnmncss, Nnnscnsc, and thc 5cicntiIic Intc!!cctua! 60
K'-18.-#)) '-1 (A# 4#$Y
Reverse Turing Tesl
60
62
CONTINTS
ix
The Ialher of AII Iseudolhinkers 64
38-(# @'$58 ;8#($, PO
Fivc: 5urviva! nI thc Lcast Fit - Can Evn!utinn Bc Fnn!cd by
Randnmncss? 68
@'$58) (A# 6.#$+%-+ 3'$>#() T%Z'$1 P[
The Good Years 71
Averaging Dovn 72
Lines in lhe Sand 72
G8A- (A# 0%+AHI%#51 F$'1#$ JO
The \B'-( Who Knev Comulers and Iqualions 75
The Trails They Shared 78
= K#&%#? 8< 3'$>#( V885) 8< K'-18.-#)) @8-)('-() J[
E'%&# 6&85B(%8-'$, FA#8$%#) [D
Can IvoIulion be IooIed by Randomness` 82
5ix: 5kcwncss and Asymmctry 84
FA# 3#1%'- M) E8( (A# 3#))'+# [O
XB55 '-1 X#'$ ]8858+, [P
=- Arroganl 29-Year-OId Son 88
Rare Ivenls 89
Symmelry and Science 90
FA# K'$# 6&#-( V'55'/, QU
The Molher of AII Decelions 93
Why Don'l Slalislicians Delecl Rare Ivenls` 96
A Mischievous ChiId ReIaces lhe Iack aIIs 97
5cvcn: Thc Prnb!cm nI Inductinn 99
V$8. X'/8- (8 0B.# QQ
@,+-B) =($'(B) 100
Niederhoffer, Viclorian GenlIeman 100
*%$ ^'$5R) ;$8.8(%-+ =+#-( %_U
Localion, Localion 105
Ioer's Ansver D_P
Oen Sociely 108
vii
CONTINTS
Nobody Is Ierfecl 108
IascaI's Wager 109
FA'-> I8B *858- ` DD_
I A R T I i s MONKIYS ON TYIIWRITIRS - SURVIVORSHII AND
OTHIR IASIS 111
Il Deends On lhe Number of Monkeys 114
Vicious ReaI Life 115
This Seclion 115
Eight: Tnn Many Mi!!innaircs Ncxt Dnnr 117
08? F8 *(8: (A# *(%-+ 8< V'%5B$# DDJ
Somevhal Hay 117
Too Much Work 118
You're a IaiIure 119
"8BY5# *B$&%&8$)A%: X%')#) DL_
More Ixerls 120
VisibiIily Winners 122
Il's a uII Markel 122
= SB$BR) 9:%-%8- DLU
Ninc: It Is Easicr Tn Buy and 5c!! Than Fry an Egg 125
V885#1 Y, EB.Y#$) DLJ
IIacebo Inveslors 127
Nobody Has To e Comelenl 128
Irgodicily 129
a%<# M) @8%-/%1#-('5 DUD
The Myslerious Leller 131
An Inlerruled Tennis Game 132
The irlhday Iaradox 132
Il's a SmaII WorId! 132
Dala Mining, Slalislics, and CharIalanism 133
The esl ook I Have Iver Read! 134
The acklesler 134
A More UnsellIing Ixlension 136
CONTINTS
XI
The Iarnings Season: IooIed by lhe ResuIls 136
Cancer Cures 137
Irofessor Iearson Goes lo Monle CarIo (LileraIIy):
Randomness Does Nol Look Random! 139
The Dog Thal Did Nol ark: On iases in Scienlific
KnovIedge 140
M 0'&# E8 @8-/5B)%8- DOD
Tcn: Lnscr Takcs A!! - On thc Nnn!incaritics nI LiIc 142
FA# *'-1:%5# 6<<#/( DOL
Inler Randomness 144
Learning lo Tye 144
3'(A#.'(%/) M-)%1# '-1 9B()%1# (A# K#'5 T8$51 DOP
uridan's Donkey or lhe Good Side of Randomness 147
TA#- M( K'%-)N M( ;8B$) DO[
E!cvcn: Randnmncss and Our Brain: Wc Arc Prnbabi!ity
B!ind 149
;'$%) 8$ (A# X'A'.')b DOQ
*8.# =$/A%(#/(B$'5 @8-)%1#$'(%8-) DW_
V$8. ;),/A858+, (8 E#B$8Y%858+, DWL
Our NaluraI Habilal 153
Kafka in a Courlroom 154
An Absurd WorId 156
Kahneman and Tversky 157
NeurobioIogy 158
IxamIes of iases in Underslanding IrobabiIily 159
We Are Olion Iind 160
;$8Y'Y%5%(%#) '-1 (A# 3#1%' c38$# G8B$-'5%)()d DPL
CNC al Lunch Time 163
You ShouId e Dead by Nov 163
The Ioomberg IxIanalions 164
IiIlering Melhods 166
We Do Nol Undersland Confidence LeveIs 168
An Admission 168
xii CONTINTS
I A R T I I I s WAX IN MY IARS - LIVING WI TH RANDOMITIS 1 6 9
I Am Nol So InleIIigenl _ 172
FA# 91,))#'- 3B(# @8..'-1 DJU
Twc!vc: Gamb!crs' Ticks and Pigcnns in a Bnx 175
F'7%H@'Y 6-+5%)A '-1 @'B)'5%(, DJW
FA# *>%--#$ ;%+#8- 67:#$%.#-( DJ[
;A%58)($'(B) K#1B7 DJQ
Thirtccn: Carncadcs Cnmcs tn Rnmc: On Prnbabi!ity and
5kcpticism 182
@'$-#'1#) @8.#) (8 K8.# D[U
IrobabiIily lhe ChiId of Skelicism 184
38-)%#B$ 1# E8$:8%)R) 9:%-%8-) D[W
Ialh Deendence of eIiefs 187
@8.:B(%-+ M-)(#'1 8< FA%->%-+ D[[
V$8. VB-#$'5 (8 VB-#$'5 DQ_
Fnurtccn: Bacchus Abandnns Antnny 191
E8(#) 8- G'/>%# 9eR) VB-#$'5 DQL
K'-18.-#)) '-1 ;#$)8-'5 65#+'-/# DQO
Epi!nguc: 5n!nn Tn!d Ynu 5n 196
evare lhe London Traffic }ams 196
E8(#) DQJ
M-1#7 DQ[
=Y8B( F6f6K6 L_O
IRIIACI AND ACKNOWLIDGMINTS
his book is lhe synlhesis of, on one hand, lhe no-nonsense
malhemalicaI lrader (seIf-slyIed "raclilioner of uncerlainly") vho
senl his Iife lrying lo resisl being fooIed by randomness and lrick lhe
emolions associaled vilh uncerlainly and, on lhe olher, lhe aeslhelicaIIy
obsessed, Iileralure-Ioving human being viIIing lo be fooIed by any form
of nonsense lhal is oIished, refined, originaI, and laslefuI. I am nol
caabIe of avoiding being lhe fooI of randomness, vhal I can do is
confine il lo vhere il brings some aeslhelic gralificalion.
Much has been vrillen aboul our biases (acquired or genelic) in
deaIing vilh randomness over lhe asl decade. My ruIes vhiIe vriling
lhis book have been lo avoid discussing (a) anylhing lhal I did nol eilher
ersonaIIy vilness on lhe loic or deveIo indeendenlIy, and (b)
anylhing lhal I have nol disliIIed veII enough lo be abIe lo vrile on lhe
sub|ecl vilh lhe sIighlesl efforl. Iverylhing lhal remoleIy feIl Iike vork
vas oul. I had lo urge lhe lexl from assages lhal seemed lo come from
a visil lo lhe Iibrary, incIuding lhe scienlific name droing. I lried lo
use no quole lhal does nol naluraIIy sring from my memory and does
nol come from a vriler vhom I have inlimaleIy frequenled over lhe
years (I delesl lhe raclice of random use of borroved visdom - much
on lhal, Ialer). =B( ('/# 'B( 58CB#$# .#5%8$' )%5#-/%8 (onIy vhen lhe
vords oulerform siIence).
XIV IRIIACI AND ACKNOWLIDGMINTS
I lried lo make lhe minimum oul of my direcl rofession of
malhemalicaI lrader. Markels are a mere seciaI case of randomness
lras. I discuss lhem in an iIIuslralive vay as I vouId | n a dinner
conversalion vilh, say, a cardioIogisl vilh inleIIecluaI curiosily (I used
as a modeI my second-generalion friend }acques Merab).
Some acknovIedgmenls: firsl, I vouId Iike lo lhank friends vho can
be considered righlfuI co-aulhors. I am gralefuI lo Nev York inleIIecluaI
and exerl in randomness Slan }onas (I do nol knov any olher
designalion lhal vouId do him |uslice) for haIf a Iifelime of conversalions
inlo aII sub|ecls bordering on robabiIily vilh lhe animalion and lhe zeaI
of lhe neohyle. I lhank my robabiIisl friend Don Geman (husband of
HeIyelle Geman, my lhesis direclor) for his enlhusiaslic suorl for my
book, he aIso made me reaIize lhal robabiIisls are born, nol made -
many malhemalicians are caabIe of comuling, bul nol underslanding,
robabiIily (lhey are no beller lhan lhe generaI ouIalion in exerling
robabiIislic |udgmenls). The reaI book slarled vilh an aII-nighl
conversalion vilh my erudile friend }amiI az during lhe summer of
1987, as he discussed lhe formalion of "nev" and "oId" money among
famiIies. I vas lhen a budding lrader and he scorned lhe arroganl
SaIomon rolhers lraders lhal surrounded him (he vas roved righl). He
insliIIed in me lhe voracious inlroseclion aboul my erformance in Iife
and reaIIy gave me lhe idea for lhis book. olh of us ended u gelling
doclorales Ialer in Iife, on an aImosl idenlicaI sub|ecl maller. I have aIso
dragged many eoIe on (very Iong) vaIks in Nev York, London, or
Iaris, discussing some arls of lhis book, such as lhe Iale }immy Iovers,
vho heIed nurlure my lrading earIy on, and vho kel reealing
"anyone can buy and seII", or my encycIoedic friend David IasleI
equaIIy al ease vilh Iileralure, malhemalics, and Semilic Ianguages. I
have aIso engaged my Iucid Ioerian coIIeague }onalhan Waxman in
numerous conversalions on lhe inlegralion of KarI Ioer's ideas in our
Iife as lraders.
Second, I have been Iucky lo meel MyIes Thomson and David
WiIson, vhen lhey bolh vere al }. WiIey & Sons. MyIes has vision - he
is lhe reverse "me loo" ubIisher. He underslands lhal books need nol
be vrillen lo salisfy a re-defined IabeIed audience, bul lhal a book viII
find ils ovn unique sel of readers - lhus giving more credil lo lhe reader
lhan lhe off-lhe-rack ubIisher. As lo David, he beIieved enough in lhe
book lo ush me lo lake il inlo ils naluraI course, free of aII IabeIs and
laxonomies. David sav me lhe vay I viev myseIf, someone vho has a
assion for robabiIily and randomness, vho is obsessed vilh Iileralure
bul haens lo be a lrader, ralher lhan a generic "exerl". He aIso saved
my idiosyncralic slyIe from lhe duIIing of lhe ediling rocess (for aII ils
fauIls, lhe slyIe is .%-#de IinaIIy, Mina SamueIs roved lo be lhe grealesl
conceivabIe edilor: immenseIy inluilive, cuIlured, aeslhelicaIIy
concerned, yel noninlrusive.
Many friends have fed me vilh ideas during conversalions, ideas lhal
found lheir vay inlo lhe lexl. I can menlion lhe usuaI susecls, aII of
lhem rime conversalionaIisls: Cynlhia SheIlon TaIeb, HeIyelle Geman,
Marie-Chrisline Riachi, IauI WiImoll, Shaiy IiIeI, David DeRosa, Iric
riys, Sid Kahn, }im GalheraI, ernard Oelil, Cyrus Iirasleh, Marlin
Mayer, runo Duire, RahaeI Douady, Marco AveIIaneda, Didier
}avice, NeiI Chriss, and IhiIie AsseiIy.
Some of lhese chalers vere comosed and discussed as arl of lhe
"Odeon CircIe", as my friends and I mel vilh a varying degree of
reguIarily (on Wednesdays al 10 .m. afler my Couranl cIass) al lhe bar
of lhe reslauranl Odeon in Tribecca. S#-%B) 58/% ("lhe siril of lhe
Iace") and oulslanding Odeon slaff member Tarek KheIifi made sure
lhal ve vere veII laken care of and enforced our assiduily by making
me feeI guiIly on no-shovs, lhus heIing grealIy vilh lhe eIaboralion of
lhe book. We ove him a Iol.
I musl aIso acknovIedge lhe eoIe vho read lhe MS, diIigenlIy
heIed vilh lhe errors, or conlribuled lo lhe eIaboralion of lhe book
vilh usefuI commenls: Inge Ivchenko, Danny Toslo, Manos
Vourkouliolis, Slan MeleIils, }ack Rabinovilz, SiIverio Ioresi, AchiIIes
VenelouIias, and NichoIas Slehanou. Irik SlellIer vas invaIuabIe in his
roIe as a shadov coy edilor. AII mislakes are mine.
IinaIIy, many versions of lhis book sal on lhe veb, yieIding soradic
(and random) bursls of Iellers of encouragemenl, correclions, and
vaIuabIe queslions vhich made me veave ansvers inlo lhe lexl. Many
chalers of lhis book came in resonse lo readers' queslions. Irancesco
CorieIIi from occoni aIerled me on lhe biases in lhe disseminalion of
scienlific resuIls.
This book vas vrillen and finished afler I founded Imirica, my
inleIIecluaI home, "Cam Imirica", in lhe voods in lhe back counlry
of Greenvich, CT, vhich I designed lo fil my lasle and feeI Iike a hobby,
a combinalion of an aIied robabiIily research Iaboralory, alhIelic
summer cam, and, nol Ieasl, a crisis hunling hedge fund oeralion (I
had exerienced one of my besl rofessionaI years vhiIe vriling lhese
Iines). I lhank aII lhe Iike-minded eoIe vho heIed fueI lhe slimuIaling
almoshere lhere: IaIIo Angsuun, Danny Toslo, Ieler HaIIe, Mark
SilznageI, Yuzhang Zhou, and CyriI de LambiIIy as veII as lhe
members of IaIoma Iarlners such as Tom Wilz vho chaIIenged our
visdom on a daiIy basis or DonaId Sussman vho suIied me vilh his
enelraling |udgmenl.
Onc: II Ynu'rc 5n Rich Why Arcn't Ynu 5n 5mart?
An i!!ustratinn nI thc cIIcct nI randnmncss nn sncia! pccking nrdcr and |ca!nusy,
thrnugh twn charactcrs nI nppnsitc attitudcs. On thc cnncca!cd rarc cvcnt. Hnw
things in mndcrn !iIc may changc rathcr rapid!y, cxccpt, pcrhaps, in dcntistry.
Twn: A Bizarrc Accnunting Mcthnd
On a!tcrnativc histnrics, a prnbabi!istic vicw nI thc wnr!d, intc!!cctua! Iraud, and thc
randnmncss wisdnm nI a Frcnchman with stcady bathing habits. Hnw |nurna!ists
arc brcd tn nnt undcrstand randnm scrics nI cvcnts. Bcwarc bnrrnwcd wisdnm: hnw
a!mnst a!! grcat idcas cnnccrning randnm nutcnmcs arc against cnnvcntinna!
sapicncc. On thc diIIcrcncc bctwccn cnrrcctncss and intc!!igibi!ity.
Thrcc: A Mathcmatica! Mcditatinn nn Histnry
On Mnntc Car!n simu!atinn as a mctaphnr tn undcrstanding a scqucncc nI randnm
histnrica! cvcnts. On randnmncss and artiIicia! histnry. Agc is bcauty, a!mnst
a!ways, and thc ncw and thc ynung arc gcncra!!y tnxic. 5cnd ynur histnry prnIcssnr
tn an intrnductnry c!ass nn samp!ing thcnry.
Fnur: Randnmncss, Nnnscnsc, and thc 5cicntiIic Intc!!cctua!
On cxtcnding thc Mnntc Car!n gcncratnr tn prnducc artiIicia! thinking and cnmparc
it with rignrnus nnn-randnm cnnstructs. Thc scicncc wars cntcr thc busincss wnr!d.
Why thc acsthctc in mc !nvcs tn bc Inn!cd by randnmncss.
xviii CHAITIR SUMMARI IS
Fivc: 5urviva! nI thc Lcast Fit - Can Evn!utinn Bc Fnn!cd by
Randnmncss?
A casc study nn t wn rarc cvcnts. On rarc cvcnts and cvn!utinn. HnwJ ' Dar wi ni sm"
and cvn!utinn arc cnnccpts that arc misundcrstnnd in thc nnn-bin!ngica! wnr!d. LiIc
is nnt cnntinunus. Hnw cvn!utinn wi!! bc Inn!cd by randnmncss. A prcparatinn tn
thc prnb!cm nI inductinn.
5ix: 5kcwncss and Asymmctry
Wc intrnducc thc cnnccpt nI skcwncss: why thc tcrms "bu!!" and "bcar" havc !imitcd
mcaning nutsidc nI znn!ngy. A vicinus chi!d wrccks thc structurc nI randnmncss. An
intrnductinn tn thc prnb!cm nI cpistcmn!ngica! npacity. Thc pcnu!timatc stcp bcInrc
thc prnb!cm nI inductinn.
5cvcn: Thc Prnb!cm nI Inductinn
On thc chrnmndynamics nI swans. Taking 5n!nn's warning intn snmc phi!nsnphica!
tcrritnry. Hnw Victnr NicdcrhnIIcr taught mc cmpiricism, I addcd dcductinn. Why
it is nnt scicntiIic tn takc scicncc scrinus!y. 5nrns prnmntcs Pnppcr. That bnnkstnrc
nn 21st and FiIth Avcnuc. Pasca!' s wagcr.
Eight: Tnn Many Mi!!innaircs Ncxt Dnnr
Thrcc i!!ustratinns nI thc survivnrship bias. Why vcry Icw pcnp!c shnu!d !ivc nn Park
Avcnuc. Thc mi!!innairc ncxt dnnr has vcry I!imsy c!nthcs. An nvcrcrnwding nI
cxpcrts.
Ninc: It Is Easicr Tn Buy and 5c!! Than Fry an Egg
5nmc tcchnica! cxtcnsinns nI thc survivnrship bias. On thc distributinn nI "cnin-
cidcnccs" in !iIc. It is prcIcrab!c tn bc !ucky than cnmpctcnt (but ynu can bc caught).
Thc birthday paradnx. Mnrc char!atans (and mnrc |nurna!ists). Hnw thc rcscarchcr
with wnrk cthics qan Iind |ust abnut anything in data. On dngs nnt barking.
Tcn: Lnscr Takcs A!! - On thc Nnn!incaritics nI LiIc
Thc nnn!incar vicinusncss nI !iIc. Mnving tn Bc! Air and acquiring thc viccs nI thc
rich and Iamnus. Why MicrnsnIt' s Bi!! Gatcs may nnt bc thc bcst in his busincss (but
p!casc dn nnt inInrm him nI such a Iact). Dcpriving dnnkcys nI Innd.
E!cvcn: Randnmncss and Our Brain: Wc Arc Prnbabi!ity B!ind
On thc diIIicu!ty nI thinking nI ynur vacatinn as a !incar cnmbinatinn nI Paris and
thc Bahamas. Ncr n Tu!ip may ncvcr ski in thc A!ps again. 5nmc discussinn nI
bchavinra! discnvcrics. 5nmc maniIcstatinns nI prnbabi!ity b!indncss takcn nut nI a
tcxtbnnk. A !itt!c mnrc nn |nurna!istic pn!!utinn. Why ynu may bc dcad by nnw.
CHAITIR SUMMARI IS xix
Twc!vc: Gamb!crs' Ticks and Pigcnns in a Bnx
On gamb!crs' ticks crnwding up my !iIc. Why bad taxi-cab Eng!ish can hc!p ynu
makc mnncy. Hnw I am thc Inn! nI a!! Inn!s, cxccpt that I am awarc nI it. Dca!ing
with my gcnctic unIitncss. Nn bnxcs nI chncn!atc undcr my trading dcsk.
Thirtccn: Carncadcs Cnmcs tn Rnmc: On Prnbabi!ity and 5kcpticism
Cat n thc ccnsnr scnds Carncadcs packing. Mnnsicur dc Nnrpnis dncs nnt rcmcmbcr
his n!d npininns. Bcwarc thc scicntist. Marrying idcas. Thc samc Rnbcrt Mcrtnn
hc!ping thc authnr start his Iirm. 5cicncc cvn!vcs Irnm Iuncra! tn Iuncra!.
Fnurtccn: Bacchus Abandnns Antnny
Mnnthcr!ant' s dcath. 5tnicism is nnt thc stiII uppcr !ip, but thc i!!usinn nI victnry nI
man against randnmncss. It is sn casy tn bc hcrnic. Randnmncss and pcrsnna!
c!cgancc.
IROLOGUI
4 -
+#,-$(, ./ %'( 01#$2,
T
his book is aboul Iuck disguised and erceived as non-Iuck (lhal is,
skiIIs) and, more generaIIy, randomness disguised and erceived as
non-randomness (lhal is, delerminism). Il manifesls ilseIf in lhe shae of
lhe 5B/>, <885N defined as a erson vho benefiled from a disroor-
lionale share of Iuck bul allribules his success lo some olher, generaIIy
very recise, reason. Such confusion cros u in lhe mosl unexecled
areas, even science, lhough nol in such an accenlualed and obvious
manner as il does in lhe vorId of business. Il is endemic in oIilics, as il
can be encounlered in lhe shae of a counlry's residenl discoursing on
lhe |obs lhal "he" crealed, "his" recovery, and "his redecessor's"
infIalion.
We are genelicaIIy sliII very cIose lo our anceslors vho roamed lhe
savannah. The formalion of our beIiefs is fraughl vilh suerslilions -
even loday (I mighl say, eseciaIIy loday). }usl as one day some
rimilive lribesman scralched his nose, sav rain faIIing, and deveIoed
an eIaborale melhod of scralching his nose lo bring on lhe much-needed
rain, ve Iink economic roserily lo some rale cul by lhe IederaI
Reserve oard, or lhe success of a comany vilh lhe aoinlmenl of lhe
nev residenl "al lhe heIm". ookslores are fuII of biograhies of
successfuI men and vomen resenling lheir secific exIanalion on hov
lhey made il big in Iife (ve have an exression, "lhe righl lime and lhe
righl Iace" lo veaken vhalever concIusion can be inferred from lhem).
2 IROLOGUI
This confusion slrikes eoIe of differenl ersuasions, lhe Iileralure
rofessor invesls a dee meaning inlo a mere coincidenlaI occurrence of
vord allerns, vhiIe lhe financiaI slalislician roudIy delecls
"reguIarilies" and "anomaIies" in dala lhal are Iain random.
Al lhe cosl of aearing biased, I have lo say lhal lhe Iilerary mind
can be inlenlionaIIy rone lo lhe confusion belveen -8%)# and .#'-%-+N
lhal is, belveen a randomIy conslrucled arrangemenl and a reciseIy
inlended message. Hovever, lhis causes IillIe harm, fev cIaim lhal arl is
a looI of invesligalion of lhe Trulh - ralher lhan an alleml lo escae il
or make il more aIalabIe. SymboIism is lhe chiId of our inabiIily and
unviIIingness lo accel randomness, ve give meaning lo aII manner of
shaes, ve delecl human figures in inkbIols. M )'? .8)CB#) %- (A# /58B1)
announced Arlhur Rimbaud lhe 19lh-cenlury Irench symboIic oel.
This inlerrelalion look him lo "oelic" Abyssinia (in Iasl Africa),
vhere he vas brulaIized by a Chrislian Lebanese sIave deaIer,
conlracled syhiIis, and Iosl a Ieg lo gangrene. He gave u oelry in
disgusl al lhe age of 19, and died anonymousIy in a MarseiIIes hosilaI
vard vhiIe sliII in his lhirlies. ul il vas loo Iale. Iuroean inleIIecluaI
Iife deveIoed vhal seems lo be an irreversibIe lasle for symboIism - ve
are sliII aying ils rice, vilh sychoanaIysis and olher fads.
RegrellabIy, some eoIe Iay lhe game loo seriousIy, lhey are aid
lo read loo much inlo lhings. AII my Iife I have suffered lhe confIicl
belveen my Iove of Iileralure and oelry and my rofound aIIergy lo
mosl leachers of Iileralure and "crilics". The Irench oel IauI VaIery
vas surrised lo Iislen lo a commenlary of his oems lhal found
meanings lhal had unliI lhen escaed him (of course, il vas oinled oul
lo him lhal lhese vere inlended by his subconscious).
More generaIIy, ve undereslimale lhe share of randomness in aboul
anylhing, a oinl lhal may nol meril a book - excel vhen il is lhe
seciaIisl vho is lhe fooI of aII fooIs. DislurbingIy, science has onIy
recenlIy been abIe lo handIe randomness (lhe grovlh in avaiIabIe
informalion has been exceeded by lhe exansion of noise). IrobabiIily
lheory is a young arrivaI in malhemalics, robabiIily aIied lo raclice
is aImosl nonexislenl as a disciIine.
Consider lhe Iefl and lhe righl coIumns of TabIe I. I. The besl vay lo
summarize lhe ma|or lhesis of lhis book is lhal il addresses silualions
(many of lhem lragicomicaI) vhere lhe Iefl coIumn is mislaken for lhe
3 IROLOGUI
TabIe P.! TabIe of Confusion
;$#)#-(%-+ (A# /#-($'5 1%)(%-/(%8-) B)#1 %- (A# Y88>
GENERAL
Luck 5ki!!s
Randnmncss Dct crmi ni sm
Prnbabi!ity Ccrt ai nt y
Bc!icI, cnn| cct urc Knnw! cdgc, ccrtitudc
Thcnr y Rca!ity
Anccdnt c, cnincidcncc Causa!ity, !aw
Fnr ccast Prnphccy
MARKET PERFORMANCE
Lucky idint 5ki!!cd invcstnr
5urvivnrship bias Mar kct nut pcrInrmancc
FINANCE
Vn!ati!ity Rct ur n (nr driIt)
5tnchastic variab!c Dctcrministic variab!c
PHY5IC5 AND ENGINEERING
Nni sc 5igna!
LITERARY CRITICI5M
Nnnc (!itcrary critics dn 5ymbn!
nnt sccm t n havc a namc
Inr things thcy dn nnt
undcrstand)
PHILO5OPHY OF 5CIENCE
Epistcmic prnbabi!ity Physica! prnbabi!ity
Induct i nn Dcduct i nn
5ynthctic prnpnsitinn Ana! yt i c prnpnsi t i nn
righl one. The sub-seclions aIso iIIuslrale lhe key areas of discussion on
vhich lhis book viII be based.
The reader may vonder vhelher lhe oosile case mighl nol deserve
some allenlion, lhal is, lhe silualions vhere non-randomness is
mislaken for randomness. ShouIdn'l ve be concerned vilh silualions
vhere allerns and messages may have been ignored` I have lvo
ansvers. Iirsl, I am nol overIy vorried aboul lhe exislence of
4 IROLOGUI
undelecled allerns. We have been reading Ienglhy and comIex
messages in |usl aboul any manifeslalion of nalure lhal resenls
|aggedness (such as lhe aIm of a hand, lhe residues al lhe bollom of
Turkish coffee cus, elc.). Armed vilh home suercomulers and
chained rocessors, and heIed by comIexily and "chaos" lheories, lhe
scienlisls, semi-scienlisls, and seudoscienlisls viII be abIe lo find
orlenls. Second, ve need lo lake inlo accounl lhe cosls of mislakes, in
my oinion, mislaking lhe righl coIumn for lhe Iefl one is nol as coslIy
as an error in lhe oosile direclion. Iven ouIar oinion varns lhal
bad informalion is vorse lhan no informalion al aII.
Hovever inleresling lhese areas couId be, lheir discussion vouId be a
laII order. In addilion, lhey are nol my currenl rofessionaI seciaIly.
There is one vorId in vhich I beIieve lhe habil of mislaking Iuck for skiII
is mosl revaIenl - and mosl consicuous - and lhal is lhe vorId of
lrading. y Iuck or misforlune, lhal is lhe vorId in vhich I oerale. Il is
my rofession, and as such il viII form lhe backbone of lhis book. Il is
vhal I knov besl. In addilion, business resenls lhe besl (and mosl
enlerlaining) Iaboralory for lhe underslanding of lhese differences. Ior
il is lhe area of human underlaking vhere lhe confusion is grealesl and
ils effecls lhe mosl ernicious. Ior inslance, ve oflen have lhe mislaken
imression lhal a slralegy is an exceIIenl slralegy, or an enlrereneur a
erson endoved vilh "vision", or a lrader an exceIIenl lrader, onIy lo
reaIize lhal 99.9% of lheir asl erformance is allribulabIe lo chance,
and chance aIone. Ask a rofilabIe inveslor lo exIain lhe reasons for his
success, he viII offer some dee and convincing inlerrelalion of lhe
resuIls. IrequenlIy, lhese deIusions are inlenlionaI and deserve lo bear
lhe name "charIalanism".
If lhere is one cause for lhis confusion belveen lhe Iefl and lhe righl
sides of our labIe, il is our inabiIily lo lhink crilicaIIy - ve may en|oy
resenling con|eclures as lrulh. We are vired lo be Iike lhal. We viII see
lhal our mind is nol equied vilh lhe adequale hardvare lo handIe
robabiIilies, such infirmily even slrikes lhe exerl, somelimes |usl lhe
exerl. A crilicaI mind, on lhe olher hand, is someone vho has lhe guls,
vhen confronling a given sel of informalion, lo allribule a Iarge share of
ils ossibIe cause lo lhe Iefl coIumn.
The 19lh-cenlury carloon characler, ol-beIIied bourgeois Monsieur
Irudhomme, carried around a Iarge svord vilh a doubIe inlenl:
5 IROLOGUI
rimariIy lo defend lhe ReubIic againsl ils enemies, and secondariIy lo
allack il shouId il slray from ils course. In lhe same manner, lhis book
has lvo uroses: lo defend science (as a Iighl beam across lhe noise of
randomness), and lo allack lhe scienlisl vhen he slrays from his course
(mosl disaslers come from lhe facl lhal individuaI scienlisls do nol have
an innale underslanding of slandard error or a cIue aboul crilicaI
lhinking). As a raclilioner of uncerlainly I have seen more lhan my
share of snake-oiI saIesmen dressed in lhe garb of scienlisls. The grealesl
fooIs of randomness viII be found among lhese.
This aulhor hales books lhal can be easiIy guessed from lhe labIe of
conlenls - bul a hinl of vhal comes nexl seems in order. The book is
comosed of lhree arls. The firsl is an inlroseclion inlo SoIon's
varning, as his oulbursl on rare evenls became my IifeIong mollo. In il
ve medilale on visibIe and invisibIe hislories. The second resenls a
coIIeclion of robabiIily biases I encounlered (and suffered from) in my
career in randomness - ones lhal conlinue lo fooI me. The lhird
concIudes lhe book vilh lhe reveIalion lhal erhas ridding ourseIves of
our humanily is nol in lhe vorks, ve need lricks, nol some grandiose
moraIizing heI. Again lhe eIders can heI us vilh some of lheir ruses.
PART I
" 4
SOLON' S WARNING - SKIWNISS,
ASYMMITRY, INDUCTION
f
C
roesus, King of Lydia, vas considered lhe richesl man of his lime.
To lhis day Romance Ianguages use lhe exression "rich as
Croesus" lo describe a erson of excessive veaIlh. He vas said lo be
visiled by SoIon, lhe Greek IegisIalor knovn for his dignily, reserve,
urighl moraIs, humiIily, frugaIily, visdom, inleIIigence, and courage.
SoIon did nol disIay lhe smaIIesl surrise al lhe veaIlh and sIendor
surrounding his hosl, nor lhe liniesl admiralion for lheir ovner. Croesus
vas so irked by lhe manifesl Iack of imression on lhe arl of lhis
iIIuslrious visilor lhal he allemled lo exlracl from him some
acknovIedgmenl. He asked him if he had knovn a haier man lhan
him. SoIon ciled lhe Iife of a man vho Ied a nobIe Iife and died vhiIe in
ballIe. Irodded for more, he gave simiIar examIes of heroic bul
lerminaled Iives, unliI Croesus, irale, asked him oinl-bIank if he vas
nol lo be considered lhe haiesl man of aII. SoIon ansvered: "The
observalion of lhe numerous misforlunes lhal allend aII condilions
forbids us lo grov insoIenl uon our resenl en|oymenls, or lo admire a
man's hainess lhal may yel, in course of lime, suffer change. Ior lhe
uncerlain fulure has yel lo come, vilh aII variely of fulure, and him onIy
lo vhom lhe divinily has |guaranleedj conlinued hainess unliI lhe end
ve may caII hay."
1
The modern equivaIenl has been no Iess eIoquenlIy voiced by lhe
basebaII coach Yogi erra, vho seems lo have lransIaled SoIon's
10 SOLON' S WARNI NG
oulbursl from lhe ure Allic Greek inlo no Iess ure rookIyn IngIish
vilh "il ain'l over unliI il's over", or, in a Iess dignified manner, vilh "il
ain'l over unliI lhe fal Iady sings". In addilion, aside from his use of lhe
vernacuIar, lhe Yogi erra quole resenls an advanlage of being lrue,
vhiIe lhe meeling belveen Croesus and SoIon vas one of lhese
hisloricaI facls lhal benefiled from lhe imaginalion of lhe chronicIers, as
il vas chronoIogicaIIy imossibIe for lhe lvo men lo have been in lhe
same Iocalion.
Iarl I is concerned vilh lhe degree lo vhich a silualion may yel, in
lhe course of lime, suffer change. Ior ve can be lricked by silualions
invoIving moslIy lhe aclivilies of lhe Goddess Iorluna - }uiler's
firslborn daughler. SoIon vas vise enough lo gel lhe foIIoving oinl,
lhal vhich came vilh lhe heI of Iuck couId be laken avay by Iuck (and
oflen raidIy and unexecledIy al lhal). The fIiside, vhich deserves lo
be considered as veII (in facl il is even more of our concern), is lhal
lhings lhal come vilh IillIe heI from Iuck are more resislanl lo
randomness. SoIon aIso had lhe inluilion of a robIem lhal has obsessed
science for lhe asl lhree cenluries. Il is caIIed lhe robIem of induclion.
I caII il in lhis book lhe Y5'/> )?'- or lhe $'$# #&#-(e SoIon even
underslood anolher Iinked robIem, vhich I caII lhe )>#?-#)) issue, il
does nol maller hov frequenlIy somelhing succeeds if faiIure is loo
coslIy lo bear.
Yel lhe slory of Croesus has anolher lvisl. Having Iosl a ballIe lo lhe
redoublabIe Iersian king Cyrus, he vas aboul lo be burned aIive vhen
he caIIed SoIon's name and shouled (somelhing Iike) "SoIon, you vere
righl" (again lhis is Iegend). Cyrus asked aboul lhe nalure of such
unusuaI invocalions, and he loId him aboul SoIon's varning. This
imressed Cyrus so much lhal he decided lo sare Croesus' Iife, as he
refIecled on lhe ossibiIilies as far as his ovn fale vas concerned. IeoIe
vere lhoughlfuI al lhal lime.
ONI
=- %55B)($'(%8- 8< (A# #<<#/( 8< $'-18.-#)) 8- )8/%'5 :#/>%-+
8$1#$ '-1 g#'58B),N (A$8B+A (?8 /A'$'/(#$) 8< 8::8)%(#
'((%(B1#)e 9- (A# /8-/#'5#1 $'$# #&#-(e 08? (A%-+) %- .81#$-
5%<# .', /A'-+# $'(A#$ $':%15,N #7/#:(N :#$A':)N %- 1#-(%)($,e
3(*# 4$1.5
HIT BY LIGHTNING
N
ero TuIi became obsessed vilh lrading afler vilnessing a slrange
scene one sring day as he vas visiling lhe Chicago MercanliIe
Ixchange. A red converlibIe Iorsche, driven al severaI limes lhe cily
seed Iimil, abrulIy sloed in fronl of lhe enlrance, ils lires emilling
lhe sound of igs being sIaughlered. A visibIy demenled alhIelic man in
his lhirlies, his face fIushed red, emerged and ran u lhe sles as if he
vere chased by a liger. He Iefl lhe car doubIe-arked, ils engine running,
rovoking an angry fanfare of horns. Afler a Iong minule, a bored
young man cIad in a yeIIov |ackel (yeIIov vas lhe coIor reserved for
cIerks) came dovn lhe sles, visibIy unlroubIed by lhe lraffic
commolion. He drove lhe car inlo lhe underground arking garage -
erfuncloriIy as if il vere his daiIy chore.
Thal day Nero TuIi vas hil vilh vhal lhe Irench caII a /8B: 1#
<8B1$#N a sudden inlense (and obsessive) infalualion lhal slrikes Iike
Iighlning. "This is for me!", he screamed enlhusiaslicaIIy - he couId nol
heI comaring lhe Iife of a lrader lo lhe aIlernalive Iives lhal couId
resenl lhemseIves lo him. Academia con|ured u lhe image of a siIenl
universily office vilh rude secrelaries, business, lhe image of a quiel
office slaffed vilh sIov lhinkers and semi-sIov lhinkers vho exress
lhemseIves in fuII senlences.
TEMPORARY 5ANITY
UnIike a /8B: 1# <8B1$#, lhe infalualion lriggered by lhe Chicago
scene has nol Iefl him cIose lo a decade-and-a-haIf afler lhe incidenl. Ior
Nero svears lhal no olher IavfuI rofession in our limes couId be as
devoid of boredom as lhal of lhe lrader. Iurlhermore, aIlhough he has
nol yel racliced lhe rofession of high-sea iracy, he is nov convinced
lhal even lhe occualion of irale vouId resenl more duII momenls
lhan lhal of lhe lrader.
Nero couId besl be described as someone vho randomIy (and
abrulIy) svings belveen lhe deorlmenl and seech manners of a
church hislorian and lhe verbaIIy abusive inlensily of a Chicago il
lrader. He can commil hundreds of miIIions of doIIars in a lransaclion
vilhoul a bIink or a shadov of second lhoughls, yel agonize belveen
lvo aelizers on lhe menu, changing his mind back and forlh and
vearing oul lhe mosl alienl of vailers.
Nero hoIds an undergraduale degree in ancienl Iileralure and
malhemalics from Cambridge Universily. He enroIIed in a Ih.D.
rogram in slalislics al lhe Universily of Chicago bul, afler comIeling
lhe rerequisile coursevork, as veII as lhe buIk of his docloraI research,
he svilched lo lhe hiIosohy dearlmenl. He caIIed lhe svilch "a
momenl of lemorary sanily", adding lo lhe conslernalion of his lhesis
direclor vho varned him againsl hiIosohers and redicled his relurn
back lo lhe foId. He finished vriling his lhesis in hiIosohy. ul nol lhe
Derrida conlinenlaI slyIe of incomrehensibIe hiIosohy (lhal is,
I I YOU' RI SO RI CH WHY ARIN' T YOU SO SMART` . 13
%-/8.:$#A#-)%Y5# lo anyone oulside of lheir ranks, Iike myseIf). Il vas
quile lhe oosile, his lhesis vas on lhe melhodoIogy of slalislicaI
inference in ils aIicalion lo lhe sociaI sciences. In facl, his lhesis vas
indislinguishabIe from a lhesis in malhemalicaI slalislics - il vas |usl a
bil more lhoughlfuI (and lvice as Iong).
Il is oflen said lhal hiIosohy cannol feed ils man - bul lhal vas nol
lhe reason Nero Iefl. He Iefl because hiIosohy cannol enlerlain ils
man. Al firsl, il slarled Iooking fuliIe, he recaIIed his slalislics lhesis
direclor's varnings. Then, suddenIy, il slarled lo Iook Iike vork. As he
became lired of vriling aers on some arcane delaiIs of his earIier
aers, he gave u lhe academy. These academic debales bored him lo
lears, arlicuIarIy vhen very smaII minule oinls (invisibIe lo lhe non-
inilialed) vere al slake. Aclion vas vhal Nero required. The robIem,
hovever, vas lhal he seIecled lhe academy in lhe firsl Iace in order lo
kiII vhal he delecled vas lhe fIalness and lemered submission of
emIoymenl Iife.
Afler vilnessing lhe scene of lhe lrader chased by a liger, Nero found
a lrainee sol on lhe Chicago MercanliIe Ixchange, lhe Iarge exchange
vhere lraders lransacl by shouling and geslicuIaling frenelicaIIy. There
he vorked for a resligious (bul eccenlric) 58/'5N vho lrained him in lhe
Chicago slyIe, in relurn for Nero soIving his malhemalicaI equalions.
The energy in lhe air roved molivaling lo Nero. He raidIy gradualed
lo lhe rank of seIf-emIoyed lrader. Then, vhen he gol lired of slanding
on his feel in lhe crovd, and slraining his vocaI cords, he decided lo seek
emIoymenl "uslairs", lhal is, lrading from a desk. He moved lo lhe
Nev York area and look a osilion vilh an inveslmenl house.
Nero seciaIized in quanlilalive financiaI roducls, in vhich he had an
earIy momenl of gIory, became famous and in demand. Many inveslmenl
houses in Nev York and London fIashed huge guaranleed bonuses al
him. Nero senl a couIe of years shullIing belveen Nev York and
London, allending imorlanl "meelings" and vearing exensive suils.
ul soon Nero venl inlo hiding, he raidIy uIIed back lo anonymily -
lhe WaII Slreel slardom lrack did nol quile fil his lemeramenl. To slay a
"hol lrader" requires some organizalionaI ambilions and a over hunger
lhal he feeIs Iucky nol lo ossess. He vas onIy in il for lhe fun - and his
idea of fun does nol incIude adminislralive and manageriaI vork. He is
suscelibIe lo conference room boredom and is incaabIe of laIking lo
businessmen, arlicuIarIy lhose run-of-lhe-miII variely. Nero is aIIergic
lo lhe vocabuIary of business laIk, nol |usl on Iain aeslhelic grounds.
Words Iike "game Ian", "bollom Iine", "hov lo gel lhere from here",
"ve rovide our cIienls vilh soIulions", "our mission" and olher
hackneyed exressions lhal dominale meelings Iack bolh lhe recision
and lhe coIoralion lhal he refers lo hear. Whelher eoIe ouIale
siIence vilh hoIIov senlences, or if such meelings resenl any lrue meril,
he does nol knov, al any rale he did nol vanl lo be arl of il. Indeed
Nero's exlensive sociaI Iife incIudes aImosl no business eoIe. ul
unIike me (I can be exlremeIy humiIialing vhen someone rubs me lhe
vrong vay vilh ineIeganl omousness), Nero handIes himseIf vilh
genlIe aIoofness in lhese circumslances.
So, Nero svilched career lo vhal is caIIed rorielary lrading.
Traders are sel u as indeendenl enlilies, inlernaI funds vilh lheir ovn
aIIocalion of cailaI. They are Iefl aIone lo do as lhey Iease, rovided
of course lhal lheir resuIls salisfy lhe execulives. The name rorielary
comes from lhe facl lhal lhey lrade lhe comany's ovn money. Al lhe
end of lhe year lhey receive belveen 7% and 12% of lhe rofils
generaled. The rorielary lrader has aII lhe benefils of seIf
emIoymenl, and none of lhe burdens of running lhe mundane delaiIs
of his ovn business. He can vork any hours he Iikes, can lraveI al a
vhim and engage in aII manner of ersonaI ursuils. Il is aradise for an
inleIIecluaI Iike Nero vho disIikes manuaI vork and vaIues unscheduIed
medilalion. He has been doing lhal for lhe asl len years, in lhe
emIoymenl of lvo differenl lrading firms.
MODU5 OPERANDI
A vord on Nero's melhods. He is as conservalive a lrader as one can be
in such a business. In lhe asl he has had good years and Iess lhan good
years - bul virluaIIy no lruIy "bad" years. Over lhese years he has sIovIy
buiIl for himseIf a slabIe nesl egg, lhanks lo an income ranging belveen
$300,000 and (al lhe eak) $2,500,000. On average, he manages lo
accumuIale $500,000 a year in afler-lax money (from an average income
of aboul $1,000,000), lhis goes slraighl inlo his savings accounl. In
1993, he had a fIal year and vas made lo feeI uncomforlabIe in his
comany. Olher lraders made oul much beller, so lhe cailaI al his
disosaI vas severeIy reduced, and he vas made lo feeI undesirabIe al lhe
inslilulion. He lhen venl lo gel an idenlicaI |ob, dovn lo an idenlicaIIy
designed vorksace, bul in a differenl firm lhal vas friendIier. In lhe faII
of 1994 lhe lraders vho had been comeling for lhe greal erformance
avard bIev u in unison during lhe vorIdvide bond markel crash lhal
resuIled from lhe random lighlening by lhe IederaI Reserve ank of lhe
Uniled Slales. They are aII currenlIy oul of lhe markel, erforming a
variely of lasks. This business has a high morlaIily rale.
Why doesn'l Nero make more money` ecause of his lrading slyIe -
or erhas his ersonaIily. His risk aversion is exlreme. Nero's ob|eclive
is nol lo maximize his rofils, so much as il is lo avoid having lhis
enlerlaining money machine caIIed lrading laken avay from him.
Ioving u vouId mean relurning lo lhe ledium of lhe universily or lhe
non-lrading Iife. Ivery lime his risks increase, he con|ures u lhe image
of lhe quiel haIIvay al lhe universily, lhe Iong mornings al his desk
senl in revising a aer, kel avake by bad coffee. No, he does nol
vanl lo have lo face lhe soIemn universily Iibrary vhere he vas bored lo
lears. "I am shooling for Iongevily", he is vonl lo say.
Nero has seen many lraders Y58? B:N and does nol vanl lo gel inlo
lhal silualion. X58? B: in lhe Iingo has a recise meaning, il does nol
|usl mean lo Iose money, il means lo Iose more money lhan one ever
execled, lo lhe oinl of being lhrovn oul of lhe business (lhe
equivaIenl of a doclor Iosing his Iicense lo raclice or a Iavyer being
disbarred). Nero raidIy exils lrades afler a redelermined Ioss. He
never seIIs "naked olions" (a slralegy lhal vouId Ieave him exosed lo
Iarge ossibIe Iosses). He never uls himseIf in a silualion vhere he can
Iose more lhan, say, $1,000,000 - regardIess of lhe robabiIily of such
an evenl. Thal amounl has aIvays been variabIe, il deends on his
accumuIaled rofils for lhe year. This risk aversion revenled him from
making as much money as lhe olher lraders on WaII Slreel vho are
oflen caIIed "Maslers of lhe Universe". The firms he has vorked for
generaIIy aIIocale more money lo lraders vilh a differenl slyIe, Iike }ohn
vhom ve viII encounler soon.
Nero's lemeramenl is such lhal he does nol mind Iosing smaII
money. "I Iove laking smaII Iosses", he says. "I |usl need my vinners lo
be Iarge". In no circumslances does he vanl lo be exosed lo lhose rare
16
SOLON' S WARNI NG
evenls, Iike anics and sudden crashes lhal vie a lrader oul in a fIash.
To lhe conlrary, he vanls lo benefil from lhem. When eoIe ask him
vhy he does nol hoId on lo Iosers, he invariabIy ansvers lhal he vas
lrained by "lhe mosl chicken of lhem aII", lhe Chicago lrader Slevo vho
laughl him lhe business. This is nol lrue, lhe reaI reason is his lraining in
robabiIily and his innale skelicism.
There is anolher reason vhy Nero is nol as rich as olhers in his
silualion. His skelicism does nol aIIov him lo invesl any of his ovn
money oulside of lreasury bonds. He lherefore missed oul on lhe greal buII
markel. The reason he offers is lhal il couId have lurned oul lo be a bear
markel and a lra. Nero harbors a dee susicion lhal lhe slock markel is
some form of an inveslmenl scam and cannol bring himseIf lo ovn a slock.
The difference vilh eoIe around him vho vere enriched by lhe slock
markel vas lhal he vas cash-fIov rich, bul his assels did nol infIale al aII
aIong vilh lhe resl of lhe vorId (his lreasury bonds hardIy changed in
vaIue). He conlrasls himseIf vilh one of lhose slarlu lechnoIogy
comanies lhal vere massiveIy cash-fIov negalive, bul for vhich lhe
hordes deveIoed some infalualion. This aIIoved lhe ovners lo become
rich from lheir slock vaIualion, and lhus deendenl on lhe randomness of
lhe markel's eIeclion of lhe vinner. The difference vilh his friends of lhe
invesling variely is lhal he did nol deend on lhe buII markel, and,
accordingIy, does nol have lo vorry aboul a bear markel al aII. His nel
vorlh is nol a funclion of lhe inveslmenl of his savings - he does nol vanl
lo deend on his inveslmenls, bul on his cash earnings, for his enrichmenl.
He lakes nol an inch of risk vilh his savings, vhich he invesls in lhe safesl
ossibIe vehicIes. Treasury bonds are safe, lhey are issued by lhe Uniled
Slales Governmenl, and governmenls can hardIy go bankrul since lhey
can freeIy rinl lheir ovn currency lo ay back lheir obIigalion.
NO WORK ETHI C5
Today, al 39, afler 14 years in lhe business, he can consider himseIf
comforlabIy sellIed. His ersonaI orlfoIio conlains severaI miIIion
doIIars in medium malurily Treasury onds, enough lo eIiminale any
vorry aboul lhe fulure. Whal he Iikes mosl aboul rorielary lrading is
lhal il requires considerabIy Iess lime lhan olher high-aying
rofessions, in olher vords il is erfeclIy comalibIe vilh his non-
middIe-cIass vork elhics. Trading forces someone lo lhink hard, lhose
vho mereIy vork hard generaIIy Iose lheir focus and inleIIecluaI energy.
In addilion, lhey end u drovning in randomness, vork elhics, Nero
beIieves, drav eoIe lo focus on noise ralher lhan lhe signaI (lhe
difference ve eslabIished in TabIe I.I on age 3).
This free lime has aIIoved him lo carry on a variely of ersonaI
inleresls. As Nero reads voraciousIy and sends considerabIe lime in lhe
gym and museums, he cannol have a Iavyer's or a doclor's scheduIe.
Nero found lhe lime lo go back lo lhe slalislics dearlmenl vhere he
slarled his docloraI sludies and finished lhe "harder science" doclorale
in slalislics, by revriling his lhesis in more concise lerms. Nero nov
leaches, once a year, a haIf-semesler seminar caIIed 0%)(8$, 8<
;$8Y'Y%5%)(%/ FA%->%-+ in lhe malhemalics dearlmenl of Nev York
Universily, a cIass of +$#'( originaIily lhal dravs exceIIenl graduale
sludenls. He has saved enough money lo be abIe lo mainlain his IifeslyIe
in lhe fulure and has conlingency Ians erhas lo relire inlo vriling
ouIar essays of lhe scienlific-Iilerary variely, vilh lhemes revoIving
around robabiIily and %-1#(#$.%-%). - bul onIy if some evenl in lhe
fulure causes lhe markels lo shul dovn.
THERE ARE ALWAY5 5ECRET5
Nero's robabiIislic inlroseclion may have been heIed oul by some
dramalic evenl in his Iife - one lhal he kel lo himseIf. A enelraling
observer mighl delecl in Nero a measure of susicious exuberance, an
unnaluraI drive. Ior his Iife is nol as cryslaIIine as il may seem. Nero
harbors a secrel, one lhal viII be discussed in lime.
6#'/ %'( 7.8'9:.(12 4*)2(*
Through mosl of lhe 1990s, across lhe slreel from Nero's house slood
}ohn's - a much Iarger one. }ohn vas a high-yieId lrader, bul he vas nol
a lrader in lhe slyIe of Nero. A brief rofessionaI conversalion vilh him
vouId have reveaIed lhal he resenled lhe inleIIecluaI delh and
sharness of mind of an aerobics inslruclor (lhough nol lhe-hysique). A
urbIind man couId have seen lhal }ohn had been doing markedIy beller
lhan Nero (or, al Ieasl, feIl comeIIed lo shov il). He arked lvo lo-
of-lhe-Iine German cars in his drivevay (his and hers), in addilion lo
lvo converlibIes (one of vhich vas a coIIeclibIe Ierrari), vhiIe Nero
had been driving lhe same VW cabrioIel for aImosl a decade - and sliII
does.
The vives of }ohn and Nero vere acquainlances, of lhe heaIlh-cIub
lye of acquainlance, bul Nero's vife feIl exlremeIy uncomforlabIe in
lhe comany of }ohn's. She feIl lhal lhe Iady vas nol mereIy lrying lo
imress her, bul vas lrealing her Iike someone inferior. WhiIe Nero had
become inured lo lhe sighl of lraders gelling rich (and lrying loo hard lo
become sohislicaled by lurning inlo vine coIIeclors and oera Iovers),
his vife had rareIy encounlered reressed nev veaIlh - lhe lye of
eoIe vho have feIl lhe sling of indigence al some oinl in lheir Iives
and vanl lo gel even by exhibiling lheir vares. The onIy dark side of
being a lrader, Nero oflen says, is lhe sighl of money being shovered on
unreared eoIe vho are suddenIy laughl lhal VivaIdi's V8B$ *#')8-)
is "refined" music. ul il vas hard for his souse lo be exosed aImosl
daiIy lo lhe neighbor vho kel boasling of lhe nev decoralor lhey |usl
hired. }ohn and his vife vere nol lhe Ieasl uncomforlabIe vilh lhe facl
lhal lheir "Iibrary" came vilh lhe Iealher-bound books (her readings al
lhe heaIlh cIub vas Iimiled lo ;#8:5# 3'+'Z%-# bul her sheIves incIuded
a seIeclion of unlouched books by dead American aulhors). She aIso
kel discussing unronounceabIe exolic Iocalions vhere lhey vouId
reair during lheir vacalions vilhoul so much as knoving lhe smaIIesl
lhing aboul lhe Iace - she vouId have been hard ul lo exIain in
vhich conlinenl lhe SeycheIIes IsIands vere Iocaled. Nero's vife is aII
loo human, aIlhough she kel leIIing herseIf lhal she did nol vanl lo be
in lhe shoes of }ohn's vife, she feIl as if she had been somevhal
svamed in lhe comelilion of Iife. Somehov vords and reason became
ineffecluaI in fronl of an oversized diamond, a monslrous house, and a
sorls car coIIeclion.
AN OVERPAI D HI CK
Nero aIso suffered lhe same ambiguous feeIing lovards his neighbors.
He vas quile conlemluous of }ohn, vho reresenled aboul everylhing
he is nol and does nol vanl lo be - bul lhere vas lhe sociaI ressure lhal
vas slarling lo veigh in on him. In addilion, he loo vouId Iike lo have
samIed such excessive veaIlh. InleIIecluaI conleml does nol conlroI
ersonaI envy. Thal house across lhe slreel kel gelling bigger, vilh
addilion afler addilion - and Nero's discomforl kel aace. WhiIe Nero
had succeeded beyond his viIdesl dreams, bolh ersonaIIy and inleIIec-
luaIIy, he vas slarling lo consider himseIf as having missed a chance
somevhere. In lhe ecking order of WaII Slreel, lhe arrivaI of such lyes
as }ohn had caused him no Ionger lo be a significanl lrader - bul vhiIe
he used lo nol care aboul lhis, }ohn and his house and his cars had
slarled lo gnav avay al him. AII vouId have been veII if Nero had nol
had lhal sluid Iarge house across lhe slreel |udging him vilh a
suerficiaI slandard every morning. Was il lhe genelic ecking order al
Iay, vilh }ohn's house size making him a bela maIe` Worse even, }ohn
vas aboul five years his |unior, and, desile a shorler career, vas
making al Ieasl len limes his income.
When lhey used lo run inlo each olher Nero had a cIear feeIing lhal
}ohn lried lo ul him dovn - vilh bareIy deleclabIe bul no Iess olenl
signs of condescension. Some days }ohn ignored him comIeleIy. Had
}ohn been a remole characler, one Nero couId onIy read aboul in lhe
aers, lhe silualion vouId have been differenl. ul lhere }ohn vas in
fIesh and bones and he vas his neighbor. The mislake Nero made vas lo
slarl laIking lo him, as lhe ruIe of ecking order immedialeIy emerged.
Nero lried lo soolhe his discomforl by recaIIing lhe behavior of Svann,
lhe characler in Irousl's M- *#'$/A 8< F%.# a8)(N a refined arl deaIer and
man of Ieisure vho vas al ease vilh such men as his ersonaI friend lhe
lhen Irince of WaIes, bul acled Iike he had lo rove somelhing in lhe
resence of lhe middIe cIass. Il vas much easier for Svann lo mix vilh
lhe arislocralic and veII eslabIished sel of Guermanles lhan il vas vilh
lhe sociaI-cIimbing one of lhe Verdurins, no doubl because he vas far
more confidenl in lheir resence. Likevise Nero can exacl some form of
resecl from resligious and rominenl eoIe. He reguIarIy lakes Iong
medilalive vaIks in Iaris and Venice vilh an erudile NobeI rize-caIiber
2 0 SOLON' S WARNI NG
scienlisl (lhe kind of erson vho no Ionger has lo rove anylhing) vho
acliveIy seeks his conversalion. A very famous biIIionaire secuIalor caIIs
him reguIarIy lo ask him his oinion on lhe vaIualion of some derivalive
securilies. ul lhere he vas obsessiveIy lrying lo gain lhe resecl of some
overaid hick vilh a chea Nev }ersey "Noo-}oyzy" accenl. (Had I been
in Nero's shoes I vouId have araded some of my scorn lo }ohn vilh lhe
use of body Ianguage, bul again, Nero is a nice erson.)
CIearIy, }ohn vas nol as veII educaled, veII bred, hysicaIIy fil, or
erceived as being as inleIIigenl as Nero - bul lhal vas nol aII, he vas
nol even as slreel-smarl as him! Nero has mel lrue slreel-smarl eoIe in
lhe ils of Chicago vho exhibil a raidily of lhinking lhal he couId nol
delecl in }ohn. Nero vas convinced lhal lhe man vas a confidenl
shaIIov-lhinker vho had done veII because he never made an aIIovance
for his vuInerabiIily. ul Nero couId nol, al limes, reress his envy - he
vondered vhelher il vas an ob|eclive evaIualion of }ohn, or if il vas his
feeIings of being sIighled lhal Ied him lo such an assessmenl of }ohn.
Ierhas il vas Nero vho vas nol quile lhe besl lrader. Maybe if he had
ushed himseIf harder or had soughl lhe righl oorlunily - inslead of
"lhinking", vriling arlicIes and reading comIicaled aers. Ierhas he
shouId have been invoIved in lhe high-yieId business, vhere he vouId
have shined among lhose shaIIov-lhinkers Iike }ohn.
So Nero lried lo soolhe his |eaIousy by invesligaling lhe ruIes of
ecking order. IsychoIogisls Kahneman and Tversky shoved lhal mosl
eoIe refer lo make $70,000 vhen olhers around lhem are making
$60,000 lhan lo make $80,000 vhen olhers around lhem are making
$90,000. Iconomics, schmeconomics, il is aII ecking order, he lhoughl.
No such anaIysis couId revenl him from assessing his condilion in an
absoIule ralher lhan a reIalive vay. Wilh }ohn, Nero feIl lhal, for aII his
inleIIecluaI lraining, he vas |usl anolher one of lhose vho vouId refer
lo make Iess money rovided olhers made even Iess.
Nero lhoughl lhal lhere vas al Ieasl one iece of evidence lo suorl
lhe idea of }ohn being mereIy Iucky - in olher vords Nero, afler aII,
mighl nol need lo move avay from his neighbor's slarler aIazzo. There
vas hoe lhal }ohn vouId meel his undoing. Ior }ohn seemed unavare
of one Iarge hidden risk he vas laking, lhe risk of bIov u, a risk he
couId nol see because he had loo shorl an exerience of lhe markel (bul
aIso because he vas nol lhoughlfuI enough lo sludy hislory). Hov couId
}ohn, vilh his coarse mind, olhervise be making so much money` This
business of |unk bonds deends on some knovIedge of lhe "odds", a
caIcuIalion of lhe robabiIily of lhe rare (or random) evenls. Whal do
such fooIs knov aboul odds` These lraders use "quanlilalive looIs" lhal
give lhem lhe odds - and Nero disagrees vilh lhe melhods used. This
high-yieId markel resembIes a na on a raiIvay lrack. One aflernoon,
lhe surrise lrain vouId run you over. You make money every monlh
for a Iong lime, lhen Iose a muIliIe of your cumuIalive erformance in a
fev hours. He has seen il vilh olion seIIers in 1987, 1989, 1992, and
1998. One day lhey are laken off lhe exchange fIoors, accomanied by
oversized securily men, and nobody ever sees lhem again. The big house
is simIy a Ioan, }ohn mighl end u as a Iuxury car saIesman somevhere
in Nev }ersey, seIIing lo lhe nev nevIy rich vho no doubl vouId feeI
comforlabIe in his resence. Nero cannol bIov u. His Iess oversized
abode, vilh ils 4,000 books, is his ovn. No markel evenl can lake il
avay from him. Ivery one of his Iosses is Iimiled. His lrader's dignily
viII never, never, be lhrealened.
}ohn, for his arl, lhoughl of Nero as a Ioser, and a snobbish over-
educaled Ioser al lhal. Nero vas invoIved in a malure business. He
beIieved lhal he vas vay over lhe hiII. "These 'ro' lraders are dying",
Jbc used lo say. "They lhink lhey are smarler lhan everybody eIse, bul
lhey are :'))#he
4'( ;(297#% <$==(*
IinaIIy, in Selember 1998, Nero vas vindicaled. One morning vhiIe
Ieaving lo go lo vork he sav }ohn in his fronl yard unusuaIIy smoking a
cigarelle. He vas nol vearing a business suil. He Iooked humbIe, his
cuslomary svagger vas gone. Nero immedialeIy knev lhal }ohn had
been fired. Whal he did nol susecl vas lhal }ohn aIso Iosl aImosl
everylhing he had. We viII see more delaiIs of }ohn's Iosses in Chaler 5.
Nero feIl ashamed of his feeIings of )/A'1#-<$#B1#, lhe |oy humans
can exerience uon lheir rivaIs' misforlune. ul he couId nol reress il.
Aside from il being unchivaIrous, il vas said lo bring bad Iuck (Nero is
veakIy suerslilious). ul in lhis case, Nero's merrimenl did nol come
from lhe facl lhal }ohn venl back lo his Iace in Iife, so much as il vas
from lhe facl lhal Nero's melhods, beIiefs, and lrack-record had
suddenIy gained in credibiIily. Nero vouId be abIe lo raise ubIic money
on his lrack record reciseIy because such a lhing couId nol ossibIy
haen lo him. A reelilion of such an evenl vouId ay off massiveIy
for him. Iarl of Nero's eIalion aIso came from lhe facl lhal he feIl roud
of his slicking lo his slralegy for so Iong, in sile of lhe ressure lo be lhe
aIha maIe. Il vas aIso because he vouId no Ionger queslion his lrading
slyIe vhen olhers vere gelling rich because lhey misunderslood lhe
slruclure of randomness and markel cycIes.
5EROTONIN AND RANDOMNE55
Can ve |udge lhe success of eoIe by lheir rav erformance and lheir
ersonaI veaIlh` Somelimes - bul nol aIvays. We viII see hov, al any
oinl in lime, a Iarge seclion of businessmen vilh oulslanding lrack
records viII be no beller lhan randomIy lhrovn darls. More curiousIy,
and oving lo a ecuIiar bias, cases viII abound of lhe Ieasl-skiIIed
businessmen being lhe richesl. Hovever, lhey viII faiI lo make an
aIIovance for lhe roIe of Iuck in lheir erformance.
Lucky fooIs do nol bear lhe sIighlesl susicion lhal lhey may be
Iucky fooIs - by definilion, lhey do nol knov lhal lhey beIong lo such
calegory. They viII acl as if lhey deserved lhe money. Their slrings of
successes viII in|ecl lhem vilh so much )#$8(8-%- (or some simiIar
subslance) lhal lhey viII even fooI lhemseIves aboul lheir abiIily lo
oulerform markels (our hormonaI syslem does nol knov vhelher our
successes deend on randomness). One can nolice il in lheir oslure, a
rofilabIe lrader viII vaIk urighl, dominanl "slyIe - and viII lend lo
laIk more lhan a Iosing lrader. Scienlisls found oul lhal serolonin, a
neurolransmiller, seems lo command a Iarge share of our human
behavior. Il sels a osilive feedback, lhe virluous circIe, bul, oving lo
an exlernaI kick from randomness, can slarl a reverse molion and cause
a vicious circIe. Il has been shovn lhal monkeys in|ecled vilh serolonin
viII rise in lhe ecking order, vhich in lurn causes an increase of lhe
serolonin IeveI in lheir bIood - unliI lhe virluous cycIe breaks and slarls
a vicious one (during lhe vicious cycIe faiIure viII cause one lo sIide in
lhe ecking order, causing a behavior lhal viII bring aboul furlher
dros in lhe ecking order). Likevise, an increase in ersonaI
erformance (regardIess of vhelher il is caused delerminislicaIIy or
by lhe agency of Iady Iorluna) induces a rise of serolonin in lhe sub|ecl,
ilseIf causing an increase of vhal is commonIy caIIed 5#'1#$)A%: abiIily.
One is "on a roII". Some imercelibIe changes in deorlmenl, Iike an
abiIily lo exress oneseIf vilh serenily and confidence, makes lhe
sub|ecl Iook credibIe - as if he lruIy deserved lhe shekeIs. Randomness
viII be ruIed oul as a ossibIe faclor in lhe erformance, unliI il rears
ils head once again and deIivers lhe kick lhal viII induce lhe vicious
cycIe.
IeoIe have oflen had lhe bad lasle of asking me in a sociaI selling if
my day in lrading vas rofilabIe. If my falher vere lhere, he vouId
usuaIIy slo lhem by saying "never ask a man if he is from Sarla: if he
vere, he vouId have Iel you knov such an imorlanl facl - and if he
vere nol, you couId hurl his feeIings". Likevise, never ask a lrader if he
is rofilabIe, you can easiIy see il in his geslure and gail. IeoIe in lhe
rofession can easiIy leII if lraders are making or Iosing money, head
lraders are quick al idenlifying an emIoyee vho is faring oorIy. Their
..face viII seIdom reveaI much, as eoIe consciousIy alleml lo gain
conlroI of lheir faciaI exressions. ul lhe vay lhey vaIk, lhe vay lhey
hoId lhe leIehone, and lhe hesilalion in lheir behavior, viII nol faiI lo
reveaI lheir lrue disosilion. On lhe morning afler }ohn had been fired,
he cerlainIy Iosl much of his serolonin - unIess il vas anolher subslance
lhal researchers viII discover in anolher decade. One cab driver in
Chicago exIained lo me lhal he couId leII if lraders he icked u near
lhe Chicago oard of Trade, a fulures exchange, vere doing veII. "They
gel aII uffed u", he said. I found il inleresling (and myslerious) lhal he
couId delecl il so raidIy. I Ialer gol some IausibIe exIanalion from
evoIulionary sychoIogy, vhich cIaims lhal such hysicaI manifesla-
lions of one's erformance in Iife, |usl Iike an animaI's dominanl
condilion, can be used for signaIing: il makes lhe vinners seem easiIy
visibIe, vhich is efficienl in male seIeclion.
:#$* >(/%.,% ?, ;.@'A B(*C ;.@'
We cIose lhis chaler vilh a hinl on lhe nexl discussion of resislance lo
randomness. RecaII lhal Nero can considered roserous bul nol "very
rich" by his day's slandards. Hovever, according lo some slrange
accounling measure ve viII see in lhe nexl chaler, he is exlremeIy rich
8- (A# '&#$'+# 8< 5%&#) he couId have Ied - he lakes so IillIe risk in his
lrading career lhal lhere couId have been very fev disaslrous oulcomes.
The facl lhal he did nol exerience }ohn's success vas lhe reason he did
nol suffer his dovnfaII. He vouId be lherefore veaIlhy according lo lhis
unusuaI (and robabiIislic) melhod of accounling for veaIlh. RecaII lhal
Nero rolecls himseIf from lhe rare evenl. Had Nero had lo reIive his
rofessionaI Iife a fev miIIion limes, very fev samIe alhs vouId be
marred by bad Iuck - bul, oving lo his conservalism, very fev as veII
vouId be affecled by exlreme good Iuck. Thal is, his Iife in slabiIily
vouId be simiIar lo lhal of an eccIesiaslic cIock reairman. NaluraIIy,
ve are discussing onIy his rofessionaI Iife, excIuding his (somelimes
voIaliIe) rivale one.
ArguabIy, %- #7:#/('(%8-, a denlisl is considerabIy richer lhan lhe
rock musician vho is driven in a ink RoIIs Royce, lhe secuIalor vho
bids u lhe rice of imressionisl ainlings, or lhe enlrereneur vho
coIIecls rivale |els. Ior one cannol consider a rofession vilhoul laking
inlo accounl lhe average of lhe eoIe vho enler il, nol lhe samIe of
lhose vho have succeeded in il. We viII examine lhe oinl Ialer from lhe
vanlage oinl of lhe survivorshi bias, bul here, in Iarl I, ve viII Iook al
il vilh resecl lo "resislance lo randomness.
Consider lvo neighbors, }ohn Doe A, a |anilor vho von lhe Nev
}ersey Iollery and moved lo a veaIlhy neighborhood, comared lo }ohn
Doe , his nexl-door neighbor of more modesl condilion vho has been
driIIing leelh eighl hours a day over lhe asl 35 years. CIearIy one can
say lhal, lhanks lo lhe duIIness of his career, if }ohn Doe had lo reiive
his Iife a fev lhousand limes since gradualion from denlaI schooI, lhe
range of ossibIe oulcomes vouId be ralher narrov (assuming he is
roerIy insured). Al lhe besl, he vouId end u driIIing lhe rich leelh of
lhe Nev York Iark Avenue residenls, vhiIe lhe vorsl vouId shov him
driIIing lhose of some semi-deserled lovn fuII of lraiIers in lhe CalskiIIs.
Iurlhermore, assuming he gradualed from a very resligious leelh-
driIIing schooI, lhe range of oulcomes vouId be even more comressed.
As lo }ohn Doe A, if he had lo reIive his Iife a miIIion limes, aImosl aII of
lhem vouId see him erforming |aniloriaI aclivilies (and sending
endIess doIIars on fruilIess Iollery lickels), and one in a miIIion vouId
see him vinning lhe Nev }ersey Iollery.
The idea of laking inlo accounl bolh lhe observed and unobserved
ossibIe oulcomes sounds Iike Iunacy. Ior mosl eoIe, robabiIily is
aboul vhal may haen in lhe fulure, nol evenls in lhe observed asl,
an evenl lhal has aIready laken Iace has 100% robabiIily, i.e.,
cerlainly. I have discussed lhe oinl vilh many eoIe vho Ialiludi-
nousIy accuse me of confusing mylh and reaIily. Mylhs, arlicuIarIy
veII-aged ones, as ve sav vilh SoIon's varning, can be far more olenl
(and rovide us vilh more exerience) lhan Iain reaIily.
TWO
A IZARRI ACCOUNTING MITHOD
9- '5(#$-'(%&# A%)(8$%#)N ' :$8Y'Y%5%)(%/ &%#? 8< (A# ?8$51N
%-(#55#/(B'5 <$'B1N '-1 (A# $'-18.-#)) ?%)18. 8< ' V$#-/A.'-
?%(A )(#'1, Y'(A%-+ A'Y%()e 08? g8B$-'5%)() '$# Y$#1 (8 -8(
B-1#$)('-1 $'-18. )#$%#) 8< #&#-()e X#?'$# Y8$$8?#1 ?%)18.2
A8? '5.8)( '55 +$#'( %1#') /8-/#$-%-+ $'-18. 8B(/8.#) '$#
'+'%-)( /8-&#-(%8-'5 )':%#-/#e 9- (A# 1%<<#$#-/# Y#(?##-
/8$$#/(-#)) '-1 %-(#55%+%Y%5%(,e
!1%(*/)%.D( 7.,%#*C
I
slarl vilh lhe Ialilude lhal one cannol |udge a erformance in any
given fieId (var, oIilics, medicine, inveslmenls).by lhe resuIls, bul by
lhe cosls of lhe aIlernalive (i.e. if hislory Iayed oul in a differenl vay).
Such subslilule courses of evenls are caIIed '5(#$-'(%&# A%)(8$%#)e CIearIy,
lhe quaIily of a decision cannol be soIeIy |udged based on ils oulcome,
bul such a oinl seems lo be voiced onIy by eoIe vho faiI (lhose vho
succeed allribule lheir success lo lhe quaIily of lheir decision). Such
oinion is vhal oIilicians on lheir vay oul of office kee leIIing lhose
members of lhe ress vho sliII Iislen lo lhem lhal lhey foIIoved lhe besl
A I ZARRI ACCOUNTI NG MITHOD
27
course - eIiciling lhe cuslomary commiseraling "yes, ve knov" lhal
makes lhe sling even vorse. And Iike many Ialiludes, lhis one, vhiIe
being loo obvious, is nol easy lo carry oul in raclice.
RU55IAN ROULETTE
One can iIIuslrale lhe slrange concel of aIlernalive hislories as foIIovs.
Imagine an eccenlric (and bored) lycoon offering you $10 miIIion lo
Iay Russian rouIelle, i.e. lo ul a revoIver conlaining one buIIel in lhe
six avaiIabIe chambers lo your head and uII lhe lrigger. Iach
reaIizalion vouId counl as one hislory, for a lolaI of six ossibIe
hislories of equaI robabiIilies. Iive oul of lhese six hislories vouId Iead
lo enrichmenl, one vouId Iead lo a slalislic, lhal is, an obiluary vilh an
embarrassing (bul cerlainIy originaI) cause of dealh. The robIem is lhal
onIy one of lhe hislories is observed in reaIily, and lhe vinner of $10
miIIion vouId eIicil lhe admiralion and raise of some faluous |ournaIisl
(lhe very same ones vho uncondilionaIIy admire lhe Iorbes 500
biIIionaires). Like aImosl every execulive I have encounlered during a
15-year career on WaII Slreel (lhe roIe of such execulives in my viev
being no more lhan a |udge of resuIls deIivered in a random manner),
lhe ubIic observes lhe exlernaI signs of veaIlh vilhoul even having a
gIimse al lhe source (ve caII such source lhe +#-#$'(8$de Consider lhe
ossibiIily lhal lhe Russian rouIelle vinner vouId be used as a roIe
modeI by his famiIy, friends, and neighbors.
WhiIe lhe remaining five hislories are nol observabIe, lhe vise and
lhoughlfuI erson couId easiIy make a guess as lo lheir allribules. Il
requires some lhoughlfuIness and ersonaI courage. In addilion, in lime,
if lhe rouIelle-belling fooI kees Iaying lhe game, lhe bad hislories viII
lend lo calch u vilh him. Thus, if a 25-year-oId Iayed Russian
rouIelle, say, once a year, lhere vouId be a very sIim ossibiIily of his
surviving his 50lh birlhday - bul, if lhere are enough Iayers, say
lhousands of 25-year-oId Iayers, ve can execl lo see a handfuI of
(exlremeIy rich) survivors (and a very Iarge cemelery). Here I have lo
admil lhal lhe examIe of Russian rouIelle is more lhan inleIIecluaI lo
me. I Iosl a comrade lo lhis "game" during lhe Lebanese var, vhen ve
vere in our leens. ul lhere is more. I discovered lhal I had more lhan a
shaIIov inleresl in Iileralure lhanks lo lhe effecl of Graham Greene's
accounl of his fIirl vilh such a game, il bore a slronger effecl on me lhan
lhe acluaI evenls I had recenlIy vilnessed. Greene cIaimed lhal he once
lried lo soolhe lhe duIIness of his chiIdhood by uIIing lhe lrigger on a
revoIver - making me shiver al lhe lhoughl lhal I had al Ieasl a one in six
robabiIily of having been vilhoul his noveIs.
The reader can see my unusuaI nolion of aIlernalive accounling: $10
miIIion earned lhrough Russian rouIelle does nol have lhe same vaIue as
$10 miIIion earned lhrough lhe diIigenl and arlfuI raclice of denlislry.
They are lhe same, can buy lhe same goods, excel lhal one's deendence
on randomness is grealer lhan lhe olher. To an accounlanl, lhough, lhey
vouId be idenlicaI. To your nexl-door neighbor loo. Yel, dee dovn, I
cannol heI bul consider lhem as quaIilaliveIy differenl. The nolion of
such aIlernalive accounling has inleresling inleIIecluaI exlensions and
Iends ilseIf lo malhemalicaI formuIalion, as ve viII see in lhe nexl
chaler vilh our inlroduclion of lhe Monle CarIo engine. Nole lhal such
use of malhemalics is onIy iIIuslralive, aiming al gelling lhe inluilion of
lhe oinl, and shouId nol be inlerreled as an engineering issue. In olher
vords, one need nol acluaIIy comule lhe aIlernalive hislories so much
as assess lheir allribules. Malhemalics is nol |usl a "numbers game", il is
a vay of lhinking. We viII see lhal robabiIily is a quaIilalive sub|ecl.
AN EVEN MORE VICIOU5 ROULETTE
ReaIily is far more vicious lhan Russian rouIelle. Iirsl, il deIivers lhe
falaI buIIel ralher infrequenlIy, Iike a revoIver lhal vouId have
hundreds, even lhousands of chambers inslead of six. Afler a fev
dozen lries, one forgels aboul lhe exislence of a buIIel, under a numbing
faIse sense of securily. The oinl is dubbed in lhis, book lhe Y5'/> )?'-
:$8Y5#.N vhich ve cover in Chaler 7, as il is Iinked lo lhe robIem of
induclion, a robIem lhal has kel a fev hiIosohers of science avake
al nighl. Il is aIso reIaled lo a robIem caIIed 1#-%+$'(%8- 8< A%)(8$, as
gambIers, inveslors, and decision makers feeI lhal lhe sorl of lhings lhal
haen lo olhers vouId nol necessariIy haen lo lhem.
Second, unIike a veII-defined recise game Iike Russian rouIelle,
vhere lhe risks are visibIe lo anyone caabIe of muIliIying and dividing
A I ZARRI ACCOUNTI NG MITHOD 2 9
by six, one does nol observe lhe barreI of reaIily. Very rareIy is lhe
generalor visibIe lo lhe naked eye. One is lhus caabIe of unvillingIy
Iaying Russian rouIelle - and caIIing il by some aIlernalive "Iov risk"
name. We see lhe veaIlh being generaled, never lhe rocessor, a maller
lhal makes eoIe Iose sighl of lheir risks, and never lhe Iosers. The
game seems lerribIy easy and ve Iay aIong bIilheIy.
<=##%' E((* ;(1)%.#/,
The degree of $#)%)('-/# (8 $'-18.-#)) %- 8-#R) 5%<# %) an abslracl %1#'N
arl of ils Iogic counlerinluilive, and, lo confuse mallers, ils reaIizalions
non-observabIe. ul I have been increasingIy devoled lo il - for a
coIIeclion of ersonaI reasons I viII Ieave for Ialer. CIearIy my vay of
|udging mallers is robabiIislic in nalure, il reIies on lhe nolion of vhal
couId have :$8Y'Y5, haened, and requires a cerlain menlaI allilude
vilh resecl lo one's observalions. I do nol recommend engaging an
accounlanl in a discussion aboul such robabiIislic consideralions. Ior
an accounlanl a number is a number. If he vere inleresled in robabiIily
he vouId have gollen invoIved in more inlroseclive rofessions - and
vouId be incIined lo make a coslIy mislake on your lax relurn.
WhiIe ve do nol see lhe rouIelle barreI of reaIily, some eoIe give il
a lry, il lakes a seciaI mindsel lo do so. Having seen hundreds of eoIe
enler and exil my rofession (characlerized by exlreme deendence on
randomness), I have lo say lhal lhose vho have had a modicum of
scienlific lraining lend lo go lhe exlra miIe. Ior many, such lhinking is
second nalure. This mighl nol necessariIy come from lheir scienlific
lraining :#$ )# (bevare of causaIily), bul ossibIy from lhe facl lhal
eoIe vho have decided al some oinl in lheir Iives lo devole
lhemseIves lo scienlific research lend lo have an ingrained inleIIecluaI
curiosily and a naluraI lendency for such inlroseclion. IarlicuIarIy
lhoughlfuI are lhose vho had lo abandon scienlific sludies because of
lheir inabiIily lo kee focused on a narrovIy defined robIem. Wilhoul
excessive inleIIecluaI curiosily il is aImosl imossibIe lo comIele a
Ih.D. lhesis lhese days, bul vilhoul a desire lo narrovIy seciaIize il is
imossibIe lo make a scienlific career. (There is a dislinclion, hovever,
belveen lhe mind of a ure malhemalician lhriving on abslraclion and
lhal of a scienlisl consumed by curiosily. A malhemalician is absorbed
in vhal goes inlo his head vhiIe a scienlisl searches inlo vhal is oulside
of himseIf.) Hovever, some eoIe's concern for randomness can be
excessive, I have even seen eoIe lrained in some fieIds, Iike say,
quanlum mechanics, ush lhe idea lo lhe olher exlreme, onIy seeing
aIlernalive hislories '-1 ignoring lhe one lhal acluaIIy look Iace.
Some lraders can be unexecledIy inlroseclive aboul randomness. I
recenlIy had dinner al lhe bar of lhe Odeon vilh Lauren R., a lrader
vho vas reading a drafl of lhis book. We fIied a coin lo see vho vas
going lo ay for lhe meaI. I Iosl and aid. He vas aboul lo lhank me
vhen he abrulIy sloed and said: "Reading your book you vouId say
lhal I aid for haIf of il robabiIislicaIIy".
I lhus viev eoIe dislribuled across lvo oIar calegories: on one
exlreme, lhose vho never accel lhe nolion of randomness, on lhe
olher, lhose vho are lorlured by il. When I slarled on WaII Slreel in lhe
1980s, lrading rooms vere ouIaled vilh eoIe vilh a "business
orienlalion", lhal is, generaIIy devoid of any inlroseclion, fIal as a
ancake, and IikeIy lo be fooIed by randomness. Their faiIure rale vas
exlremeIy high, arlicuIarIy vhen financiaI inslrumenls gained in
comIexily. Somehov lricky roducls, Iike exolic olions, vere
inlroduced and carried counlerinluilive ayoffs lhal vere loo difficuIl
for someone of such cuIlure lo handIe. They droed Iike fIies, I do nol
lhink lhal many of lhe hundreds of MAs of my generalion I mel on
WaII Slreel in lhe 1980s sliII engage in such forms of rofessionaI and
disciIined risk laking.
5ALVATION VIA AEROFLOT
The 1990s vilnessed lhe arrivaI of eoIe-of richer and more inleresling
backgrounds, vhich made lhe lrading rooms far more enlerlaining. I
vas saved from lhe conversalion of MAs. Many scienlisls, some of
lhem exlremeIy successfuI in lheir fieId, arrived vilh a desire lo make a
buck. They, in lurn, hired eoIe vho resembIed lhem. WhiIe mosl of
lhese eoIe vere nol Ih.D.s (indeed, lhe Ih.D. is sliII a minorily), lhe
31
cuIlure and vaIues suddenIy changed, becoming more loIeranl of
inleIIecluaI delh. Il caused an increase in lhe aIready high demand for
scienlisls on WaII Slreel, oving lo lhe raid deveIomenl of financiaI
inslrumenls. The dominanl seciaIly vas hysics, bul one couId find aII
manner of quanlilalive backgrounds among lhem. Russian, Irench,
Chinese, and Indian accenls (by order) began dominaling in bolh Nev
York and London. Il vas said lhal every Iane from Moscov had al
Ieasl ils back rov fuII of Russian malhemalicaI hysicisls #- $8B(# lo
WaII Slreel (lhey Iacked lhe slreel smarls lo gel good seals). One couId
hire very chea Iabor by going lo }IK airorl vilh a (mandalory)
lransIalor, randomIy inlervieving lhose lhal filled lhe slereolye.
Indeed, by lhe Iale 1990s one couId gel someone lrained by a vorId-
cIass scienlisl for aImosl haIf lhe rice of an MA. As lhey say,
markeling is everylhing, lhese guys do nol knov hov lo seII lhemseIves.
I had a slrong bias in favor of Russian scienlisls, many can be ul lo
aclive use as chess coaches (I aIso gol a iano leacher oul of lhe rocess).
In addilion, lhey are exlremeIy heIfuI in lhe inlerviev rocess. When
MAs aIy for lrading osilions, lhey frequenlIy boasl "advanced"
chess skiIIs on lheir resumes. I recaII lhe MA career counseIor al
Wharlon recommending our adverlising chess skiIIs "because il sounds
inleIIigenl and slralegic". MAs, lyicaIIy, can inlerrel lheir suerficiaI
knovIedge of lhe ruIes of lhe game inlo "exerlise". We used lo verify
lhe accuracy of cIaims of chess exerlise (and lhe characler of lhe
aIicanl) by uIIing a chess sel oul of a draver and leIIing lhe sludenl,
nov lurning aIe: "Yuri viII have a vord vilh you".
The faiIure rale of lhese scienlisls, lhough, vas beller, bul onIy
sIighlIy so lhan lhal of MAs, bul il came from anolher reason, Iinked
lo lheir being on average (bul onIy on average) devoid of lhe smaIIesl bil
of raclicaI inleIIigence. Some successfuI scienlisls had lhe |udgmenl
(and sociaI graces) of a door knob - bul by no means aII of lhem. Many
eoIe vere caabIe of lhe mosl comIex caIcuIalions vilh ulmosl rigor
vhen il came lo equalions, bul vere lolaIIy incaabIe of soIving a
robIem vilh lhe smaIIesl conneclion lo reaIily, il vas as if lhey
underslood lhe Ieller bul nol lhe siril of lhe malh. I am convinced lhal
X, a IikeabIe Russian man of my acquainlance, has lvo brains: one for
malh and anolher, considerabIy inferior one, for everylhing eIse (vhich
incIuded soIving robIems reIaled lo lhe malhemalics of finance). ul on
occasion a fasl-lhinking scienlific-minded erson vilh slreel smarls
vouId emerge. Whalever lhe benefils of such ouIalion shifl, il
imroved our chess skiIIs and rovided us vilh quaIily conversalion
during Iunchlime - il exlended lhe Iunch hour considerabIy. Consider
lhal I had in lhe 1980s lo chal vilh coIIeagues vho had an MA or lax
accounling background and vere caabIe of lhe heroic feal of discussing
IAS slandards. I have lo say lhal lheir inleresls vere nol loo
conlagious. The inleresling lhing aboul lhese hysicisls does nol Iie in
lheir abiIily lo discuss fIuid dynamics, il is lhal lhey vere naluraIIy
inleresled in a variely of inleIIecluaI sub|ecls and rovide Ieasanl
conversalion.
5OLON VI5IT5 K6SGE6R* NIGHT CLUB
As lhe reader may aIready susecl, my oinions aboul randomness have
nol earned me lhe smoolhesl of reIalions vilh some of my eers during
my WaII Slreel career (many of vhom lhe reader can see indireclIy - bul
onIy indireclIy - orlrayed in lhese chalers). ul vhere I had uneven
reIalions vas vilh some of lhose vho had lhe misforlune of being my
bosses. Ior I had lvo bosses in my Iife of conlrasling characlerislics in
aboul every lrail.
The firsl, vhom I viII caII Kenny, vas lhe eilome of lhe suburban
famiIy man. He vouId be of lhe lye lo coach soccer on Salurday
morning, and invile his brolher-in-Iav for a Sunday aflernoon barbecue.
He gave lhe aearance of someone I vouId lrusl vilh my savings -
indeed he rose quile raidIy in lhe inslilulion in sile of his Iack of
lechnicaI comelence in financiaI derivalives (his firm's cIaim lo fame).
ul he vas loo much a no-nonsense erson lo make oul my Iogic. He
once bIamed me for nol being imressed vilh lhe successes of some of his
lraders vho did veII during lhe buII markel for Iuroean bonds of 1993,
vhom I oenIy considered nolhing beller lhan random gunsIingers. I
lried resenling him vilh lhe nolion of survivorshi bias (Iarl II of lhis
book) in vain. His lraders have aII exiled lhe business since lhen "lo
ursue olher inleresls" (incIuding him). ul he gave lhe aearance of
being a caIm, measured man, vho soke his mind and knev hov lo ul
lhe olher erson al ease during a conversalion. He vas arlicuIale,
A I ZARRI ACCOUNTI NG MITHOD 33
exlremeIy resenlabIe lhanks lo his alhIelic Iooks, veII measured in his
seech, and vas endoved vilh lhe exlremeIy rare quaIily of being an
exceIIenl Iislener. His ersonaI charm aIIoved him lo vin lhe confidence
of lhe chairman - bul I couId nol conceaI my disresecl, arlicuIarIy as
he couId nol make oul lhe nalure of my conversalion. In sile of his
conservalive Iooks he vas a erfecl lime bomb, licking avay.
The second, vhom I viII caII }ean-Ialrice, in conlrasl, vas a moody
Irenchman vilh an exIosive lemer and a hyer-aggressive ersonaIily.
Ixcel for lhose he lruIy Iiked (nol lhal many), he vas exerl al making
his subordinales uncomforlabIe, ulling lhem in a slale of conslanl
anxiely. He grealIy conlribuled lo my formalion as a risk-laker, he is one
of lhe very rare eoIe vho have lhe guls lo care onIy aboul lhe
generalor, enlireIy obIivious of lhe resuIls. He resenled lhe visdom of
SoIon, bul, vhiIe one vouId execl someone vilh such ersonaI visdom
and such underslanding of randomness lo Iead a duII Iife, he Iived a
coIorfuI one. In conlrasl vilh Kenny, vho vore conservalive dark suils
and vhile shirls (his onIy induIgence vas fIashy equeslrian Hermes lies),
}ean-Ialrice dressed Iike a eacock: bIue shirls, Iaid sorls coals sluffed
vilh gaudy siIk ockel squares. No famiIy-minded man, he rareIy came lo
vork before noon - lhough I can safeIy say lhal he carried his vork vilh
him lo lhe mosl unIikeIy Iaces. He frequenlIy caIIed me from K#+%-#R)N
an uscaIe nighl-cIub in Nev York, vaking me u al lhree in lhe morning
lo discuss some smaII (and irreIevanl) delaiIs of my risk exosure. In sile
of his sIighl coruIence, vomen seemed lo find him irresislibIe, he
frequenlIy disaeared al midday and vas unreachabIe for hours. His
advanlage mighl have been in his being a Nev York Irenchman vilh
sleady balhing habils. Once, recenlIy, he inviled me lo discuss an urgenl
business issue vilh him. CharaclerislicaIIy, I found him mid-aflernoon in
a slrange "cIub" in Iaris lhal carried no nameIale and vhere he sal vilh
documenls slrevn across lhe labIe from him. Siing chamagne, he vas
simuIlaneousIy caressed by lvo scanliIy dressed young Iadies. SlrangeIy,
he invoIved lhem in lhe conversalion as if lhey vere arl of lhe meeling.
He even had one of lhe Iadies ick u his conslanlIy ringing mobiIe hone
as he did nol vanl our conversalion lo be inlerruled.
I am sliII amazed al lhis fIamboyanl man's obsession vilh risks, vhich
he conslanlIy Iayed in his head - he IileraIIy lhoughl of everylhing lhal
couId ossibIy haen. He forced me lo make an aIlernalive Ian shouId
a Iane crash inlo lhe 8<<%/# buiIding - and fumed al my '-)?#$ (A'( (A#
financiaI condilion of his dearlmenl vouId be of smaII inleresl lo me in
such circumslances. He had a horribIe reulalion as a hiIanderer, a
lemeramenlaI boss caabIe of firing someone al a vhim, yel he Iislened
lo me and underslood every vord I had lo say, encouraging me lo go lhe
exlra miIe in my sludy of randomness. He laughl me lo Iook for lhe
invisibIe risks of bIovu in any orlfoIio. Nol coincidenlaIIy, he has an
immense resecl for science and an aImosl favning deference for
scienlisls, a decade or so afler ve vorked logelher he shoved u
unexecledIy during lhe defense of my docloraI lhesis, smiIing from lhe
back of lhe room. WhiIe Kenny knev hov lo cIimb lhe Iadder of an
inslilulion, reaching a high IeveI in lhe organizalion before being forced
oul, }ean-Ialrice did nol have such a hay career, a maller lhal laughl
me lo bevare of malure financiaI inslilulions.
Il can be dislurbing for many seIf-slyIed "bollom Iine" orienled
eoIe lo be queslioned aboul lhe hislories lhal did nol lake Iace ralher
lhan lhe ones lhal acluaIIy haened. CIearIy, lo a no-nonsense erson
of lhe "successfuI in business" variely, my Ianguage (and, I have lo
reckon, some lrails of my ersonaIily) aear slrange and incomre-
hensibIe. To my amusemenl, lhe argumenl aears offensive lo many.
The conlrasl belveen Kenny and }ean-Ialrice is nol a mere coin-
cidence in a rolracled career. evare lhe sendlhrifl "businessvise"
erson, lhe cemelery of markels is disroorlionaleIy veII slocked vilh
lhe seIf-slyIed "bollom Iine" eoIe. In conlrasl vilh lheir cuslomary
Maslers of lhe Universe demeanor, lhey suddenIy Iook aIe, humbIe and
hormone-derived on lhe vay lo lhe ersonneI office for lhe cuslomary
discussion of lhe severance agreemenl.
F(#*8( G.11 ?, 3# <#1#/H
I/ 0#$/%(*./%$.%.D(A 4*$%',
ReaIism can be unishing. IrobabiIislic skelicism is vorse. Il is difficuIl
lo go aboul Iife vearing robabiIislic gIasses, as one slarls seeing fooIs
of randomness aII around, in a variely of silualions - obdurale in lheir
35
ercelionaI iIIusion. To slarl, il is imossibIe lo read a hislorian's
anaIysis vilhoul queslioning lhe inferences: ve knov lhal HannibaI and
HilIer vere mad in lheir ursuils, as Rome is nol loday Ihoenician-
seaking and Times Square in Nev York currenlIy exhibils no
svaslikas. ul vhal of aII lhose generaIs vho vere equaIIy fooIish,
bul ended u vinning lhe var and consequenlIy lhe esleem of lhe
hisloricaI chronicIer` Il is hard lo lhink of AIexander lhe Greal or }uIius
Caesar as men vho von onIy in lhe visibIe hislory, bul vho couId have
suffered defeal in olhers. If ve have heard of lhem, il is simIy because
lhey look considerabIe risks, aIong vilh lhousands of olhers and
haened lo vin. They vere inleIIigenl, courageous, nobIe (al limes),
had lhe highesl ossibIe oblainabIe cuIlure in lheir day - bul so did
lhousands of olhers vho Iive in lhe musly foolnoles of hislory. Again I
am nol conlesling lhal lhey von lheir vars - onIy lhe cIaims concerning
lhe quaIily of lheir slralegies. (My very firsl imression uon a recenl
rereading of lhe M5%'1N lhe firsl in my aduIlhood, is lhal lhe eic oel did
nol |udge his heroes by lhe resuIl: heroes von and Iosl ballIes in a
manner lhal vas lolaIIy indeendenl of lheir ovn vaIor, lheir fale
deended uon lolaIIy exlernaI forces, generaIIy lhe exIicil agency of
lhe scheming gods (nol devoid of neolism). Heroes are heroes because
lhey are heroic in behavior, nol because lhey von or Iosl. IalrocIes does
nol slrike us as a hero because of his accomIishmenls (he vas raidIy
kiIIed) bul because he referred lo die lhan see AchiIIes suIking inlo
inaclion. CIearIy lhe eic oels underslood invisibIe hislories. AIso Ialer
lhinkers and oels had more eIaborale melhods for deaIing vilh
randomness, as ve viII see vilh sloicism.)
Lislening lo lhe media, moslIy because I am nol used lo il, can cause
me on occasion lo |um oul of my seal and become emolionaI in fronl
of lhe moving image (I grev u vilh no leIevision and vas in my Iale
lvenlies vhen I Iearned lo oerale a TV sel). One iIIuslralion of a
dangerous refusaI lo consider aIlernalive hislories is rovided by lhe
inlerviev lhal media erson George WiII, a "commenlalor" of lhe
exlensiveIy commenling variely, conducled vilh Irofessor Roberl
ShiIIer, a man knovn lo lhe ubIic for his besl-seIIing book M$$'(%8-'5
67BY#$'-/#N bul knovn lo lhe connoisseur for his remarkabIe insighls
aboul lhe slruclure of markel randomness and voIaliIily (exressed in
lhe recision of malhemalics).
The inlerviev is iIIuslralive of lhe deslruclive asecl of lhe media, in
calering lo our heaviIy vared common sense and biases. I vas loId lhal
George WiII vas very famous and exlremeIy resecled (lhal is, for a
|ournaIisl). He mighl even be someone of ulmosl inleIIecluaI inlegrily,
his rofession, hovever, is mereIy lo sound smarl and inleIIigenl lo lhe
hordes. ShiIIer, on lhe olher hand, underslands lhe ins and ouls of
randomness, he is lrained lo deaI vilh rigorous argumenlalion, bul does
sound Iess smarl in ubIic because his sub|ecl maller is highIy
counlerinluilive. ShiIIer had been ronouncing lhe slock markel lo be
overriced for a Iong lime. George WiII indicaled lo ShiIIer lhal had
eoIe Iislened lo him in lhe asl lhey vouId have Iosl money, as lhe
markel has more lhan doubIed since he slarled ronouncing il
overvaIued. To such a |ournaIislic and veII sounding (bul senseIess)
argumenl, ShiIIer vas unabIe lo resond excel lo exIain lhal lhe facl
lhal he vas vrong in one singIe markel caII shouId nol carry undue
significance. ShiIIer, as a scienlisl, did nol cIaim being a rohel or one
of lhe enlerlainers vho commenl on lhe markels on lhe evening nevs.
Yogi erra vouId have had a beller lime vilh his confidenl commenl on
lhe fal Iady nol having sung yel.
I couId nol undersland vhal ShiIIer, unlrained lo comress his ideas
inlo vaid sound-biles, vas doing on such a TV shov. CIearIy, il is
fooIish lo lhink lhal an irralionaI markel cannol become even more
irralionaI, ShiIIer's vievs on lhe ralionaIily of lhe markel are nol
invaIidaled by lhe argumenl lhal he vas vrong in lhe asl. Here I couId
nol heI seeing in lhe erson of George WiII lhe reresenlalive of so
many nighlmares in my career, my allemling lo revenl someone from
Iaying Russian rouIelle for $10 miIIion and seeing |ournaIisl George
WiII humiIialing me in ubIic by saying lhal had lhe erson Iislened lo
me il vouId have cosl him a considerabIe forlune. In addilion, WiII's
commenl vas nol an off-lhe-cuff remark, he vrole an arlicIe on lhe
maller discussing ShiIIer's bad "rohecy". Such lendency lo make and
unmake rohels based on lhe fale of lhe rouIelle vheeI is symlomalic
of our genelic inabiIily lo coe vilh lhe comIex slruclure of
randomness revaiIing in lhe modern vorId. Mixing forecasl and
rohecy is symlomalic of randomness fooIishness (rohecy beIongs
lo lhe righl coIumn, forecasl is ils mere Iefl-coIumn equivaIenl).
HUMI LI ATED IN DEBATE5
CIearIy, lhis idea of aIlernalive hislory does nol make inluilive sense,
vhich is vhere lhe fun begins. Ior slarlers, ve are nol vired in a vay lo
undersland robabiIily, a oinl lhal ve viII examine backvard and
forvard in lhis book. I viII |usl say al lhis oinl lhal researchers of lhe
brain beIieve lhal malhemalicaI lrulhs make IillIe sense lo our mind,
arlicuIarIy vhen il comes lo lhe examinalion of random oulcomes.
Mosl resuIls in robabiIily are enlireIy counlerinluilive, ve viII see
Ienly of lhem. Then vhy argue vilh a mere |ournaIisl vhose aycheck
comes from Iaying on lhe convenlionaI visdom of lhe hordes` I recaII
lhal every lime I have been humiIialed in a ubIic discussion on markels
by someone (of lhe George WiII variely) vho seemed lo resenl more
aIalabIe and easier lo undersland argumenls, I lurned oul (much Ialer)
lo be righl. I do nol disule lhal argumenls shouId be simIified lo lheir
maximum olenliaI, bul eoIe oflen confuse comIex ideas lhal cannol
be simIified inlo a media-friendIy slalemenl as symlomalic of a
confused mind. MAs Iearn lhe concel of cIarily and simIicily, lhe
five-minule-manager lake on lhings. The concel may aIy lo lhe
business Ian for a ferliIizer Ianl, bul nol lo highIy robabiIislic
argumenls - vhich is lhe reason I have anecdolaI evidence in my
business lhal MAs lend lo bIov u in financiaI markels, as lhey are
lrained lo simIify mallers a couIe of sles beyond lheir requiremenl (I
beg lhe MA reader nol lo lake offense, I am myseIf lhe unhay hoIder
of lhe degree).
evare lhe confusion belveen correclness and inleIIigibiIily. Iarl of
convenlionaI visdom favors lhings lhal can be exIained ralher
inslanlIy and "in a nulsheII" - in many circIes il is considered Iav.
Having allended a Irench eIemenlary schooI, a 5,/## :$%.'%$#N I vas
lrained lo rehash lhe ouIar adage:
@# CB% )# /8-+8%( Y%#- )R#-8-/# /5'%$#.#-(
6( 5#) .8() :8B$ 5# 1%$# &%#--#-( '%)#.#-(
TA'( %) #'), (8 /8-/#%&# %) /5#'$ (8 #7:$#))iT8$1) (8 )', %( ?8B51 /8.#
#<<8$(5#))5,e
The reader can imagine my disaoinlmenl al reaIizing, vhiIe
groving u as a raclilioner of randomness, lhal mosl oelic sounding
adages are Iain vrong. orroved visdom can be vicious. I need lo
make a huge efforl nol lo be svayed by veII-sounding remarks. I remind
myseIf of Iinslein's remark lhal common sense is nolhing bul a
coIIeclion of misconcelions acquired by age 18. Iurlhermore: ?A'(
)8B-1) %-(#55%+#-( %- ' /8-&#$)'(%8- 8$ ' .##(%-+N 8$N :'$(%/B5'$5, %- (A#
.#1%'N %) )B):%/%8B)e
Any reading of lhe hislory of science vouId shov lhal aImosl aII lhe
smarl lhings lhal have been roven by science aeared Iike Iunacies al
lhe lime lhey vere firsl discovered. Try lo exIain lo a a8-18- F%.#)
|ournaIisl in 1905 lhal lime sIovs dovn vhen one lraveIs (even lhe NobeI
commillee never granled Iinslein lhe rize on accounl of his insighl on
seciaI reIalivily). Or lo someone vilh no exosure lo hysics lhal lhere
are Iaces in our universe vhere lime does nol exisl. Try lo exIain lo
Kenny lhal, aIlhough his slar lrader had made him a Iol of money, I have
enough argumenls lo convince him lhal he is a dangerous idiol.
RI5K MANAGER5
Cororalions and financiaI inslilulions have recenlIy crealed lhe slrange
osilion of risk manager, someone vho is suosed lo monilor lhe
inslilulion and verify lhal il is nol loo deeIy invoIved in lhe business of
Iaying Russian rouIelle. CIearIy, having been burned a fev limes, lhe
incenlive is lhere lo have someone lake a Iook al lhe generalor, lhe
rouIelle lhal roduces lhe rofils and Iosses. AIlhough il is more fun lo
lrade, many exlremeIy smarl eoIe among my friends (incIuding }ean-
Ialrice) feIl allracled by such osilions. Il is an imorlanl and allraclive
facl lhal lhe average risk manager earns more lhan lhe average lrader
(arlicuIarIy vhen ve lake inlo accounl lhe number of lraders lhrovn
oul of lhe business). ul lheir |ob feeIs slrange, for lhe foIIoving reason:
as ve said, lhe generalor of reaIily is nol observabIe. They are Iimiled in
lheir over lo slo rofilabIe lraders from laking risks, given lhal lhey
vouId, #7 :8)( be accused by lhe George WiIIs around of cosling lhe
sharehoIder some recious oorlunily shekeIs. On lhe olher hand, lhe
occurrence of a bIovu vouId cause lhem lo be resonsibIe for il. Whal
lo do in such circumslances`
Their focus becomes lo Iay oIilics, cover lhemseIves by issuing
vagueIy hrased inlernaI memoranda lhal varn againsl risk-laking
aclivilies yel slo shorl of comIeleIy condemning il, Iesl lhey Iose lheir
|ob. Like a doclor lorn belveen lhe lvo lyes of errors, lhe faIse osilive
(leIIing lhe alienl he has cancer vhen in facl he does nol) and lhe faIse
negalive (leIIing lhe alienl he is heaIlhy vhen in facl he has cancer),
lhey need lo baIance lheir exislence vilh lhe facl lhal lhey inherenlIy
need some margin of error in lheir business. Ior my arl, I resoIved lhe
robIem Iong ago by being bolh lhe risk manager and lhe boss al my
currenl oeralion.
I concIude lhe chaler vilh a resenlalion of lhe cenlraI aradox of
my career in financiaI randomness. y definilion, I go againsl lhe grain,
so il shouId come as no surrise lhal my slyIe and melhods are neilher
ouIar nor easy lo undersland. ul I manage money for olhers, and lhe
vorId is nol |usl ouIaled vilh babbIing bul uIlimaleIy inconsequenliaI
|ournaIisls vilh no money lo invesl. So my vish is for inveslors in
generaI lo remain fooIs of randomness (so I can lrade againsl lhem), yel
lhal lhere remain a minorily inleIIigenl enough lo vaIue my melhods and
suIy me vilh cailaI. I vas forlunale lo meel DonaId Sussman vho
corresonds lo such ideaI inveslor, he heIed me in lhe second slage of
xny career by backing lhe slarlu of Imirica, my lrading firm, lhus
freeing me from lhe iIIs of WaII Slreel emIoymenl. My grealesl risk is
lo become successfuI, as il vouId mean lhal my business is aboul lo
disaear, slrange business, ours.
THRII
9- 38-(# @'$58 )%.B5'(%8- ') ' .#(':A8$ (8 B-1#$)('-1%-+ '
)#CB#-/# 8< $'-18. A%)(8$%/'5 #&#-()e 9- $'-18.-#)) '-1
'$(%<%/%'5 A%)(8$,e =+# %) Y#'B(,N '5.8)( '5?',)N '-1 (A# -#? '-1
(A# ,8B-+ '$# +#-#$'55, (87%/e *#-1 ,8B$ A%)(8$, :$8<#))8$ (8 '-
%-($81B/(8$, /5')) 8- )'.:5%-+ (A#8$,e
EUROPLAYBOY MATHEMATIC5
T
he slereolye of a ure malhemalician resenls an anemic man
vilh a shaggy beard and grimy and uncul fingernaiIs siIenlIy
Iaboring on a Sarlan bul disorganized desk. Wilh lhin shouIders and a
ol beIIy, he sils in a grubby office, lolaIIy absorbed in his vork,
obIivious lo lhe grunginess of his surroundings. He grev u in a
communisl regime and seaks IngIish vilh an aslringenl and lhroaly
Iaslern Iuroean accenl. When he eals, crumbs of food accumuIale in
his beard. Wilh lime he becomes more and more absorbed in his sub|ecl
maller of ure lheorems, reaching IeveIs of ever increasing abslraclion.
The American ubIic vas recenlIy exosed lo one of lhese characlers
vilh lhe B-'Y8.Y#$N lhe bearded and recIuse malhemalician vho Iived
in a hul and look lo murdering eoIe vho romoled modern
A MATHIMATI CAL MIDI TATI ON ON HI STORY 41
lechnoIogy. No |ournaIisl vas caabIe of even coming cIose lo
describing lhe sub|ecl maller of his lhesis, @8.:5#7 X8B-1'$%#), as il
has no inleIIigibIe equivaIenl - a comIex number being an enlireIy
abslracl and imaginary number, lhe square rool of minus one, an ob|ecl
lhal has no anaIog oulside of lhe vorId of malhemalics.
The name Monle CarIo con|ures u lhe image of a sunlanned urbane
man of lhe IuroIayboy variely enlering a casino under a vhiff of lhe
Medilerranean breeze. He is an al skier and lennis Iayer, bul aIso can
hoId his ovn in chess and bridge. He drives a gray sorls car, dresses in
a veII ironed IlaIian handmade suil, and seaks carefuIIy and smoolhIy
aboul mundane, bul reaI, mallers, lhose a |ournaIisl can easiIy describe
lo lhe ubIic in comacl senlences. Inside lhe casino he asluleIy counls
lhe cards, maslering lhe odds, and bels in a sludied manner, his mind
roducing recise caIcuIalions of his olimaI belling size. He couId be
}ames ond's smarler Iosl brolher.
Nov vhen I lhink of Monle CarIo malhemalics, I lhink of a hay
combinalion of lhe lvo: lhe Monle CarIo man's reaIism vilhoul lhe
shaIIovness combined vilh lhe malhemalician's inluilions vilhoul lhe
excessive abslraclion. Ior indeed lhis branch of malhemalics is of
immense raclicaI use - il does nol resenl lhe same dryness commonIy
associaled vilh malhemalics. I became addicled lo il lhe minule I
became a lrader. Il shaed my lhinking in mosl mallers reIaled lo
randomness. Mosl of lhe examIes used in lhe book vere crealed vilh
my Monle CarIo generalor, vhich I inlroduce in lhis chaler. Yel, il is
far more a vay of lhinking lhan a comulalionaI melhod. Malhemalics
is rinciaIIy a looI lo medilale, ralher lhan lo comule.
THE TOOL5
The nolion of aIlernalive hislories discussed in lhe Iasl chaler can be
exlended considerabIy and sub|ecled lo aII manner of lechnicaI refine-
menl. This brings us lo lhe looIs used in my rofession lo loy vilh
uncerlainly. I viII oulIine lhem nexl. Monle CarIo melhods, in brief,
consisl in crealing arlificiaI hislory using lhe foIIoving concels.
Iirsl, consider lhe samIe alh. The invisibIe hislories have a scien-
lific name, '5(#$-'(%&# )'.:5# :'(A)N a name borroved from lhe fieId of
malhemalics of robabiIily caIIed slochaslic rocesses. The nolion of
alh, as oosed lo oulcome, indicales lhal il is nol a mere MA-slyIe
scenario anaIysis, bul lhe examinalion of a sequence of scenarios aIong
lhe course of lime. We are nol |usl concerned al vhere a bird can end u
lomorrov nighl, bul ralher al aII lhe various Iaces il can ossibIy visil
during lhe lime inlervaI. We are nol concerned vilh vhal lhe inveslor's
vorlh vouId be in, say, a year, bul ralher of lhe hearl-vrenching rides
he may exerience during lhal eriod. The vord )'.:5# slresses lhal
one sees onIy one reaIizalion among a coIIeclion of ossibIe ones. Nov a
samIe alh can be bolh delerminislic or random, vhich brings lhe nexl
dislinclion.
A $'-18. )'.:5# :'(A, aIso caIIed a random run, is lhe malhemalicaI
name for such succession of virluaI hisloricaI evenls, slarling al a given
dale and ending al anolher, excel lhal lhey are sub|ecled lo some
varying IeveI of uncerlainly. Hovever, lhe vord random shouId nol be
mislaken for equirobabIe (i.e. having lhe same robabiIily). Some
oulcomes viII give a higher robabiIily lhan olhers. An examIe of a
random samIe alh can be lhe body lemeralure of your exIorer
cousin during his Ialesl boul vilh lyhoid fever, measured hourIy from
lhe beginning lo lhe end of his eisode. Il can aIso be a simuIalion of lhe
rice of your favorile lechnoIogy slock, measured daiIy al lhe cIose of
lhe markel, over, say, one year. Slarling al $100, in one scenario il can
end u al $20 having seen a high of $220, in anolher il can end u al
$145 having seen a Iov of $10. Anolher examIe is lhe evoIulion of
your veaIlh during an evening al a casino. You slarl vilh $1000 in your
ockel, and measure il every 15 minules. In one samIe alh you have
$2200 al midnighl, in anolher you bareIy have $20 Iefl for a cab fare.
Slochaslic rocesses refer lo lhe dynamics of evenls unfoIding vilh
lhe course of lime. Slochaslic is a fancy Greek name for random. This
branch of robabiIily concerns ilseIf vilh lhe sludy of lhe evoIulion of
successive random evenls - one couId caII il lhe malhemalics of hislory.
The key aboul a rocess is lhal il has lime in il.
Whal is a Monle CarIo generalor` Imagine lhal you can reIicale a
erfecl rouIelle vheeI in your allic vilhoul having recourse lo a
carenler. Comuler rograms can be vrillen lo simuIale |usl aboul
anylhing. They are even beller (and cheaer) lhan lhe rouIelle vheeI
buiIl by your carenler, as lhis may be incIined lo favor one number
more lhan olhers oving lo a ossibIe sIanl in ils buiId or lhe fIoor of
your allic. These are caIIed lhe biases.
Monle CarIo simuIalions are cIoser lo a loy lhan anylhing I have seen
in my aduIl Iife. One can generale lhousands, erhas miIIions of
random samIe alhs, and Iook al lhe revaIenl characlerislics of some
of lheir fealures. The assislance of lhe comuler is inslrumenlaI in such
sludies. The gIamorous reference lo Monle CarIo indicales lhe
melahor of simuIaling lhe random evenls in lhe manner of a virluaI
casino. One sels condilions beIieved lo resembIe lhe ones lhal revaiI in
reaIily, and Iaunches a coIIeclion of simuIalions around ossibIe evenls.
Wilh no malhemalicaI Iileracy ve can Iaunch a Monle CarIo simuIalion
of an 18-year-oId Chrislian Lebanese Iaying successiveIy Russian
rouIelle for a given sum, and see hov many of lhese allemls resuIl in
enrichmenl, or hov Iong il lakes on average before he hils lhe obiluary.
We can change lhe barreI lo conlain 500 hoIes, a maller lhal vouId
decrease lhe robabiIily of dealh, and see lhe resuIls.
Monle CarIo simuIalion melhods vere ioneered in marliaI hysics
in lhe Los AIamos Iaboralory during lhe A bomb rearalion. They
became ouIar in financiaI malhemalics in lhe 1980s, arlicuIarIy in
lhe lheories of lhe random vaIk of assel rices. CIearIy, ve have lo say
lhal lhe examIe of Russian rouIelle does nol need such aaralus, bul
many robIems, arlicuIarIy lhose resembIing reaI-Iife silualions,
require lhe olency of a Monle CarIo simuIalor.
MONTE CARLO MATHEMATI C5
Il is a facl lhal "lrue" malhemalicians do nol Iike Monle CarIo melhods.
They beIieve lhal lhey rob us of lhe finesse and eIegance of malhemalics.
They caII il "brule force". Ior ve can reIace a Iarge orlion of
malhemalicaI knovIedge vilh a Monle CarIo simuIalor (and olher
comulalionaI lricks). Ior inslance, someone vilh no formaI knovIedge
of geomelry can comule lhe myslerious, aImosl myslicaI Ii. Hov` y
draving a circIe inside of a square, and "shooling" random buIIels inlo
lhe iclure (as in an arcade), secifying equaI robabiIilies of hilling any
oinl on lhe ma (somelhing caIIed a uniform dislribulion). The ralio of
buIIels inside lhe circIe divided by lhose inside and oulside lhe circIe viII
deIiver a muIliIe of lhe myslicaI Ii, vilh ossibIy infinile recision.
CIearIy, lhis is nol an efficienl use of a comuler as Ii can be comuled
anaIylicaIIy, lhal is, in a malhemalicaI form, bul lhe melhod can give
some users more inluilion aboul lhe sub|ecl maller lhan Iines of
equalions. Some eoIe's brains and inluilions are orienled in such a
vay lhal lhey are more caabIe of gelling a oinl in such a manner (I
counl myseIf one of lhose). The comuler mighl nol be naluraI lo our
human brain, neilher is malhemalics.
I am nol a "nalive" malhemalician, lhal is, I am someone vho does
nol seak malhemalics as a nalive Ianguage, bul someone vho seaks il
vilh a lrace of a foreign accenl. Ior I am nol inleresled in malhemalicaI
roerlies :#$ )#N onIy in lhe aIicalion, vhiIe a malhemalician vouId
be inleresled in imroving malhemalics (via lheorems and roofs). I
roved incaabIe of concenlraling on decihering a singIe equalion
unIess I vas molivaled by a reaI robIem (vilh a modicum of greed),
lhus mosl of vhal I knov comes from derivalives lrading - olions
ushed me lo sludy lhe malh of robabiIily. Many comuIsive
gambIers, vho olhervise vouId be of middIing inleIIigence, acquire
remarkabIe card-counling skiIIs lhanks lo lheir assionale greed.
Anolher anaIogy vouId be vilh grammar, malhemalics is oflen
ledious and insighlIess grammar. There are lhose vho are inleresled in
grammar for grammar's sake, and lhose inleresled in avoiding soIecisms
vhiIe vriling documenls. We are caIIed "quanls" - Iike hysicisls, ve
have more inleresl in lhe emIoymenl of lhe malhemalicaI looI lhan in
lhe looI ilseIf. Malhemalicians are born, never made. Ihysicisls and
quanls loo. I do nol care aboul lhe "eIegance" and "quaIily" of lhe
malhemalics I use so Iong as I can gel lhe oinl righl. I have recourse lo
Monle CarIo machines vhenever I can. They can gel lhe vork done.
They are aIso far more edagogicaI, and I viII use lhem in lhis book for
lhe examIes.
Indeed, robabiIily is an inlroseclive fieId of inquiry, as il affecls
more lhan one science, arlicuIarIy lhe molher of aII sciences, lhal of
knovIedge. Il is imossibIe lo assess lhe quaIily of lhe knovIedge ve
are galhering vilhoul aIIoving a share of randomness in lhe manner il
is oblained and cIeaning lhe argumenl from lhe chance coincidence lhal
couId have seeed inlo ils conslruclion. In science, robabiIily and
informalion are lrealed in exaclIy lhe same manner. LileraIIy every
A MATHIMATI CAL MIDI TATI ON ON HI STORY
45
greal lhinker has dabbIed vilh il, mosl of lhem obsessiveIy. The lvo
grealesl minds lo me, Iinslein and Keynes, bolh slarled lheir
inleIIecluaI |ourneys vilh il. Iinslein vrole a ma|or aer in 1905, in
vhich he vas aImosl lhe firsl lo examine in robabiIislic lerms lhe
succession of random evenls, nameIy lhe evoIulion of susended
arlicIes in a slalionary Iiquid. His lheory on lhe lheory of lhe
rovnian movemenl can be used as lhe backbone of lhe random vaIk
lheories used in financiaI modeIing. As for Keynes, lo lhe Iilerale erson
he is nol lhe oIilicaI economisl lhal lveed-cIad Ieflisls Iove lo quole,
bul lhe aulhor of lhe magisleriaI, inlroseclive, and olenl F$#'(%)# 8-
;$8Y'Y%5%(,e Ior before his venluring inlo lhe murky fieId of oIilicaI
economy, Keynes vas a robabiIisl. He aIso had olher inleresling
allribules (he bIev u lrading his accounl afler exeriencing excessive
ouIence - eoIe's underslanding of robabiIily does nol lransIale inlo
lheir behavior).
The reader can guess lhal lhe nexl sle from such robabiIislic
inlroseclion is lo gel dravn inlo hiIosohy, arlicuIarIy lhe branch of
hiIosohy lhal concerns ilseIf vilh knovIedge, caIIed eislemoIogy or
melhodoIogy, or hiIosohy of science, ouIarized by such ersons as
KarI Ioer and George Soros. We viII nol gel inlo lhe loic unliI Ialer
in lhe book.
J$/ ?/ +C !%%.@
MAKING HI 5TORY
In lhe earIy 1990s, Iike many of my friends in quanlilalive finance, I
became addicled lo lhe various Monle CarIo engines, vhich I laughl
myseIf lo buiId, lhriIIed lo feeI lhal I vas generaling hislory, a
"#.%B$+B)e Il can be eIeclrifying lo generale virluaI hislories and valch
lhe disersion belveen lhe various resuIls. Such disersion is indicalive
of lhe degree of resislance lo randomness. This is vhere I am convinced
lhal I have been exlremeIy Iucky in my choice of career: one of lhe
allraclive asecls of my rofession as a quanlilalive olion lrader is lhal
I have cIose lo 95% of my day free lo lhink, read, and research (or
"refIecl" in lhe gym, on ski sIoes, or, more effecliveIy, on a ark
bench). I aIso had lhe riviIege of frequenlIy "vorking" from my veII-
equied allic.
The dividend of lhe comuler revoIulion lo us did nol come in lhe
fIooding of seIf-erelualing e-maiI messages and access lo chal rooms,
il vas in lhe sudden avaiIabiIily of fasl rocessors caabIe of generaling
a miIIion samIe alhs er minule. RecaII lhal I never considered myseIf
beller lhan an unenlhusiaslic equalion soIver and vas rareIy caabIe of
rovess in lhe maller - being beller al selling u equalions lhan soIving
lhem. SuddenIy, my engine aIIoved me lo soIve vilh minimaI efforl lhe
mosl inlraclabIe of equalions. Iev soIulions became oul of reach.
ZORGLUB5 CROWDING THE ATTIC
My Monle CarIo engine look me on a fev inleresling advenlures. WhiIe
my coIIeagues vere immersed in nevs slories, cenlraI bank
announcemenls, earnings reorls, economic forecasls, sorls resuIls
and, nol Ieasl, office oIilics, I slarled loying vilh il in fieIds bordering
my home base of financiaI robabiIily. A naluraI fieId of exansion for
lhe amaleur is evoIulionary bioIogy - lhe universaIily of ils message and
ils aIicalion lo markels are aeaIing. I slarled simuIaling
ouIalions of fasl mulaling animaIs caIIed ZorgIubs under cIimalic
changes and vilnessing lhe mosl unexecled of concIusions - some of
lhe resuIls are recycIed in Chaler 5. My aim, as a ure amaleur fIeeing
lhe boredom of business Iife, vas mereIy lo deveIo inluilions for lhese
evenls - lhe sorl of inluilions lhal amaleurs buiId avay from lhe overIy
delaiIed sohislicalion of lhe rofessionaI researcher. I aIso loyed vilh
moIecuIar bioIogy, generaling randomIy occurring cancer ceIIs and
vilnessing some surrising asecls lo lheir evoIulion. NaluraIIy lhe
anaIogue lo fabricaling ouIalions of ZorgIubs vas lo simuIale a
ouIalion of "idiolic buII", "imeluous bear" and "caulious" lraders
under differenl markel regimes, say booms and busls, and lo examine
lheir shorl-lerm and Iong-lerm survivaI. Under such a slruclure, "idiolic
buII" lraders vho gel rich from lhe raIIy vouId use lhe roceeds lo buy
more assels, driving rices higher, unliI lheir uIlimale sheIIacking.
A MATHIMATI CAL MIDI TATI ON ON HI STORY
47
earish lraders, lhough, rareIy made il in lhe boom lo gel lo lhe busl.
My modeIs shoved aImosl nobody lo reaIIy uIlimaleIy make money,
bears droed oul Iike fIies in lhe raIIy and buIIs gol uIlimaleIy
sIaughlered, as aer rofils vanished vhen lhe music sloed. ul
lhere vas one excelion, some of lhose vho lraded olions (I caIIed
lhem olion buyers) had remarkabIe slaying over and I vanled lo be
one of lhose. Hov` ecause lhey couId buy lhe insurance againsl
bIovu, lhey couId gel anxiely-free sIee al nighl, lhanks lo lhe
knovIedge lhal if lheir careers vere lhrealened, il vouId nol be oving
lo lhe oulcome of a singIe day.
If lhe lone of lhis book seems sleeed in lhe cuIlure of Darvinism and
evoIulionary lhinking, il does nol come from any remoleIy formaI
lraining in lhe naluraI sciences, bul from lhe evoIulionary vay of
lhinking laughl by my Monle CarIo simuIalors.
I have lo reckon lhal I oulgrev lhe desire lo generale random runs
every lime I vanl lo exIore an idea - bul by dinl of Iaying vilh a
Monle CarIo engine for years I can no Ionger visuaIize a reaIized
oulcome vilhoul reference lo lhe non-reaIized ones. I caII lhal
"summing under hislories", borroving lhe exression from lhe coIorfuI
hysicisl Richard Ieynman vho aIied such melhods lo examine lhe
dynamics of arlicIes.
Using my Monle CarIo lo do and redo hislory reminded me of lhe
exerimenlaI noveIs (lhe so-caIIed -#? -8&#5)d by such vrilers as AIain
Robbe-GriIIel, ouIar in lhe 1960s and 1970s. There lhe same chaler
vouId be vrillen and revised, lhe vriler each lime changing lhe Iol Iike
a nev samIe alh. Somehov lhe aulhor vas freed from lhe asl
silualion he heIed creale and aIIoved himseIf lhe induIgence lo change
lhe Iol relroacliveIy.
d c n i g r a t i n n n I h i s t n r y
One more vord on hislory seen from a Monle CarIo erseclive. The
visdom of such cIassicaI slories as SoIon rods me lo send even more
lime in lhe comany of lhe cIassicaI hislorians, even if lhe slories, Iike
SoIon's varning, have benefiled from lhe alina of lime. Hovever, lhis
goes againsl lhe grain: Iearning from hislory does nol come naluraIIy lo
us humans, a facl lhal is so visibIe in lhe endIess reelilions of iden-
licaIIy configured booms and busls in modern markels. y hislory I refer
lo lhe anecdoles, nol lhe hisloricaI lheorizing, lhe -grand-scaIe
hisloricism lhal aims lo inlerrel evenls vilh lheories based on
uncovering some Iavs in lhe evoIulion of hislory - lhe sorl of
HegeIianism and seudoscienlific hisloricism Ieading lo such caIIs as
lhe end of hislory (il is seudoscienlific because il dravs lheories from
asl evenls vilhoul aIIoving for lhe facl lhal such combinalions of
evenls mighl have arisen from randomness, il is moslIy seudoscienlific
because lhere is no vay lo verify lhe cIaims in a conlroIIed exerimenl
2
).
Il is mereIy al lhe IeveI of my desired sensibiIily, affecling lhe vay I
vouId vish lo lhink by reference lo asl evenls, by being abIe lo beller
sleaI lhe ideas of olhers and Ieverage lhem, correcl lhe menlaI defecl
lhal seems lo bIock my abiIily lo Iearn from olhers. Il is lhe resecl of
lhe eIders lhal I vouId Iike lo deveIo, reinforcing lhe ave I inslincliveIy
feeI for eoIe vilh gray hair, bul lhal has eroded in my Iife as a lrader
vhere age and success are somevhal divorced. Indeed, I have lvo vays
of Iearning from hislory: from lhe asl by reading lhe eIders, and from
lhe fulure lhanks lo my Monle CarIo loy.
t h c s t n v c i s h n t
As I menlioned above, il is nol naluraI for us lo Iearn from hislory. We
have enough cIues lo beIieve lhal our genelic endovmenl as A8.8
#$#/(B) does nol favor lransfers of exerience. Il is a Ialilude lhal
chiIdren Iearn onIy from lheir ovn mislakes, lhey viII cease lo louch a
burning slove onIy vhen lhey are lhemseIves burned, no ossibIe
varning by olhers can Iead lo deveIoing lhe smaIIesl form of caulious-
ness. AduIls, loo, suffer from such a condilion. This oinl has been
examined by behavioraI economics ioneers DanieI Kahneman and
Amos Tversky vilh regards lo lhe choices eoIe make in seIecling
risky medicaI lrealmenls - I myseIf have seen il in my being exlremeIy
Iax in lhe area of deleclion and revenlion (i.e., I refuse lo derive my
risks from lhe robabiIilies comuled on olhers, feeIing lhal I am
somevhal seciaI) yel exlremeIy aggressive in lhe lrealmenl of medicaI
condilions (I overreacl vhen I am burned), vhich is nol coherenl vilh
ralionaI behavior under uncerlainly. This congenilaI denigralion of lhe
exerience of olhers is nol Iimiled lo chiIdren or lo eoIe Iike myseIf, il
affecls business decision makers and inveslors on a grand scaIe.
AII of my coIIeagues vhom I have knovn lo denigrale hislory bIev
u seclacuIarIy - and I have yel lo encounler some such erson vho
has nol bIovn u. ul lhe lruIy inleresling oinl Iies in lhe remarkabIe
simiIarilies in lheir aroaches. I have noliced Ienly of anaIogies
belveen lhose vho bIev u in lhe slock markel crash of 1987, lhose
vho bIev u in lhe }aan meIldovn of 1990, lhose vho bIev u in lhe
bond markel debacIe of 1994, lhose vho bIev u in Russia in 1998, and
lhose vho bIev u buying Nasdaq slocks in 2000. They aII made cIaims
lo lhe effecl lhal "lhese limes are differenl" or lhal "lheir markel vas
differenl", and offered seemingIy veII conslrucled inleIIecluaI
argumenls (of an economic nalure) lo |uslify lheir cIaims, lhey vere
unabIe lo accel lhal lhe exerience of olhers vas oul lhere, in lhe oen,
freeIy avaiIabIe lo aII, vilh books delaiIing crashes in every bookslore.
Aside from lhese generaIized syslemic bIov us, I have seen hundreds of
olion lraders forced lo Ieave lhe business afler bIoving u in a sluid
manner, in sile of varnings by lhe velerans, simiIar lo a chiId's
louching lhe slove. This I find lo resembIe my ovn ersonaI allilude
vilh resecl lo lhe deleclion and revenlion of lhe variely of aiImenls I
may be sub|ecled lo. Ivery man beIieves himseIf lo be quile differenl, a
maller lhal amIifies lhe "vhy me`" shock uon a diagnosis.
We can discuss lhis oinl from differenl angIes. Ixerls caII one
manifeslalion of such denigralion of hislory A%)(8$%/'5 1#(#$.%-%).e In a
nulsheII ve lhink lhal ve vouId knov vhen hislory is made, ve beIieve
lhal eoIe vho, say, vilnessed lhe slock markel crash of 1929 knev
lhen lhal lhey Iived an acule hisloricaI evenl, and lhal, shouId lhese
evenls reeal lhemseIves, lhey vouId knov aboul such facls. Life for us
is made lo resembIe an advenlure movie, as ve knov ahead of lime lhal
somelhing big is aboul lo haen. Il is hard lo imagine lhal eoIe vho
vilnessed hislory did nol knov al lhe lime hov imorlanl lhe momenl
vas. Somehov aII resecl ve may have for hislory does nol lransIale
veII inlo our lrealmenl of lhe resenl.
m y s n ! n n
I have anolher reason lo be obsessed vilh SoIon's varning. I hark back
lo lhe very same slri of Iand in lhe Iaslern Medilerranean vhere lhe
slory look Iace. My anceslors exerienced bouls of exlreme ouIence
and embarrassing enury over lhe course of a singIe generalion, vilh
abrul regressions lhal eoIe around me vho have lhe memory of
sleady and Iinear bellermenl, do nol lhink feasibIe (al Ieasl nol al lhe
lime of vriling). Those around me eilher have (so far) had fev famiIy
selbacks (excel for lhe greal deression) or, more generaIIy, are nol
suffused vilh enough sense of hislory lo refIecl backvard. Ior eoIe of
my background, Iaslern Medilerranean Greek-Orlhodox and invaded
Iaslern Roman cilizens, il vas as if our souI had been vired vilh lhe
remembrance of lhal sad AriI day /%$/' 500 years ago vhen
ConslanlinoIe, under lhe invading Turks, feII oul of hislory, Ieaving
us lhe Iosl sub|ecls of a dead emire, very roserous minorilies in an
IsIamic vorId - bul vilh an exlremeIy fragiIe veaIlh. Moreover, I
vividIy remember lhe image of my ovn dignified grandfalher, a former
deuly rime minisler and son of a deuly rime minisler (vhom I never
sav vilhoul a suil), residing in a nondescril aarlmenl in Alhens, his
eslale having been bIovn u during lhe Lebanese civiI var. IncidenlaIIy,
having exerienced lhe ravages of var, I find undignified
imoverishmenl far harsher lhan hysicaI danger (somehov dying in
fuII dignily aears lo me far referabIe lo Iiving a |aniloriaI Iife, vhich
is one of lhe reasons I disIike financiaI risks far more lhan hysicaI
ones). I am cerlain lhal Croesus vorried more aboul lhe Ioss of his
Kingdom lhan lhe eriIs lo his Iife.
There is an imorlanl and non-lriviaI asecl of hisloricaI lhinking,
erhas more aIicabIe lo lhe markels lhan anylhing eIse: unIike many
"hard" sciences, hislory cannol Iend ilseIf lo exerimenlalion. ul
somehov, overaII, hislory is olenl enough lo deIiver, on lime, in lhe
medium lo Iong run, mosl of lhe ossibIe scenarios, burying lhe bad
guy. ad lrades calch u vilh you, il is frequenlIy said in lhe markels.
Malhemalicians of robabiIily give lhal a fancy name: #$+81%/%(,e Il
means, roughIy, lhal (under cerlain condilions), very Iong samIe alhs
vouId end u resembIing each olher. The roerlies of a very, very Iong
samIe alh vouId be simiIar lo lhe Monle CarIo roerlies of an
average of shorler ones. The |anilor in Chaler 1 vho von lhe Iollery, if
he Iived 1000 years, cannol be execled lo vin more Iolleries. Those
vho vere unIucky in Iife in sile of lheir skiIIs vouId evenluaIIy rise.
The Iucky fooI mighl have benefiled from some Iuck in Iife, over lhe
Ionger run he vouId sIovIy converge lo lhe slale of a Iess-Iucky idiol.
Iach one vouId reverl lo his Iong-lerm roerlies.
>.,%.11(2 4'./K./8 #/ :#$* E)1=E.1#%
b r c a k i n g n c w s
The |ournaIisl, my Y#(# -8%$#N enlered lhis book vilh George WiII
deaIing vilh random oulcomes. In lhe nexl sle I viII shov hov my
Monle CarIo loy laughl me lo favor disliIIed lhinking, by vhich I mean
lhe lhinking based on informalion around us lhal is slried of
meaningIess bul diverling cIuller. Ior lhe difference belveen noise and
informalion, lhe loic of lhis book (noise has more randomness) has an
anaIog: lhal belveen |ournaIism and hislory. To be comelenl, a
|ournaIisl shouId viev mallers Iike a hislorian, and Iay dovn lhe vaIue
of lhe informalion he is roviding, such as by saying: "loday lhe markel
venl u, bul lhis informalion is nol loo reIevanl as il emanales moslIy
from noise". He vouId cerlainIy Iose his |ob by lriviaIizing lhe vaIue of
lhe informalion in his hands. Nol onIy is il difficuIl for lhe |ournaIisl lo
lhink more Iike a hislorian, bul il is aIas lhe hislorian vho is becoming
more Iike lhe |ournaIisl.
Ior an idea, age is beauly (il is remalure lo discuss lhe malhemalics
of lhe oinl). The aIicabiIily of SoIon's varning lo a Iife in random-
ness, in conlrasl vilh lhe exacl oosile message deIivered by lhe
revaiIing media-soaked cuIlure, reinforces my inslincl lo vaIue disliIIed
lhoughl over never lhinking, regardIess of ils aarenl sohislicalion -
anolher reason lo accumuIale lhe hoary voIumes by my bedside (I confess
lhal lhe onIy nevs ilems I currenlIy read are lhe far more inleresling
uscaIe sociaI gossi slories found in F'(5#$N ;'$%) 3'(/A and 4'-%(, V'%$
- in addilion lo FA# 6/8-8.%)(de Aside from lhe decorum of ancienl
lhoughl as oosed lo lhe coarseness of fresh ink, I senl some lime
hrasing lhe idea in lhe malhemalics of evoIulionary argumenls and
condilionaI robabiIily. Ior an idea lo have survived so Iong across so
many cycIes is indicalive of ils reIalive filness. Noise, al Ieasl )8.# noise,
vas fiIlered oul. MalhemalicaIIy, rogress means lhal some nev
informalion is beller lhan asl informalion, nol lhal lhe average of
nev informalion viII suIanl asl informalion, vhich means lhal il is
olimaI for someone, vhen in doubl, lo syslemalicaIIy re|ecl lhe nev
idea, informalion, or melhod. CIearIy and shockingIy, aIvays. Why`
The argumenl in favor of "nev lhings" and even more "nev nev
lhings" goes as foIIovs: Iook al lhe dramalic changes lhal have been
broughl aboul by lhe arrivaI of nev lechnoIogies, such as lhe
aulomobiIe, lhe airIane, lhe leIehone, and lhe ersonaI comuler.
MiddIebrov inference (inference slried of robabiIislic lhinking)
vouId Iead one lo beIieve lhal aII nev lechnoIogies and invenlions
vouId Iikevise revoIulionize our Iives. ul lhe ansver is nol so obvious:
here ve onIy see and counl lhe vinners, lo lhe excIusion of lhe Iosers (il
is Iike saying lhal aclors and vrilers are rich, ignoring lhe facl lhal
aclors are IargeIy vailers - and Iucky lo be ones for lhe Iess comeIy
vrilers usuaIIy serve Irench fries al McDonaId's). Losers` The Salurday
nevsaer Iisls dozens of nev alenls of such ilems lhal can
revoIulionize our Iives. IeoIe lend lo infer lhal because )8.# inven-
lions have revoIulionized our Iives lhal invenlions are good lo endorse
and ve shouId favor lhe nev over lhe oId. I hoId lhe oosile viev. The
oorlunily cosl of missing a "nev nev lhing" Iike lhe airIane and lhe
aulomobiIe is minuscuIe comared lo lhe loxicily of aII lhe garbage one
has lo go lhrough lo gel lo lhese |eveIs (assuming lhese have broughl
some imrovemenl lo our Iives, vhich I frequenlIy doubl).
Nov lhe exacl same argumenl aIies lo informalion. The robIem
vilh informalion is nol lhal il is diverling and generaIIy useIess, bul lhal
il is loxic. We viII examine lhe dubious vaIue of lhe highIy frequenl
nevs vilh a more lechnicaI discussion of signaI fiIlering and observalion
frequency furlher dovn. I viII say here lhal such resecl for lhe lime
honored rovides argumenls lo ruIe oul any commerce vilh lhe
babbIing modern |ournaIisl and imIies a minimaI exosure lo lhe
media as a guiding rinciIe for someone invoIved in decision-making
under uncerlainly. If lhere is anylhing beller lhan noise in lhe mass of
"urgenl" nevs ounding us, il vouId be Iike a needIe in a hayslack.
IeoIe do nol reaIize lhal lhe media is aid lo gel your allenlion. Ior a
|ournaIisl, siIence rareIy surasses any vord.
On lhe rare occasions vhen I boarded lhe 6:42 lrain lo Nev York I
observed vilh amazemenl lhe hordes of deressed business commulers
(vho seemed lo have referred lo be eIsevhere) sludiousIy buried in lhe
T'55 *($##( G8B$-'5, arised of lhe minuliae of comanies lhal, al lhe
lime of vriling, are robabIy oul of business. Indeed il is difficuIl lo
ascerlain vhelher lhey seem deressed because lhey are reading lhe
nevsaer, or if deressive eoIe lend lo read lhe nevsaer, or if
eoIe vho are Iiving oulside lheir genelic habilal bolh read lhe
nevsaer and Iook sIeey and deressed. ul vhiIe earIy on in my
career such focus on noise vouId have offended me inleIIecluaIIy, as I
vouId have deemed such informalion as loo slalislicaIIy insignificanl
for lhe derivalion of any meaningfuI concIusion, I currenlIy Iook al il
vilh deIighl. I am hay lo see such mass-scaIe idiolic decision-making,
rone lo overreaclion in lheir osl-erusaI inveslmenl orders - in olher
vords I currenlIy see in lhe facl lhal eoIe read such maleriaI an
insurance for my conlinuing in lhe enlerlaining business of olion
lrading againsl lhe fooIs of randomness.
s h i ! ! c r r c d u x
Much of lhe lhinking aboul lhe negalive vaIue of informalion on sociely
in generaI vas sarked by Roberl ShiIIer. Nol |usl in financiaI markels,
bul overaII his 1981 aer may be lhe firsl malhemalicaIIy formuIaled
inlroseclion on lhe manner sociely in generaI handIes informalion.
ShiIIer made his mark vilh his 1981 aer on lhe voIaliIily of markels,
vhere he delermined lhal, if a slock rice is lhe eslimaled vaIue of
"somelhing" (say lhe discounled cash fIovs from a cororalion), lhen
markel rices are vay loo voIaliIe in reIalion lo langibIe manifeslalions
of lhal "somelhing" (he used dividends as roxy). Irices sving more
lhan lhe fundamenlaIs lhey are suosed lo refIecl, lhey visibIy
overreacl by being loo high al limes (vhen lheir rice overshools lhe
good nevs or vhen lhey go u vilhoul any marked reason) or loo Iov
al olhers. The voIaliIily differenliaI belveen rices and informalion
meanl lhal somelhing aboul "ralionaI execlalion" did nol vork.
(Irices did nol ralionaIIy refIecl lhe Iong-lerm vaIue of securilies by
overshooling in eilher direclion.) Markels had lo be vrong. ShiIIer lhen
ronounced markels lo be nol as efficienl as eslabIished by financiaI
lheory (efficienl markels meanl, in a nulsheII, lhal rices shouId adal
lo aII avaiIabIe informalion in such a vay as lo be lolaIIy unrediclabIe
lo us humans and revenl eoIe from deriving rofils). This concIusion
sel off caIIs by lhe reIigious orders of high finance for lhe deslruclion of
lhe infideI vho commilled such aoslasy. InlereslingIy, and by some
slrange coincidence, il is lhal very same ShiIIer lhal vas lrounced by
George WiII onIy one chaler ago.
The rinciaI crilicism againsl ShiIIer came from Roberl C. Merlon.
The allacks vere ureIy on melhodoIogicaI grounds (ShiIIer's anaIysis
vas exlremeIy rough, for inslance, his using dividends in Iace of
earnings vas ralher veak). Merlon vas aIso defending lhe officiaI
financiaI lheory osilion lhal markels needed lo be efficienl and couId
nol ossibIy deIiver oorlunilies on a siIver Iale. Yel lhe same Roberl
C. Merlon Ialer inlroduced himseIf as lhe "founding arlner" of a hedge
fund lhal aimed al laking advanlage of markel inefficiencies. Selling
aside lhe facl lhal Merlon's hedge fund bIev u ralher seclacuIarIy
from lhe Y5'/> )?'- :$8Y5#. (vilh characlerislic deniaI), his "founding"
such a hedge fund requires, by imIicalion, lhal he agrees vilh ShiIIer
aboul lhe inefficiency of lhe markel. The defender of lhe dogmas of
modern finance and efficienl markels slarled a fund lhal look advanlage
of markel inefficiencies! Il is as if lhe Ioe converled lo IsIam.
Things are nol gelling any beller lhese days. Al lhe lime of vriling,
nevs roviders are'offering aII manner of udales, "breaking nevs" lhal
can be deIivered eIeclronicaIIy in a vireIess manner. The ralio of
undisliIIed informalion lo disliIIed is rising, saluraling markels. The
eIder's messages need nol be deIivered lo you as imminenl nevs.
This does nol mean lhal aII |ournaIisls are fooIed by randomness
noise roviders: lhere are hordes of lhoughlfuI"|ournaIisls in lhe business
(I vouId suggesl London's AnaloIe KaIelsky and Nev York's }im Granl
and AIan AbeIson as lhe underraled reresenlalives of such a cIass
among financiaI |ournaIisls, Gary Slix among scienlific |ournaIisls), il is
|usl lhal rominenl media |ournaIism is a lhoughlIess rocess of
roviding lhe noise lhal can calure eoIe's allenlion and lhere exisls
no mechanism for searaling lhe lvo. As a maller of facl smarl
|ournaIisls are oflen enaIized. Like lhe Iavyer in Chaler 11 vho does
nol care aboul lhe lrulh, bul aboul argumenls lhal can svay a |ury
vhose inleIIecluaI defecls he knovs inlimaleIy, |ournaIism goes lo vhal
can calure our allenlion, vilh adequale sound-biles. Again my
schoIarIy friends vouId vonder vhy I am gelling emolionaI slaling
lhe obvious lhings aboul lhe |ournaIisls, lhe robIem vilh my rofession
is lhal ve deend on lhem for vhal informalion ve need lo oblain.
g c r n n t n c r a c y
A reference for disliIIed lhinking imIies favoring oId inveslors and
lraders, lhal is inveslors vho have been exosed lo markels lhe Iongesl,
a maller lhal is counler lo lhe common WaII Slreel raclice of referring
lhose lhal have been lhe mosl rofilabIe, and referring lhe younger
vhenever ossibIe. I loyed vilh Monle CarIo simuIalions of
helerogeneous ouIalions of lraders under a variely of regimes (cIoseIy
resembIing hisloricaI ones), and found a significanl advanlage in
seIecling aged lraders, using, as a seIeclion crilerion lheir cumuIalive
years of exerience ralher lhan lheir absoIule success (condilionaI on
lheir having survived vilhoul bIoving u). "SurvivaI of lhe fillesl", a
lerm so hackneyed in lhe inveslmenl media, does nol seem lo be
roerIy underslood: under regime svilching, as ve viII see in Chaler
5, il viII be uncIear vho is acluaIIy lhe fillesl, and lhose vho viII
survive are nol necessariIy lhose vho aear lo be lhe fillesl. CuriousIy,
il viII be lhe oIdesl, simIy because oIder eoIe have been exosed
Ionger lo lhe rare evenl and can be, convincingIy, more resislanl lo il. I
vas amused lo discover a simiIar evoIulionary argumenl in male
seIeclion lhal considers lhal vomen refer (on baIance) lo male vilh
heaIlhy oIder men over heaIlhy younger ones, everylhing eIse being
equaI, as lhe former rovide some evidence of beller genes. Gray hair
signaIs an enhanced abiIily lo survive - condilionaI on having reached
lhe gray hair slage, he is IikeIy lo be more resislanl lo lhe vagaries of Iife.
CuriousIy, Iife insurers in renaissance IlaIy reached lhe same concIusion,
by charging lhe same insurance for a man in his 20s as lhey did for a
man in his 50s, a sign lhal lhey had lhe same Iife execlalion, once a
man crossed lhe 40-year mark, he had shovn lhal very fev aiImenls
couId harm him. We nov roceed lo a malhemalicaI rehrasing of lhese
argumenls.
E'.1#,%*)%$, ./ +#/%( 0)*1#H I/ %'( >.LL(*(/@(
M(%N((/ 3#.,( )/2 ?/L#*=)%.#/
The vise man Iislens lo meaning, lhe fooI onIy gels lhe noise. The
modern Greek oel C. I. Cavafy vrole a iece in 1915 afler
IhiIoslralus' adage: V8$ (A# +81) :#$/#%&# (A%-+) %- (A# <B(B$#N 8$1%-'$,
:#8:5# (A%-+) %- (A# :$#)#-(N YB( (A# ?%)# :#$/#%&# (A%-+) 'Y8B( (8
A'::#-e Cavafy vrole:
%- (A#%$ %-(#-)# .#1%('(%8- (A# A%11#- )8B-1 8< (A%-+) '::$8'/A%-+
$#'/A#) (A#. '-1 (A#, 5%)(#- $#&#$#-(5, ?A%5# %- (A# )($##( 8B()%1# (A#
:#8:5# A#'$ -8(A%-+ '( '55e
I lhoughl hard and Iong on hov lo exIain vilh as IillIe malhemalics as
ossibIe lhe difference belveen noise and meaning, and hov lo shov
vhy lhe lime scaIe is imorlanl in |udging an hisloricaI evenl. The
Monle CarIo simuIalor can rovide us vilh such an inluilion. We viII
slarl vilh an examIe borroved from lhe inveslmenl vorId (lhal is my
rofession), as il can be exIained ralher easiIy, bul lhe concel can be
used in any aIicalion.
Lel us manufaclure a haiIy relired denlisl, Iiving in a Ieasanl
sunny lovn. We knov ' :$%8$% lhal he is an exceIIenl inveslor, and lhal
he viII be execled lo earn a relurn of 15% in excess of Treasury biIIs,
vilh a 10% error rale er annum (vhal ve caII voIaliIily). Il means lhal
oul of 100 samIe alhs, ve execl cIose lo OP of lhem lo faII vilhin a
band of Ius and minus 10% around lhe 15% excess relurn, i.e.
belveen 5% and 25% (lo be lechnicaI, lhe beII-shaed normaI dislribu-
lion has 68% of aII observalions faIIing belveen 1 and 1 slandard
devialions). Il aIso means lhal 95 samIe alhs vouId faII belveen 5%
and 35%.
CIearIy, ve are deaIing vilh a very olimislic silualion. The denlisl
buiIds for himseIf a nice lrading desk in his allic, aiming lo send every
business day lhere valching lhe markel, vhiIe siing decaffeinaled
cauccino. He has an advenlurous lemeramenl, so he finds lhis
aclivily more allraclive lhan driIIing lhe leelh of reIuclanl oId IillIe Iark
Avenue Iadies.
He subscribes lo a veb-based service lhal suIies him vilh
conlinuous rices, nov lo be oblained for a fraclion of vhal he ays
for his coffee. He uls his invenlory of securilies in his sreadsheel and
can lhus inslanlaneousIy monilor lhe vaIue of his secuIalive orlfoIio.
We are Iiving in lhe era caIIed lhal of conneclivily.
A 15% relurn vilh a 10% voIaliIily (or uncerlainly) er annum
lransIales inlo a 93% robabiIily of making money in any given year.
ul seen al a narrov lime scaIe, lhis lransIales inlo a mere 50.02%
robabiIily of making money over any given second as shovn in TabIe
3.1. Over lhe very narrov lime incremenl, lhe observalion viII reveaI
cIose lo nolhing. Yel lhe denlisl's hearl viII nol leII him lhal. eing
emolionaI, he feeIs a ang vilh every Ioss, as il shovs in red on his
screen. He feeIs some Ieasure vhen lhe erformance is osilive, bul nol
in equivaIenl amounl as lhe ain exerienced vhen lhe erformance is
negalive.
Al lhe end of every day lhe denlisl viII be emolionaIIy drained. A
minule-by-minule examinalion of his erformance means lhal each day
(assuming eighl hours er day) he viII have 241 IeasurabIe minules
againsl 239 unIeasurabIe ones. These amounl lo 60,688 and 60,271,
resecliveIy, er year. Nov reaIize lhal if lhe unIeasurabIe minule is
TabIe 3.1 IrobabiIily of making money al differenl scaIes.
5ca!c Prnbabi!ity
1 ycar 9 3 %
1 quart cr 7 7 %
1 mnnt h 6 7 %
1 day 5 4 %
1 hnur 5 1 . 3 %
1 mi nut c 5 0 . 1 7 %
1 sccnnd 5 0 . 0 2 %
vorse in reverse Ieasure lhan lhe IeasurabIe minule is in Ieasure
lerms, lhen lhe denlisl incurs a Iarge deficil vhen examining his
erformance al a high frequency.
Consider lhe silualion vhere lhe denlisl examines his orlfoIio onIy
uon receiving lhe monlhIy accounl from lhe brokerage house. As 67%
of his monlhs viII be osilive, he incurs onIy four angs of ain er
annum and eighl uIifling exeriences. This is lhe same denlisl
foIIoving lhe same slralegy. Nov consider lhe denlisl Iooking al his
erformance onIy every year. Over lhe nexl 20 years lhal he is execled
lo Iive, he viII exerience 19 Ieasanl surrises for every unIeasanl
one!
This scaIing roerly of randomness is generaIIy misunderslood, even
by rofessionaIs. I have seen Ih.D.s argue over a erformance observed
in a narrov lime scaIe (meaningIess by any slandard). efore addilionaI
duming on lhe |ournaIisl, more observalions seem in order.
Vieving il from anolher angIe, if ve lake lhe ralio of noise lo vhal
ve caII nonnoise (i.e., Iefl coIumn/righl coIumn), vhich ve have lhe
riviIege here of examining quanlilaliveIy, lhen ve have lhe foIIoving.
Over one year ve observe roughIy 0.7 arls noise for every one arl
erformance. Over one monlh, ve observe roughIy 2.32 arls noise for
every one arl erformance. Over one hour, 30 arls noise for every one
arl erformance, and over one second, 1796 arls noise for every one
arl erformance.
A fev concIusions:
1. Over a shorl lime incremenl, one observes lhe variabiIily of lhe
orlfoIio, nol lhe relurns. In olher vords, one sees lhe variance, IillIe
eIse. I aIvays remind myseIf lhal vhal one observes is al besl a
combinalion of variance and relurns, nol |usl relurns.
2. Our emolions are nol designed lo undersland lhe oinl. The denlisl
did beller vhen he deaIl vilh monlhIy slalemenls ralher lhan
infrequenl ones. Ierhas il vouId be even beller for him if he Iimiled
himseIf lo yearIy slalemenls.
3. When I see an inveslor moniloring his orlfoIio vilh Iive rices on
his ceIIuIar leIehone or his IaImIiIol, I smiIe and smiIe.
IinaIIy I reckon lhal I am nol immune lo such an emolionaI defecl. ul I
deaI vilh il by having no access lo informalion, excel in rare
circumslances. Again, I refer lo read oelry. If an evenl is imorlanl
enough, il viII find ils vay lo my ears. I viII relurn lo lhis oinl in lime.
The same melhodoIogy can exIain vhy lhe nevs (lhe high scaIe) is
fuII of noise and vhy hislory (lhe Iov scaIe) is IargeIy slried of il
(lhough fraughl vilh inlerrelalion robIems). This exIains vhy I
refer nol lo read lhe nevsaer (oulside of lhe obiluary), vhy I never
chilchal aboul markels, and, vhen in a lrading room, I frequenl lhe
malhemalicians and lhe secrelaries, nol lhe lraders. Il exIains vhy il is
beller lo read FA# 6/8-8.%)( on Salurdays lhan lhe T'55 *($##( G8B$-'5
every morning (from lhe slandoinl of frequency, aside from lhe
massive ga in inleIIecluaI cIass belveen lhe lvo ubIicalions).
IinaIIy, lhis exIains vhy eoIe vho Iook loo cIoseIy al randomness
burn oul, lheir emolions drained by lhe series of angs lhey exerience.
RegardIess of vhal eoIe cIaim, a negalive ang is nol offsel by a
osilive one (some behavioraI economisls eslimale lhe negalive effecl lo
be u lo 2.5 lhe magnilude of a osilive one), il viII Iead lo an
emolionaI deficil.
Some so-caIIed vise and ralionaI ersons oflen bIame me for
"ignoring" ossibIe vaIuabIe informalion in lhe daiIy nevsaer and
refusing lo discounl lhe delaiIs of lhe noise as "shorl-lerm evenls". Some
of my emIoyers have bIamed me for Iiving on a differenl Ianel.
My robIem is lhal I am nol ralionaI and I am exlremeIy rone lo
drovn in randomness and lo incur emolionaI lorlure. I am avare of my
need lo ruminale on ark benches and in cafes avay from informalion,
bul I can onIy do so if I am somevhal derived of il. My soIe advanlage
in Iife is lhal I knov some of my veaknesses, moslIy lhal I am incaabIe
of laming my emolions facing nevs and incaabIe of seeing a
erformance vilh a cIear head. SiIence is far beller. More on lhal in
Iarl III.
IOUR
RANDOMNISS, NONSINSI, AND THI
SCIINTIIIC INTILLICTUAL
9- #7(#-1%-+ (A# 38-(# @'$58 +#-#$'(8$ (8 :$81B/# '$(%<%/%'5
(A%->%-+ '-1 /8.:'$# %( ?%(A $%+8$8B) -8-H$'-18. /8-)($B/()e
FA# )/%#-/# ?'$) #-(#$ (A# YB)%-#)) ?8$51e TA, (A# '#)(A#(# %-
.# 58&#) (8 Y# <885#1 Y, $'-18.-#))e
;)/2#=/(,, )/2 %'( B(*"
O
ur Monle CarIo engine can lake us inlo more Iilerary lerrilory.
IncreasingIy, a dislinclion is being made belveen lhe scienlific
inleIIecluaI and lhe Iilerary inleIIecluaI - cuIminaling vilh vhal is caIIed
lhe "science vars", Iolling faclions of Iilerale non-scienlisls againsl no
Iess Iilerale scienlisls. The dislinclion belveen lhe lvo aroaches
originaled in Vienna in lhe 1930s, vilh a coIIeclion of hysicisls vho
decided lhal lhe Iarge gains in science vere becoming significanl enough
lo make cIaims on lhe fieId knovn lo beIong lo lhe humanilies. In lheir
viev, Iilerary lhinking couId conceaI Ienly of veII-sounding nonsense.
They vanled lo slri lhinking from rheloric (excel in Iileralure and
oelry vhere il roerIy beIonged).
RANDOMNISS, NONSINSI, AND THI SCI INTI II C I NTILLICTUAL 61
The vay lhey inlroduced rigor inlo inleIIecluaI Iife is by decIaring
lhal a slalemenl couId faII onIy inlo lvo calegories: 1#1B/(%&#, Iike "2 +
2 4", i.e., inconlroverlibIy fIoving from a reciseIy defined axiomalic
framevork (here lhe ruIes of arilhmelic), or %-1B/(%&#N i.e., verifiabIe in
some manner (exerience, slalislics, elc.), Iike "il rains in Sain" or
"Nev Yorkers are generaIIy rude". Anylhing eIse vas Iain
unaduIleraled hogvash (music couId be a far beller reIacemenl lo
melahysics). NeedIess lo say lhal induclive slalemenls may lurn oul lo
be difficuIl, even imossibIe, lo verify, as ve viII see vilh lhe bIack
svan robIem - and emiricism can be vorse lhan any olher form of
hogvash vhen il gives someone confidence (il viII lake me a fev
chalers lo driII lhe oinl). Hovever, il vas a good slarl lo make
inleIIecluaIs resonsibIe for roviding some form of evidence for lheir
slalemenls. This Vienna CircIe vas al lhe origin of lhe deveIomenl of
lhe ideas of Willgenslein, Ioer, Carna, and fIocks of olhers.
Whalever meril lheir originaI ideas may have, lhe imacl on bolh
hiIosohy and lhe raclice of science has been significanl. Some of
lheir imacl on non-hiIosohicaI inleIIecluaI Iife is slarling lo deveIo,
aIbeil considerabIy more sIovIy.
One conceivabIe vay lo discriminale belveen a scienlific inleIIecluaI
and a Iilerary inleIIecluaI is by considering lhal a scienlific inleIIecluaI can
: usuaIIy recognize lhe vriling of anolher bul lhal lhe Iilerary inleIIecluaI
vouId nol be abIe lo leII lhe difference belveen Iines |olled dovn by a
scienlisl and lhose by a gIib non-scienlisl. This is even more aarenl
vhen lhe Iilerary inleIIecluaI slarls using scienlific buzzvords, Iike
"uncerlainly rinciIe", "GodeI's lheorem", "araIIeI universe", or
"reIalivily" eilher oul of conlexl or, as oflen, in exacl oosilion lo lhe
scienlific meaning. I suggesl reading lhe hiIarious V')A%8-'Y5# E8-)#-)#
by AIan SokaI for an iIIuslralion of such raclice (I vas Iaughing so IoudIy
and so frequenlIy vhiIe reading il on a Iane lhal olher assengers kel
vhisering lhings aboul me). y duming lhe kilchen sink of scienlific
references in a aer, one can make anolher Iilerary inleIIecluaI beIieve
lhal one's maleriaI has lhe slam of science. CIearIy, lo a scienlisl, science
Iies in lhe rigor of lhe inference, nol in random references lo such
grandiose concels as generaI reIalivily or quanlum indelerminacy. Such
rigor can be seIIed oul in Iain IngIish. Science is melhod and rigor, il
can be idenlified in lhe simIesl of rose vriling. Ior inslance, vhal
slruck me vhiIe reading Richard Davkins' *#5<%)A S#-#
3
is lhal, aIlhough
lhe lexl does nol exhibil a singIe equalion, il seems as if il vere lransIaled
from lhe Ianguage of malhemalics. Yel il is arlislic rose.
r c v c r s c t u r i n g t c s t
Randomness can be of considerabIe heI vilh lhe maller. Ior lhere is
anolher, far more enlerlaining vay lo make lhe dislinclion belveen lhe
babbIer and lhe lhinker. You can somelimes reIicale somelhing lhal can
be mislaken for a Iilerary discourse vilh a Monle CarIo generalor bul il
is nol ossibIe randomIy lo conslrucl a scienlific one. Rheloric can be
conslrucled randomIy, bul nol genuine scienlific knovIedge. This is lhe
aIicalion of FB$%-+R) (#)( of arlificiaI inleIIigence, excel in reverse.
Whal is lhe Turing lesl` The briIIianl rilish malhemalician, eccenlric,
and comuler ioneer AIan Turing came u vilh lhe foIIoving lesl: a
comuler can be said lo be inleIIigenl if il can (on average) fooI a human
inlo mislaking il for anolher human. The converse shouId be lrue. A
human can be said lo be uninleIIigenl if ve can reIicale his seech by a
comuler, vhich ve knov is uninleIIigenl, and fooI a human inlo
beIieving lhal il vas vrillen by a human. Can one roduce a iece of
vork lhal can be IargeIy mislaken for Derrida enlireIy randomIy`
The ansver seems lo be yes. Aside from lhe hoax by AIan SokaI (lhe
same of lhe hiIarious book a fev Iines ago) vho managed lo roduce
nonsense and gel il ubIished by some rominenl |ournaI,
4
lhere are
Monle CarIo generalors designed lo slruclure such lexls and vrile enlire
aers. Ied vilh "oslmodernisl" lexls, lhey can randomize hrases
under a melhod caIIed recursive grammar, and roduce grammalicaIIy
sound bul enlireIy meaningIess senlences lhal sound Iike }acques
Derrida, CamiIIe IagIia, and such a crovd. Oving lo lhe fuzziness of his
lhoughl, lhe Iilerary inleIIecluaI can be fooIed by randomness.
Al lhe Monash Universily rogram in AuslraIia fealuring lhe Dada
Ingine buiIl by Andrev C. uIha,
5
I loyed vilh lhe engine and
generaled a fev aers conlaining lhe foIIoving senlences:
08?#&#$N (A# .'%- (A#.# 8< (A# ?8$>) 8< KB)A1%# %) -8( (A#8$,N ')
(A# 1%'5#/(%/ :'$'1%+. 8< $#'5%(, )B++#)()N YB( :$#(A#8$,e FA# :$#.%)#
8< (A# -#8)#.'-(%/%)( :'$'1%+. 8< 1%)/8B$)# %.:5%#) (A'( )#7B'5
%1#-(%(,N %$8-%/'55,N A') )%+-%<%/'-/#e
3'-, -'$$'(%&#) /8-/#$-%-+ (A# $85# 8< (A# ?$%(#$ ') 8Y)#$&#$ .', Y#
$#&#'5#1e M( /8B51 Y# )'%1 (A'( %< /B5(B$'5 -'$$'(%&# A851)N ?# A'&# (8
/A88)# Y#(?##- (A# 1%'5#/(%/ :'$'1%+. 8< -'$$'(%&# '-1 -#8H
/8-/#:(B'5 3'$7%).e *'$($#R) '-'5,)%) 8< /B5(B$'5 -'$$'(%&# A851)
(A'( )8/%#(,N :'$'187%/'55,N A') 8Yg#/(%&# &'5B#e
FAB)N (A# :$#.%)# 8< (A# -#81%'5#/(%/ :'$'1%+. 8< #7:$#))%8- %.:5%#)
(A'( /8-)/%8B)-#)) .', Y# B)#1 (8 $#%-<8$/# A%#$'$/A,N YB( 8-5, %<
$#'5%(, %) 1%)(%-/( <$8. /8-)/%8B)-#))j %< (A'( %) -8( (A# /')#N ?# /'-
'))B.# (A'( 5'-+B'+# A') %-($%-)%/ .#'-%-+e
Some business seeches beIong lo lhis calegory in lheir ovn righl,
excel lhal lhey are Iess eIeganl and drav on a differenl lye of
vocabuIary lhan lhe Iilerary ones. We can randomIy conslrucl a seech
imilaling lhal of your chief execulive officer lo insure vhelher vhal he
is saying has vaIue, or if il is mereIy dressed-u nonsense from someone
vho vas Iucky lo be ul lhere. Hov` You seIecl randomIy five hrases
beIov, lhen connecl lhem by adding lhe minimum required lo conslrucl
a grammalicaIIy sound seech.
T# 588> '<(#$ 8B$ /B)(8.#$R) %-(#$#)()i(A# $8'1 'A#'1i8B$ '))#() '$#
8B$ :#8:5#i/$#'(%8- 8< )A'$#A851#$ &'5B#i8B$ &%)%8-i8B$ #7:#$(%)# 5%#)
%-i?# :$8&%1# %-(#$'/(%&# )85B(%8-)i?# :8)%(%8- 8B$)#5&#) %- (A%)
.'$>#(iA8? (8 )#$&# 8B$ /B)(8.#$) Y#((#$i)A8$( (#$. :'%- <8$ 58-+
(#$. +'%-i?# ?%55 Y# $#?'$1#1 %- (A# 58-+ $B-i?# :5', <$8. 8B$
)($#-+(A '-1 %.:$8&# 8B$ ?#'>-#))#)i/8B$'+# '-1 1#(#$.%-'(%8- ?%55
:$#&'%5i?# '$# /8..%((#1 (8 %--8&'(%8- '-1 (#/A-858+,i' A'::,
#.:58,## %) ' :$81B/(%&# #.:58,##k/8..%(.#-( (8 #7/#55#-/#k
)($'(#+%/ :5'-i8B$ ?8$> #(A%/)e
If lhis bears loo cIose a resembIance lo lhe seech you |usl heard from
lhe boss of your comany, lhen I suggesl Iooking for a nev |ob.
t h c I a t h c r n I a ! ! p s c u d n t h i n k c r s
Il is hard lo resisl discussion of arlificiaI hislory vilhoul a commenl on
lhe falher of aII seudolhinkers, HegeI. HegeI vriles a |argon lhal is
meaningIess oulside of a chic Lefl-ank Iarisian cafe or lhe humanilies
dearlmenl of some universily exlremeIy veII insuIaled from lhe reaI
vorId. I suggesl lhis assage from lhe German "hiIosoher" (lhis
assage vas delecled, lransIaled and reviIed by KarI Ioer):
*8B-1 %) (A# /A'-+# %- (A# ):#/%<%/ /8-1%(%8- 8< )#+$#+'(%8- 8< (A#
.'(#$%'5 :'$()N '-1 %- (A# -#+'(%8- 8< (A%) /8-1%(%8-j .#$#5, '-
'Y)($'/( 8$ '- %1#'5 %1#'5%(,N ') %( ?#$#N 8< (A'( ):#/%<%/'(%8-e XB( (A%)
/A'-+#N '//8$1%-+5,N %) %()#5< %..#1%'(#5, (A# -#+'(%8- 8< (A# .'(#$%'5
):#/%<%/ )BY)%)(#-/#j ?A%/A %)N (A#$#<8$#N $#'5 %1#'5%(, 8< ):#/%<%/
+$'&%(, '-1 /8A#)%8-N %e#e H A#'(e FA# A#'(%-+ B: 8< )8B-1%-+ Y81%#)N
gB)( ') 8< Y#'(#- '-1 8$ $BYY#1 8-#)N %) (A# '::#'$'-/# 8< A#'(N
8$%+%-'(%-+ /8-/#:(B'55, (8+#(A#$ ?%(A )8B-1e
Iven a Monle CarIo engine couId nol sound as random as lhe greal
hiIosohicaI masler lhinker (il vouId lake Ienly of samIe runs lo gel
lhe mixlure of A#'( and )8B-1de IeoIe caII lhal hiIosohy and
frequenlIy finance il vilh laxayer subsidies! Nov consider lhal
HegeIian lhinking is generaIIy Iinked lo a "scienlific" aroach lo
hislory, il has roduced such resuIls as Marxisl regimes and even a
branch caIIed "neo-HegeIian" lhinking. These "lhinkers" shouId be
given an undergraduale-IeveI cIass on slalislicaI samIing lheory rior lo
lheir reIease in lhe oen vorId.
+#/%( 0)*1# E#(%*C
There are inslances vhere I Iike lo be fooIed by randomness. My aIIergy
lo nonsense and verbiage dissiales vhen il comes lo arl and oelry. On
lhe one hand, I lry lo define myseIf and behave officiaIIy as a no-
nonsense hyer-reaIisl ferreling oul lhe roIe of chance, on lhe olher, I
have no quaIms induIging in aII manner of ersonaI suerslilions. Where
do I drav lhe Iine` The ansver is aeslhelics. Some aeslhelic forms
aeaI lo somelhing genelic in us, vhelher or nol lhey originale in
random associalions or Iain haIIucinalion. Somelhing in our human
genes is deeIy moved by lhe fuzziness and ambiguily of Ianguage, lhen
vhy fighl il`
The oelry and Ianguage-Iover in me vas iniliaIIy deressed by lhe
accounl of lhe 67CB%)%(# @'1'&#$) oelic exercise vhere inleresling and
oelic senlences are randomIy conslrucled. y lhroving enough vords
logelher, some unusuaI and magicaI-sounding melahor is bound lo
emerge according lo lhe Iavs of combinalorics. Yel one cannol deny
lhal some of lhese oems are of ravishing beauly. Who cares aboul lheir
origin if lhey manage lo Iease our aeslhelic senses`
The slory of lhe 67CB%)%(# @'1'&#$) is as foIIovs. In lhe aflermalh of
lhe Iirsl WorId War, a coIIeclion of surreaIisl oels, vhich incIuded
Andre relon, lheir oe, IauI IIuard, and olhers gol logelher in cafes
and lried lhe foIIoving exercise (modern Iilerary crilics allribule lhe
exercise lo lhe deressed mood afler lhe var and lhe need lo escae
reaIily). On a foIded iece of aer, in lurn, each one of lhem vouId
vrile a redelermined arl of a senlence, nol knoving lhe olher's
choice. The firsl vouId ick an ad|eclive, lhe second a noun, lhe lhird a
verb, lhe fourlh an ad|eclive, and lhe fiflh a noun. The firsl ubIicized
exercise of such random (and coIIeclive) arrangemenl roduced lhe
foIIoving oelic senlence:
FA# #7CB%)%(# /'1'&#$) )A'55 1$%-> (A# -#? ?%-#
ca#) /'1'&$#) #7CB%) Y8%$8-( 5# &%- -8B&#'B). Imressive` Il sounds even
more oelic in lhe nalive Irench. Quile imressive oelry vas roduced
in such a manner, somelimes vilh lhe aid of a comuler. ul oelry has
never been lruIy laken seriousIy oulside of lhe beauly of ils associalions,
vhelher lhey have been roduced by lhe random ranling of one or more
disorganized brains, or lhe more eIaborale conslruclions of one
conscious crealor.
Nov regardIess of vhelher lhe oelry vas oblained by a Monle
CarIo engine or sung by a bIind man in Asia Minor, Ianguage is olenl
in bringing Ieasure and soIace. Tesling ils inleIIecluaI vaIidily by
lransIaling il inlo simIe IogicaI argumenls vouId rob il of a varying
degree of ils olency, somelimes excessiveIy, nolhing can be more bIand
lhan lransIaled oelry. A convincing argumenl of lhe roIe of Ianguage is
lhe exislence of surviving hoIy Ianguages, uncorruled by lhe no-
nonsense lesls of daiIy use. Semilic reIigions, lhal is }udaism, IsIam, and
originaI Chrislianily underslood lhe oinl, kee a Ianguage avay from
lhe ralionaIizalion of daiIy use and avoid lhe corrulion of lhe
vernacuIar. Iour decades ago, lhe CalhoIic church lransIaled lhe
services and Iilurgies from Lalin lo lhe IocaI vernacuIars, il can be
argued lhal lhis caused a dro in reIigious beIiefs. SuddenIy reIigion
sub|ecled ilseIf lo being |udged by inleIIecluaI and scienlific, vilhoul lhe
aeslhelic, slandards. The Greek Orlhodox church made lhe Iucky
mislake, uon lransIaling some of ils rayers from Church-Greek inlo
lhe Semilic-based vernacuIar soken by lhe Grecosyrians of lhe Anlioch
region (Soulhern Turkey and Norlhern Syria), of choosing cIassicaI
Arabic, an enlireIy dead Ianguage. My foIks are lhus Iucky lo ray in a
mixlure of dead ^8%-# (Church Greek) and no Iess dead Koranic
Arabic.
Whal does lhis oinl have lo do vilh a book on randomness` Our
genes diclale a need for :#/A# .%+-8-e Iven lhe economisls, vho
usuaIIy find abslruse vays comIeleIy lo escae reaIily, are slarling lo
undersland lhal vhal makes us lick is nol necessariIy lhe caIcuIaling
accounlanl in us. We do nol need lo be ralionaI and scienlific vhen il
comes lo lhe delaiIs of our daiIy Iife - onIy in lhose lhal can harm us and
lhrealen our survivaI. Modern Iife seems lo invile us lo do lhe exacl
oosile, become exlremeIy reaIislic and inleIIecluaI vhen il comes lo
such mallers as reIigion and ersonaI behavior, yel as irralionaI as
ossibIe vhen il comes lo markels and mallers ruIed by randomness. I
have encounlered coIIeagues, "ralionaI" no-nonsense eoIe, vho do
nol undersland vhy I cherish lhe oelry of audeIaire or obscure (and
oflen imenelrabIe) vrilers Iike IIias Canelli, orges, or Sainl-}ohn
Ierse. Yel lhey gel sucked inlo Iislening lo lhe "anaIyses" of a leIevision
"guru", or inlo buying lhe slock of a comany lhey knov absoIuleIy
nolhing aboul, based on lis by neighbors vho drive exensive cars.
The Vienna CircIe, in lheir duming on HegeI-slyIe verbiage-based
hiIosohy, exIained lhal, from a scienlific slandoinl, il vas Iain
garbage, and, from an arlislic oinl of viev, il vas inferior lo music. I
have lo say lhal I find audeIaire far more Ieasanl lo frequenl lhan
CNN nevscaslers or Iislening lo George WiII.
There is a Yiddish saying: M< M '. +8%-+ (8 Y# <8$/#1 (8 #'( :8$>N %(
Y#((#$ Y# 8< (A# Y#)( >%-1e If I am going lo be fooIed by randomness, il
beller be of lhe beaulifuI (and harmIess) kind. This oinl viII be made
again in Iarl III.
IIVI
4
SURVIVAL OI THI LIAST IIT -
CAN IVOLUTION I IOOLID
Y RANDOMNISS`
= /')# )(B1, 8- (?8 $'$# #&#-()e 9- $'$# #&#-() '-1 #&85B(%8-e
08? h"'$?%-%).h '-1 #&85B(%8- '$# /8-/#:() (A'( '$# .%)H
B-1#$)(881 %- (A# -8-HY%858+%/'5 ?8$51e a%<# %) -8( /8-(%-B8B)e
08? #&85B(%8- ?%55 Y# <885#1 Y, $'-18.-#))e = :$#:'$'(%8- (8
(A# :$8Y5#. 8< %-1B/(%8-e
0)*1#, %'( Q=(*8./8 +)*K(%, G.R)*2
I
used lo meel CarIos al a variely of Nev York arlies, vhere he vouId
shov u imeccabIy dressed, lhough a bil shy vilh lhe Iadies. I used
lo reguIarIy ounce on him and lry lo ick his brains aboul vhal he did
for a Iiving, nameIy buying or seIIing emerging markel bonds. A nice
genlIeman, he comIied vilh my requesls, bul lensed u, for him
seaking IngIish, in sile of his fIuency, seemed lo require some
exendilure of hysicaI efforl lhal made him conlracl his head and neck
muscIes (some eoIe are nol made lo seak foreign Ianguages). Whal
SURVI VAL OI THI LIAST II T 69
are emerging markel bonds` "Imerging markel" is lhe oIilicaIIy
correcl euhemism lo define a counlry lhal is nol very deveIoed (as a
skelic, I do nol imarl lo lheir "emergence" such Iinguislic cerlainly).
The bonds are financiaI inslrumenls issued by lhese foreign govern-
menls, moslIy Russia, Mexico, raziI, Argenlina, and Turkey. These
bonds lraded for ennies vhen lhese governmenls vere nol doing veII.
SuddenIy inveslors rushed inlo lhese markels in lhe earIy 1990s and
ushed lhe enveIoe furlher and furlher by acquiring increasingIy more
exolic securilies. AII lhese counlries vere buiIding holeIs vhere Uniled
Slales cabIe nevs channeIs vere avaiIabIe, vilh heaIlh cIubs equied
vilh lreadmiIIs and Iarge-screen leIevision sels lhal made lhem |oin lhe
gIobaI viIIage. They aII had access lo lhe same gurus and financiaI
enlerlainers. ankers vouId come lo invesl in lheir bonds and lhe
counlries vouId use lhe roceeds lo buiId nicer holeIs so more inveslors
vouId visil. Al some oinl lhese bonds became lhe vogue and venl from
ennies lo doIIars, lhose vho knev lhe sIighlesl lhing aboul lhem
accumuIaled vasl forlunes.
CarIos suosedIy comes from a alrician Lalin-American famiIy
lhal vas heaviIy imoverished by lhe economic lroubIes of lhe 1980s,
bul, again, I have rareIy run inlo anyone from a ravaged counlry vhose
famiIy did nol al some |unclure ovn an enlire rovince or, say, suIy
lhe Russian Czar vilh sels of dominoes. Afler briIIianl undergraduale
sludies, he venl lo Harvard lo ursue a Ih.D. in economics, as il vas
lhe sorl of lhing Lalin-American alricians had gollen inlo lhe habil of
doing al lhe lime (vilh a viev lo saving lheir economies from lhe eviIs of
non-Ih.D. hands). He vas a good sludenl bul couId nol find a decenl
lhesis loic for his disserlalion. Nor did he gain lhe resecl of his lhesis
advisor, vho found him unimaginalive. CarIos sellIed for a Masler's
degree and a WaII Slreel career.
The nascenl emerging markel desk of a Nev York bank hired CarIos
in 1992. He had lhe righl ingredienls for success, he knev vhere on lhe
ma lo find lhe counlries lhal issued "rady bonds", doIIar-
denominaled debl inslrumenls issued by Less DeveIoed Counlries.
He knev vhal Gross Domeslic Iroducl meanl. He Iooked serious,
brainy and veII soken, in sile of his heavy Sanish accenl. He vas lhe
kind of erson banks feIl comforlabIe ulling in fronl of lheir
cuslomers. Whal a conlrasl vilh lhe olher lraders vho Iacked oIish!
CarIos gol lhere righl in lime lo see lhings haening in lhal markel.
When he |oined lhe bank, lhe markel for emerging markel debl
inslrumenls vas smaII and lraders vere Iocaled in undesirabIe arls of
lrading fIoors. ul lhe aclivily raidIy became a Iarge, and groving, arl
of lhe bank's revenues.
He vas generic among lhis communily of emerging markel lraders,
lhey are a coIIeclion of cosmooIilan alricians from across lhe
emerging markel vorId lhal remind me of lhe inlernalionaI coffee hour
al lhe Wharlon SchooI. I find il odd lhal rareIy does a erson seciaIize
in lhe markel of his or her birlhIace. Mexicans based in London lrade
Russian securilies, Iranians and Greeks seciaIize in raziIian bonds,
and Argenlines lrade Turkish securilies. UnIike my exerience vilh reaI
lraders, lhey are generaIIy urbane, dress veII, coIIecl arl, bul are non-
inleIIecluaI. They seem loo conformisl lo be lrue lraders. They are
moslIy belveen 30 and 40, oving lo lhe youlh of lheir markel. You can
execl many of lhem lo hoId season lickels lo lhe MelrooIilan Oera.
True lraders, I beIieve, dress sIoiIy, are oflen ugIy and exhibil lhe
inleIIecluaI curiosily of someone vho vouId be more inleresled in lhe
informalion-reveaIing conlenls of lhe garbage can lhan lhe Cezanne
ainling on lhe vaII.
CarIos lhrived as a lrader-economisl. He had a Iarge nelvork of
friends in lhe various Lalin-American counlries and knev exaclIy vhal
look Iace lhere. He boughl bonds lhal he found allraclive, eilher
because lhey aid him a good rale of inleresl, or because he beIieved
lhal lhey vouId become more in demand in lhe fulure, lherefore
arecialing in rice. Il vouId be erhas erroneous lo caII him a ($'1#$e
A lrader buys and .seIIs (he may seII vhal he does nol ovn and buy il
back Ialer, hoefuIIy making a rofil in a decIine, lhis is caIIed
"shorling"). CarIos |usl boughl - and he boughl in size. He beIieved lhal
he vas aid a good risk remium lo hoId lhese bonds because lhere vas
economic vaIue in Iending lo lhese counlries. Shorling, in his oinion,
made no economic sense.
Wilhin lhe bank CarIos vas lhe emerging markels reference. He
couId roduce lhe Ialesl economic figures al lhe dro of a hal. He had
frequenl Iunches vilh lhe chairman. In his oinion, lrading vas
economics, IillIe eIse. Il had vorked so veII for him. He gol romolion
afler romolion, unliI he became lhe head lrader of lhe emerging markel
desk al lhe inslilulion. Slarling in 1995, CarIos did exonenliaIIy veII in
his nev funclion, gelling an exansion of his cailaI on a sleady basis
(i.e., lhe bank aIIocaled a Iarger orlion of ils funds lo his oeralion) -
so fasl lhal he vas incaabIe of using u lhe nev risk Iimils.
t h c g n n d y c a r s
The reason CarIos had good years vas nol |usl because he boughl
emerging markel bonds and lheir vaIue venl u over lhe eriod. Il vas
moslIy because he aIso boughl dis. He accumuIaled vhen rices
exerienced a momenlary anic. The year 1997 vouId have been a bad
year had he nol added lo his osilion afler lhe di in Oclober lhal
accomanied lhe faIse slock markel crash lhal look Iace lhen.
Overcoming lhese smaII reversaIs of forlune made him feeI invincibIe.
He couId do no vrong. He beIieved lhal lhe economic inluilion he vas
endoved vilh aIIoved him lo make good lrading decisions. Afler a
markel di he vouId verify lhe fundamenlaIs, and, if lhey remained
sound, he vouId buy more of lhe securily and Iighlen u as lhe markel
recovered. Looking back al lhe emerging markel bonds belveen lhe
lime CarIos slarled his invoIvemenl vilh lhese markels and his Iasl
bonus check in December 1997, one sees an uvard sIoing Iine, vilh
occasionaI bIis, such as lhe Mexican devaIualion of 1995, foIIoved by
an exlended raIIy. One can aIso see some occasionaI dis lhal lurned oul
lo be "exceIIenl buying oorlunilies".
Il vas lhe summer of 1998 lhal undid CarIos - lhal Iasl di did nol
lransIale inlo a raIIy. His lrack record loday incIudes |usl one bad
quarler - bul bad il vas. He had earned cIose lo $80 miIIion
cumuIaliveIy in his revious years. He Iosl $300 miIIion in |usl one
summer. Whal haened` When lhe markel slarled diing in }une, his
friendIy sources informed him lhal lhe seII-off vas mereIy lhe resuIl of a
"Iiquidalion" by a Nev }ersey hedge fund run by a former Wharlon
rofessor. Thal fund seciaIized in morlgage securilies and had |usl
received inslruclions lo vind dovn lhe overaII invenlory. The invenlory
incIuded some Russian bonds, moslIy because ,%#51 A8+)N as lhese funds
are knovn, engage in lhe aclivily of buiIding a "diversified" orlfoIio of
high-yieIding securilies.
a v c r a g i n g d n w n
When lhe markel slarled faIIing, he accumuIaled more Russian bonds,
al an average of around $52. Thal vas CarIos's lrail, average dovn. The
robIems, he deemed, had nolhing lo do vilh Russia, and il vas nol
some Nev }ersey fund run by some mad scienlisl lhal vas going lo
decide lhe fale of Russia. "Read my Iis: Il's a Ii-qui-da-lion!" he yeIIed
al lhose vho queslioned his buying.
y lhe end of }une, his lrading revenues for 1998 had droed from
u $60 miIIion lo u $20 miIIion. Thal made him angry. ul he
caIcuIaled lhal shouId lhe markel rise back lo lhe re-Nev }ersey seII-
off, lhen he vouId be u $100 miIIion. Thal vas unavoidabIe, he
asserled. These bonds, he said, vouId never, ever lrade beIov $48. He
vas risking so IillIe, lo ossibIy make so much.
Then came }uIy. The markel droed a bil more. The benchmark
Russian bond vas nov al $43. His osilions vere under valer, bul he
increased his slakes. y nov he vas dovn $30 miIIion for lhe year. His
bosses vere slarling lo become nervous, bul he kel leIIing lhem lhal, afler
aII, Russia vouId nol go under. He reealed lhe cIiche lhal il vas loo big
lo faiI. He eslimaled lhal baiIing lhem oul vouId cosl so IillIe and vouId
benefil lhe vorId economy so much lhal il did nol make sense lo Iiquidale
his invenlory nov. "This is lhe lime lo buy, nol lo seII", he said reealedIy.
"These bonds are lrading very cIose lo lheir ossibIe defauIl vaIue". In
olher vords, shouId Russia go inlo defauIl, and run oul of doIIars lo ay
lhe inleresl on ils debl, lhese bonds vouId hardIy budge. Where did he gel
lhis idea` Irom discussions vilh olher lraders and emerging markel
economisls (or lrader-economisl hybrids). CarIos ul aboul haIf his nel
vorlh, lhen $5,000,000, in lhe Russia IrinciaI ond. "I viII relire on
lhese rofils", he loId lhe slockbroker vho execuled lhe lrade.
! i nc s i n t h c s a n d
The markel kel going lhrough lhe Iines in lhe sand. y earIy Augusl,
lhey vere lrading in lhe 30s. y lhe middIe of Augusl, lhey vere in lhe
20s. And he vas laking no aclion. He feIl lhal lhe rice on lhe screen
vas quile irreIevanl in his business of buying "vaIue".
SURVI VAL OI THI LIAST II T
73
Signs of ballIe faligue vere slarling lo shov in his behavior. CarIos
vas gelling |umy and Iosing some of his comosure. He yeIIed al
someone in a meeling: "slo Iosses are for schmucks! I am nol going lo
buy high and seII Iov!" During his slring of successes he had Iearned lo
ul dovn and berale lraders of lhe non-emerging markel variely. "Had
ve gollen oul in Oclober 1997 afler our heavy Ioss ve vouId nol have
had lhose exceIIenl 1997 resuIls", he vas aIso knovn lo reeal. He aIso
loId managemenl: "lhese bonds lrade al very deressed IeveIs. Those
vho can invesl nov in lhese markels vouId reaIize vonderfuI relurns".
Ivery morning, CarIos senl an hour discussing lhe silualion vilh
markel economisls around lhe gIobe. They aII seemed lo resenl a
simiIar slory: lhis seII-off is overdone.
CarIos's desk exerienced Iosses in olher emerging markels as veII.
He aIso Iosl money in lhe domeslic Russian RubIe ond markel. His
Iosses vere mounling, bul he kel leIIing his managemenl rumors aboul
very Iarge Iosses among olher banks - Iarger lhan his. He feIl |uslified lo
shov lhal "he fared veII reIalive lo lhe induslry". This is a symlom of
syslemic lroubIes, il shovs lhal lhere vas an enlire communily of
lraders vho vere conducling lhe exacl same aclivily. Such slalemenls,
lhal olher lraders had aIso gollen inlo lroubIe, are seIf-incriminaling. A
lrader's menlaI conslruclion shouId direcl him lo do reciseIy ?A'(
8(A#$ :#8:5# 18 -8( 18e
Tovards lhe end of Augusl, lhe beIIvelher Russia IrinciaI onds
vere lrading beIov $10. CarIos's nel vorlh vas reduced by aImosl haIf.
He vas dismissed. So vas his boss, lhe head of lrading. The residenl of
lhe bank vas demoled lo a "nevIy crealed osilion". oard members
couId nol undersland vhy lhe bank had so much exosure lo a govern-
menl lhal vas nol aying ils ovn emIoyees - vhich, dislurbingIy,
incIuded armed soIdiers. This vas one of lhe smaII oinls lhal emerging
markel economisls around lhe gIobe, from laIking lo each olher so
much, forgol lo lake inlo accounl. Veleran lrader Marly O'ConneII caIIs
lhis lhe firehouse effecl. He had observed lhal firemen vilh much
dovnlime vho laIk lo each olher for loo Iong come lo agree on many
lhings lhal an oulside, imarliaI observer, vouId find Iudicrous (lhey
deveIo oIilicaI ideas lhal are very simiIar). IsychoIogisls give il a
fancier name, bul my friend Marly has no lraining in cIinicaI
sychoIogy.
The nerdy lyes al lhe InlernalionaI Monelary Iund had been laken
for a ride by lhe Russian governmenl vho chealed on lheir accounl. Lel
us remember lhal economisls are evaIualed on hov inleIIigenl lhey
sound, nol on a scienlific measure of lheir knovIedge of reaIily. Hov-
ever, lhe rice of lhe bonds vas nol fooIed. Il knev more lhan lhe
economisls, more lhan lhe CarIoses of lhe emerging markel dearlmenls.
Louie, a veleran lrader on lhe neighboring desk vho suffered much
humiIialion by lhese rich emerging markel lraders, vas lhere, vindicaled.
Louie vas lhen a 52-year-oId rookIyn-born-and-raised lrader vho over
lhree decades survived every singIe conceivabIe markel cycIe. He caImIy
Iooked al CarIos being escorled by a securily guard lo lhe door Iike a
calured soIdier laken lo lhe arena. He mullered in his rookIyn accenl:
h6/8-8.%/) */A.#/8-8.%/)e M( %) '55 .'$>#( 1,-'.%/)he
CarIos is nov oul of lhe markel. The ossibiIily lhal hislory may
rove him righl (al some oinl in lhe fulure) has nolhing lo do vilh lhe
facl lhal he is a bad lrader. He has aII of lhe lrails of a lhoughlfuI
genlIeman, and vouId be an ideaI son-in-Iav. ul he has mosl of lhe
allribules of lhe bad lrader. And, al any oinl in lime, lhe richesl lraders
are oflen lhe vorsl lraders. This, I viII caII lhe /$8))H)#/(%8-'5 :$8Y5#.2
al a given lime in lhe markel, lhe mosl rofilabIe lraders are IikeIy lo be
lhose lhal are besl fil lo lhe Ialesl cycIe. This does nol haen loo oflen
vilh denlisls or ianisls - because of lhe nalure of randomness.
6#'/ %'( 7.8'9:.(12 4*)2(*
We mel }ohn, Nero's neighbor, in Chaler 1. Al lhe age of 35 he had
been on WaII Slreel as a cororale "high-yieId" bonds lrader for seven
years, since his gradualion from Iace Graduale usiness SchooI. He rose
lo head u a leam of len lraders in record lime - lhanks lo a |um
belveen lvo simiIar WaII Slreel firms lhal afforded him a generous
rofil-sharing conlracl. The conlracl aIIoved him lo be aid 20% of his
rofils, as lhey slood al lhe end of each caIendar year. In addilion, he
vas aIIoved lo invesl his ovn ersonaI money in his lrades - a greal
riviIege.
}ohn is nol someone vho can be lermed as rinciaIIy inleIIigenl, bul
he vas beIieved lo be endoved vilh a good measure of business sense.
He vas said lo be "ragmalic" and "rofessionaI". He gave lhe
imression lhal he vas born a businesserson, never saying anylhing
remoleIy unusuaI or oul of Iace. He remained caIm in mosl
circumslances, rareIy belraying any form of emolion. Iven his
occasionaI cursing (lhis is WaII Slreel!) vas so much in conlexl lhal il
sounded, veII, rofessionaI.
}ohn dressed imeccabIy. This vas in arl due lo his monlhIy lris lo
London vhere his unil had a saleIIile suervising Iuroean high-yieId
aclivilies. He vore a SaviIIe Rov laiIored dark business suil, vilh a
Ierragamo lie - enough lo convey lhe imression lhal he vas lhe
eilome of lhe successfuI WaII Slreel rofessionaI. Iach lime Nero ran
inlo him he came avay feeIing oorIy dressed.
}ohn's desk engaged rinciaIIy in an aclivily caIIed "high-yieId"
lrading, vhich consisled in acquiring "chea" bonds lhal yieIded, say
10%, vhiIe lhe borroving rale for his inslilulion vas 5.5%. Il nelled a
4. 5% revenue, aIso caIIed %-(#$#)( $'(# 1%<<#$#-(%'5 - vhich seemed smaII
excel lhal he couId Ieverage himseIf and muIliIy such rofil by lhe
Ieverage faclor. He did lhis in various counlries, borroving al lhe IocaI
rale and invesling in "risky" assels. Il vas easy for him lo amass over $3
biIIion doIIars in face vaIue of such lrade across a variely of conlinenls.
He hedged lhe inleresl rale exosure by seIIing U.S., U.K., Irench, and
olher governmenl bond fulures, lhus Iimiling his bel lo lhe differenliaI
belveen lhe lvo inslrumenls. He feIl rolecled by lhis hedging slralegy
- cocooned (or so he lhoughl) againsl lhose nasly fIuclualions in lhe
vorId's gIobaI inleresl rales.
t h c \l=EF w h n knc w c n m p u t c r s a n d c q u a t i n n s
}ohn vas assisled by Henry, a foreign CB'-( vhose IngIish vas
incomrehensibIe, bul vho vas beIieved lo be al Ieasl equaIIy
comelenl in risk-managemenl melhods. }ohn knev no malh, he reIied
on Henry. "His brains and my business sense", he vas vonl lo say.
Henry suIied him vilh risk assessmenls concerning lhe overaII
orlfoIio. Whenever }ohn feIl vorried, he vouId ask Henry for anolher
freshIy udaled reorl. Henry vas a graduale sludenl in Oeralions
Research vhen }ohn hired him. His seciaIly vas a fieId caIIed
ComulalionaI Iinance, vhich, as ils name indicales, seems lo focus
soIeIy on running comuler rograms overnighl. Henry's income venl
from $50,000 lo $600,000 in lhree years.
Mosl of lhe rofil }ohn generaled for lhe inslilulion vas nol
allribulabIe lo lhe inleresl rale differenliaI belveen lhe inslrumenls
described above. Il came from lhe changes in lhe vaIue of lhe securilies
}ohn heId, moslIy because many olher lraders vere acquiring lhem lo
imilale }ohn's lrading slralegy (lhus causing lhe rice of lhese assels lo
rise). The inleresl rale differenliaI vas gelling cIoser lo vhal }ohn
beIieved vas "fair vaIue". }ohn beIieved lhal lhe melhods he used lo
caIcuIale "fair vaIue" vere sound. He vas backed by an enlire
dearlmenl lhal heIed him anaIyze and delermine vhich bonds vere
allraclive and offered cailaI arecialion olenliaI. Il vas normaI for
him lo be earning lhese Iarge rofils over lime.
}ohn made sleady money for his emIoyers, erhas even beller lhan
sleady. Ivery year lhe revenues he generaled aImosl doubIed as com-
ared lo lhe revious year. During his Iasl year, his income exerienced a
quanlum Iea as he sav lhe cailaI aIIocaled lo his lrades sveII beyond
his viIdesl execlalions. His bonus check vas for $10 miIIion (relax,
vhich vouId generale cIose lo a $5 miIIion lolaI lax biII). }ohn's ersonaI
nel vorlh reached $1 miIIion al lhe age of 32. y lhe age of 35 il had
exceeded $16 miIIion. Mosl of il came from lhe accumuIalion of bonuses
- bul a sizeabIe share came from rofils on his ersonaI orlfoIio. Of lhe
$16 miIIion, aboul $14 miIIion he insisled in keeing invesled in his
business. They AIIoved him, lhanks lo lhe Ieverage (i.e., use of borroved
money), lo kee a orlfoIio of $50 miIIion invoIved in his lrades, vilh
$36 miIIion borroved from lhe bank. The effecl of lhe Ieverage is lhal a
smaII Ioss vouId be comounded and vouId vie him oul.
Il look onIy a fev days for lhe $14 miIIion lo lurn inlo lhin air - and
for }ohn lo Iose his |ob al lhe same lime. Il aII haened during lhe
summer of 1998, vilh lhe meIldovn of high-yieId bond vaIues. Markels
venl inlo a voIaliIe hase in vhich nearIy everylhing he had invesled in
venl againsl him '( (A# )'.# (%.#e His hedges no Ionger vorked oul. He
vas mad al Henry for nol having figured oul lhal lhese evenls couId
haen. Ierhas lhere vas a bug in lhe rogram.
His reaclion lo lhe firsl Iosses vas, characlerislicaIIy, lo ignore lhe
markel. "One vouId go crazy if one vere lo Iislen lo lhe mood svings of
lhe markel", he said. Whal he meanl by lhal slalemenl vas lhal lhe "noise"
vas mean reverling, and vouId IikeIy be offsel by "noise" in lhe oosile
direclion. Thal vas lhe lransIalion in Iain IngIish of vhal Henry
exIained lo him. ul lhe "noise" kel adding u in lhe same direclion.
As in a bibIicaI cycIe, il look seven years lo make }ohn a hero and |usl
seven days lo make him an idiol. }ohn is nov a ariah, he is oul of a |ob
and his leIehone caIIs are nol relurned. Many of his friends vere in lhe
same silualion. Hov` Wilh aII lhal informalion avaiIabIe lo him, his
erfecl lrack record (and lherefore, in his eyes, an above average
inleIIigence and skiII-sel) and lhe benefil of sohislicaled malhemalics,
hov couId he have faiIed` Is il erhas ossibIe lhal he forgol aboul lhe
shadovy figure of randomness`
Il look a Iong lime for }ohn lo figure oul vhal had haened,
oving lo lhe raidily vilh vhich lhe evenls unfoIded and his slale of
sheIIshock. The di in lhe markel vas nol very Iarge. Il vas |usl
lhal his Ieverage vas enormous. Whal vas more shocking for him
vas lhal aII lheir caIcuIalions gave lhe evenl a robabiIily of 1 in
1,000,000,000,000,000,000,000,000 years. Henry caIIed lhal a "len
sigma" evenl. The facl lhal Henry doubIed lhe odds did nol seem lo
maller. Il made lhe robabiIily 2 in 1,000,000,000,000,000,000,000,000
years.
When viII }ohn recover from lhe ordeaI` IrobabIy never. The reason
is nol because }ohn Iosl money. Losing money is somelhing good lraders
are accuslomed lo. Il is because he bIev u, he Iosl more lhan he
Ianned lo Iose. His ersonaI confidence vas vied oul. ul lhere is
anolher reason vhy }ohn may never recover. The reason is lhal }ohn
vas never a lrader in lhe firsl Iace. He is one of lhose eoIe vho
haened lo be lhere vhen il aII haened.
IoIIoving lhe incidenl, }ohn regarded himseIf "ruined", yel his nel
vorlh is sliII cIose lo $1 miIIion, vhich couId be lhe envy of more lhan
99.9% of lhe inhabilanls of our Ianel. Yel lhere is a difference belveen
a veaIlh IeveI reached from 'Y8&# and a veaIlh reached from Y#58?e
The road from $16 miIIion lo $1 miIIion is nol as Ieasanl as lhe one
from 0 lo $1 miIIion. In addilion, }ohn is fuII of shame, he sliII vorries
aboul running inlo oId friends on lhe slreel.
His emIoyer shouId erhas be mosl unhay vilh lhe overaII
oulcome. }ohn uIIed some money oul of lhe eisode, lhe $1 miIIion he
had saved. He shouId be lhankfuI lhal lhe eisode did -8( cosl him
anylhing - excel lhe emolionaI drain. His nel vorlh did nol become
negalive. Thal vas nol lhe case for his Iasl emIoyer. }ohn had earned
for lhe emIoyers, Nev York inveslmenl banks, around $250 miIIion in
lhe course of lhe seven years. He Iosl more lhan $600 miIIion for his Iasl
emIoyer in bareIy a fev days.
t h c t r a i t s t h c y s h a r c d
The reader needs lo be varned lhal nol aII of lhe emerging markel and
high-yieId lraders laIk and behave Iike CarIos and }ohn. OnIy lhe mosl
successfuI ones - aIas, or erhas lhose vho vere lhe mosl successfuI
during lhe 1992-1998 buII cycIe.
Al lheir age, bolh }ohn and CarIos sliII have lhe chance lo make a
career. Il vouId be vise for lhem lo Iook oulside of lhe financiaI
markels. The odds are lhal lhey viII nol survive lhe incidenl. Why`
ecause by discussing lhe silualion vilh each of lhem, one can raidIy
see lhal lhey share lhe lrails of lhe '/B(# )B//#))<B5 $'-18.-#)) <885e
Whal is more vorrisome is lhal lheir bosses and emIoyers shared lhe
same lrail. They, loo, are ermanenlIy oul of lhe markel. We viII see
lhroughoul lhis book vhal characlerizes lhe lrail. Again, lhere may nol
be a cIear definilion for il, bul you can recognize il vhen you see il. No
maller vhal }ohn and CarIos do, lhey viII remain fooIs of randomness.
! ;(D.(N #L +)*K(% J##1, #L ;)/2#=/(,,
0#/,%)/%,
Mosl of lhe lrails arlake of lhe same TabIe I.I righl-coIumn-Iefl-
coIumn confusion, hov lhey are fooIed by randomness. eIov is a brief
oulIine of lhem:
=- 8&#$#)(%.'(%8- 8< (A# '//B$'/, 8< (A#%$ Y#5%#<) %- )8.# .#')B$#N
#%(A#$ #/8-8.%/ c@'$58)d 8$ )('(%)(%/'5 cG8A-de They never con-
sidered lhal lhe facl lhal lrading on economic variabIes has vorked
in lhe asl may have been mereIy coincidenlaI, or, erhas even
vorse, lhal economic anaIysis vas fil lo asl evenls lo mask lhe
random eIemenl in il. CarIos enlered lhe markel al a lime vhen il
vorked, bul he never lesled for eriods vhen markels did lhe
oosile of sound economic anaIysis. There vere eriods vhen
economics faiIed lraders, and olhers vhen il heIed lhem.
The U.S. doIIar vas overriced (i.e. lhe foreign currencies vere
undervaIued) in lhe earIy 1980s. Traders vho used lheir economic
inluilions and boughl foreign currencies vere vied oul. ul Ialer
lhose vho did so gol rich (members of lhe firsl cro vere busl). Il is
random! Likevise, lhose vho "shorled" }aanese slocks in lhe Iale
1980s suffered lhe same fale - fev survived lo recou lheir Iosses
during lhe coIIase of lhe 1990s. Al lhe lime of vriling, lhere is a
grou of oeralors caIIed "macro" lraders vho are droing Iike
fIies, vilh "Iegendary" (ralher, Iucky) inveslor }uIian Roberlson
cIosing sho in 2000 afler having been a slar unliI lhen. Our
discussion of survivorshi bias viII enIighlen us furlher, bul, cIearIy,
lhere is nolhing Iess rigorous lhan lheir seemingIy rigorous use of
economic anaIysis lo lrade.
= (#-1#-/, (8 +#( .'$$%#1 (8 :8)%(%8-)e There is a saying lhal bad
lraders divorce lheir souse sooner lhan abandon lheir osilions.
LoyaIly lo ideas is nol a good lhing for lraders, scienlisls - or
anyone.
FA# (#-1#-/, (8 /A'-+# (A#%$ )(8$,e They become inveslors "for lhe
Iong hauI" vhen lhey are Iosing money, svilching back and forlh
belveen lraders and inveslors lo fil recenl reversaIs of forlune. The
difference belveen a lrader and an inveslor Iies in lhe duralion of lhe
bel, and lhe corresonding size. There is absoIuleIy nolhing vrong
vilh invesling "for lhe Iong hauI", rovided one does nol mix il vilh
shorl-lerm lrading - il is |usl lhal many eoIe become Iong-lerm
inveslors afler lhey Iosl money, osloning lheir decision lo seII, as
arl of lheir deniaI.
E8 :$#/%)# +'.# :5'- 'A#'1 8< (%.# ') (8 ?A'( (8 18 %- (A# #&#-( 8<
58))#)e They simIy vere nol avare of such a ossibiIily. olh
boughl more bonds afler lhe markel decIined sharIy,, bul nol in
resonse lo a redelermined Ian.
=Y)#-/# 8< /$%(%/'5 (A%->%-+ #7:$#))#1 %- 'Y)#-/# 8< $#&%)%8- 8< (A#%$
)('-/# ?%(A h)(8: 58))#)he MiddIebrov lraders do nol Iike seIIing
vhen il is "even beller vaIue". They did nol consider lhal erhas
lheir melhod of delermining vaIue is vrong, ralher lhan lhe markel
faiIing lo accommodale lheir measure of vaIue. They may be righl,
bul, erhas, some aIIovance for lhe ossibiIily of lheir melhods
being fIaved vas nol made. Ior aII his fIavs, ve viII see lhal Soros
seems rareIy lo examine an unfavorabIe oulcome vilhoul lesling his
ovn framevork of anaIysis.
"#-%'5e When lhe Iosses occurred lhere vas no cIear accelance of
vhal had haened. The rice on lhe screen Iosl ils reaIily in favor of
some abslracl "vaIue". In cIassic deniaI mode, lhe usuaI "lhis is onIy
lhe resuIl of Iiquidalion, dislress saIes" vas roffered. They
conlinuousIy ignored lhe message from reaIily.
Hov couId lraders vho made every singIe mislake in lhe book become
so successfuI` ecause of a simIe rinciIe concerning randomness.
This is one manifeslalion of lhe survivorshi bias. We lend lo lhink lhal
lraders make money Y#/'B)# lhey are good. Ierhas ve have lurned lhe
causaIily on ils head, ve consider lhem good |usl because lhey make
money. One can make money in lhe financiaI markels lolaIIy oul of
randomness.
olh CarIos and }ohn beIong lo lhe cIass of eoIe vho benefiled
from a markel cycIe. Il vas nol mereIy because lhey vere invoIved in lhe
righl markels. Il vas because lhey had a benl in lheir slyIe lhal cIoseIy
filled lhe roerlies of lhe raIIies exerienced in lheir markel during lhe
eisode. They vere 1%: YB,#$)e Thal haened, in hindsighl, lo be lhe
lrail lhal vas lhe mosl desirabIe belveen 1992 and lhe summer of 1998
in lhe secific markels in vhich lhe lvo men seciaIized. Mosl of lhose
vho haened lo have lhal secific lrail, over lhe course of lhal segmenl
of hislory, dominaled lhe markel. Their score vas higher and lhey
reIaced eoIe vho, erhas, vere beller lraders.
3).D( QD#1$%.#/)*C 4'(#*.(,
This slory iIIuslrales hov bad lraders have a shorl- and medium-lerm
survivaI advanlage over good lraders. Nexl ve lake lhe argumenl lo a
higher IeveI of generaIily. One musl be eilher bIind or fooIish lo re|ecl
lhe lheories of Darvinian seIf-seIeclion. Hovever, lhe simIicily of lhe
concel has dravn segmenls of amaleurs (as veII as a fev rofessionaI
scienlisls) inlo bIindIy beIieving in conlinuous and infaIIibIe Darvinism
in aII fieIds, vhich incIudes economics.
The bioIogisl }acques Monod bemoaned a couIe of decades ago lhal
everyone beIieves himseIf an exerl on evoIulion (lhe same can be said
aboul lhe financiaI markels), lhings have gollen vorse. Many amaleurs
beIieve lhal Ianls and animaIs reroduce on a one-vay roule lovards
erfeclion. TransIaling lhe idea in sociaI lerms, lhey beIieve lhal
comanies and organizalions are, lhanks lo comelilion (and lhe
disciIine of lhe quarlerIy reorl), irreversibIy heading lovards
bellermenl. The slrongesl viII survive, lhe veakesl viII become exlincl.
As lo inveslors and lraders, lhey beIieve lhal by Ielling lhem comele,
lhe besl viII roser and lhe vorsl viII go Iearn a nev crafl (Iike
uming gas or, somelimes, denlislry).
Things are nol as simIe as lhal. We viII ignore lhe basic misuse of
Darvinian ideas in lhe facl lhal organizalions do nol reroduce Iike Iiving
members of nalure - Darvinian ideas are aboul reroduclive filness, nol
aboul survivaI. The robIem comes, as everylhing eIse in lhis book, from
randomness. ZooIogisls found lhal once randomness is in|ecled inlo a
syslem, lhe resuIls can be quile surrising: vhal seems lo be an evoIulion
may be mereIy a diversion, and ossibIy regression. Ior inslance, Sleven }ay
GouId (admilledIy more of a ouIarizer lhan a genuine scienlisl) found
amIe evidence of vhal he caIIs "genelic noise", or "negalive mulalions",
lhus causing lhe vralh of some of his coIIeagues (he look lhe idea a IillIe
loo far). An academic debale ensued, Iolling GouId againsl coIIeagues Iike
Davkins vho vere considered by lheir eers as beller lrained in lhe
malhemalics of randomness. Negalive mulalions are lrails lhal survive in
sile of being vorse, from lhe reroduclive filness slandoinl, lhan lhe
ones lhey reIaced. Hovever, lhey cannol be execled lo Iasl more lhan a
fev generalions (under vhal is caIIed lemoraI aggregalion).
Iurlhermore, lhings can gel even more surrising vhen randomness
changes in shae, as vilh regime svilches. A regime svilch corresonds
lo silualions vhen aII of lhe allribules of a syslem change lo. lhe oinl of
il becoming unrecognizabIe lo lhe observer. Darvinian filness aIies lo
secies deveIoing over a very Iong lime, nol observed over a shorl lerm
- lime aggregalion eIiminales much of lhe effecls of randomness, lhings
(I read -8%)#d baIance oul over lhe Iong run, as eoIe say.
Oving lo lhe abrul rare evenls, ve do nol Iive in a vorId vhere
lhings "converge" conlinuousIy lovards bellermenl. Nor do lhings in
Iife move /8-(%-B8B)5, al aII. The beIief in conlinuily vas ingrained in
our scienlific cuIlure unliI lhe earIy lvenlielh cenlury. Il vas said lhal
-'(B$# 18#) -8( .'># gB.:)HN eoIe quole lhis in veII-sounding Lalin:
-'(B$' -8 <'/%( )'5(B)e Il is generaIIy allribuled lo lhe eighleenlh-cenlury
bolanisl Linnaeus vho obviousIy gol il aII vrong. Il vas aIso used by
Leibniz as a |uslificalion of caIcuIus, as he beIieved lhal lhings are
conlinuous no maller lhe resoIulion al vhich ve Iook al lhem. Like
many veII-sounding "make sense" lyes of slalemenls (such dynamics
made erfecl inleIIecluaI sense), il lurned oul lo be enlireIy vrong, as il
vas denied by quanlum mechanics. We discovered lhal, in lhe very
smaII, arlicIes |um (discreleIy) belveen slales, lhey do nol sIide
belveen lhem.
c a n c v n ! u t i n n bc I n n ! c d by r a n d n m n c s s ?
We end lhis chaler vilh lhe foIIoving lhoughl. RecaII lhal someone
vilh onIy casuaI knovIedge aboul lhe robIems of randomness vouId
beIieve lhal an animaI is al lhe maximum filness for lhe condilions of his
lime. This is nol vhal evoIulion means, 8- '&#$'+# animaIs viII be fil,
bul nol every singIe one of lhem, and nol al aII limes. }usl as an animaI
couId have survived because ils samIe alh vas Iucky, lhe "besl"
oeralors in a given business can come from a subsel of oeralors vho
survived because of over-filness lo a samIe alh - a samIe alh lhal
vas free of lhe evoIulionary rare evenl. One vicious allribule is lhal lhe
Ionger lhese animaIs can go vilhoul encounlering lhe rare evenl, lhe
more vuInerabIe lhey viII be lo il. We said lhal shouId one exlend lime
lo infinily, lhen, by #$+81%/%(,N lhal evenl viII haen vilh cerlainly -
lhe secies viII be vied oul! Ior evoIulion means filness lo one and
onIy lime series, nol lhe average of aII lhe ossibIe environmenls.
y some viciousness of lhe slruclure of randomness, a rofilabIe
erson Iike }ohn, someone vho is a ure Ioser in lhe Iong run and
corresondingIy unfil for survivaI, resenls a high degree of eIigibiIily in
lhe shorl run and has lhe roensily lo muIliIy his genes. RecaII lhe
hormonaI effecl on oslure and ils signaIing effecl lo olher olenliaI
males. His success (or seudo-success oving lo ils fragiIily) viII shov in
his fealures as a beacon. An innocenl olenliaI male viII be fooIed inlo
lhinking (uncondilionaIIy) lhal he has a suerior genelic makeu, unliI
lhe foIIoving rare evenl. SoIon seems lo have gollen lhe oinl, bul lry lo
exIain lhe robIem lo a naive business Darvinisl - or your rich
neighbor across lhe slreel.
SIX
SKIWNISS AND ASYMMITRY
T# %-($81B/# (A# /8-/#:( 8< )>#?-#))2 ?A, (A# (#$.) hYB55h '-1
hY#'$h A'&# 5%.%(#1 .#'-%-+ 8B()%1# 8< Z8858+,e = &%/%8B) /A%51
?$#/>) (A# )($B/(B$# 8< $'-18.-#))e =- %-($81B/(%8- (8 (A#
:$8Y5#. 8< #:%)(#.858+%/'5 8:'/%(,e FA# :#-B5(%.'(# )(#:
Y#<8$# (A# :$8Y5#. 8< %-1B/(%8-e
he vriler and scienlisl Sleven }ay GouId (vho, for a vhiIe, vas my
roIe modeI), vas once diagnosed vilh a deadIy form of cancer of
lhe Iining of lhe slomach. The firsl iece of informalion he received
aboul his odds of making il vas lhal lhe .#1%'- survivaI for lhe aiImenl
is aroximaleIy eighl monlhs, informalion he feIl akin lo Isaiah's
in|unclion lo King Hezekiah lo ul his house in order in rearalion for
Nov a medicaI diagnosis, arlicuIarIy one of such severily, can
molivale eoIe lo do inlensive research, arlicuIarIy lhose roIific
vrilers Iike GouId vho needed more lime vilh us lo comIele a fev
book ro|ecls. The furlher research by GouId uncovered a very differenl
4'( +(2.)/ ?, 3#% %'( +(,,)8(
dealh.
SKIWNISS AND ASYMMITRY 85
slory lo lhe informalion he had iniliaIIy been given, mainIy lhal lhe
#7:#/(#1 (i.e., average) survivaI vas considerabIy higher lhan eighl
monlhs. Il came lo his nolice lhal #7:#/(#1 and .#1%'- do nol mean lhe
same lhing al aII. Median means roughIy lhal 50% of lhe eoIe die
before eighl monlhs and 50% survive Ionger lhan eighl monlhs. ul
lhose vho survive vouId Iive considerabIy Ionger, generaIIy going aboul
Iife |usl Iike a reguIar erson and fuIfiIIing lhe average 73.4 or so years
redicled by insurance morlaIily labIes.
There is asymmelry. Those vho die do so very earIy in lhe game,
vhiIe lhose vho Iive go on Iiving very Iong. Whenever lhere is
asymmelry in oulcomes, lhe '&#$'+# survivaI has nolhing lo do vilh lhe
.#1%'- survivaI. This romled GouId, vho lhus discovered lhe
concel of skevness, lo vrile his hearlfeIl iece "The Median is Nol
lhe Message". His oinl is lhal lhe concel of median used in medicaI
research does nol characlerize a robabiIily dislribulion.
I viII simIify GouId's oinl by inlroducing lhe concel of .#'- (aIso
caIIed #7:#/('(%8-d as foIIovs by using a Iess morbid examIe, lhal of
gambIing. I viII give an examIe of bolh asymmelric odds and
asymmelric oulcomes lo exIain lhe oinl. Asymmelric odds means
lhal robabiIilies are nol 50% for each evenl, bul lhal lhe robabiIily
on one side is higher lhan lhe robabiIily on lhe olher. Asymmelric
oulcomes mean lhal lhe ayoffs are nol equaI.
Assume I engage in a gambIing slralegy lhal has 999 chances in 1,000
of making $1 (evenl A) and 1 chance in 1,000 of Iosing $10,000 (evenl
), as in TabIe 6.1.
TabIe 6.1
6&#-( ;$8Y'Y%5%(, 9B(/8.# 67:#/('(%8-
A 999/1000 $1 $.999
1/1000 -$10,000 -$10.00
TolaI -$9,001
My execlalion is a Ioss of cIose lo $9 (oblained by muIliIying lhe
robabiIilies by lhe corresonding oulcomes). The <$#CB#-/, or
:$8Y'Y%5%(, of lhe Ioss, in and by ilseIf, is lolaIIy irreIevanl, il needs lo
be |udged in conneclion vilh lhe .'+-%(B1# of lhe oulcome. Here A is
86
SOLON' S WARNI NG
far more IikeIy lhan . Odds are lhal ve vouId make money by belling
for evenl A, bul il is nol a good idea lo do so.
This oinl is ralher common and simIe, il is underslood by anyone
making a simIe bel. Yel I had lo slruggIe aII my Iife vilh eoIe in lhe
financiaI markels vho do nol seem lo inlernaIize il. I am nol laIking of
novices, I am laIking of eoIe vilh advanced degrees (aIbeil MAs)
vho cannol come lo gris vilh lhe difference.
Hov couId eoIe miss such a oinl` Why do lhey confuse
robabiIily and execlalion, lhal is, robabiIily and robabiIily limes
lhe ayoff` MainIy because much of eoIe's schooIing comes from
examIes in symmelric environmenls, Iike a coin-loss, vhere such a
difference does nol maller. In facl lhe so-caIIed "eII Curve" lhal seems
lo have found universaI use in sociely is enlireIy symmelric. More on
lhal Ialer.
M$11 )/2 M()* S##1#8C
The generaI ress fIoods us vilh concels Iike YB55%)A and Y#'$%)A as
lhese mean lo refer lo lhe effecl of higher (buIIish) or Iover (bearish)
rices in lhe financiaI markels. ul aIso ve hear eoIe saying "I am
YB55%)A on }ohnny" or "I am Y#'$%)A on lhal guy Nassim in lhe back vho
seems incomrehensibIe lo me", lo denole lhe beIief in lhe IikeIihood of
someone's rise in Iife. I have lo say lhal lhe nolion YB55%)A or Y#'$%)A are
oflen hoIIov vords vilh no aIicalion in a vorId of randomness -
arlicuIarIy if such a vorId, Iike ours, resenls asymmelric oulcomes.
When I vas in lhe emIoymenl of lhe Nev York office of a Iarge
inveslmenl house, I vas sub|ecled on occasions lo lhe harrying veekIy
"discussion meeling", vhich galhered mosl rofessionaIs of lhe Nev York
lrading room. I do nol conceaI lhal I vas nol fond of such galherings, and
nol onIy because lhey cul inlo my gym lime. WhiIe lhe meelings incIuded
lraders, lhal is, eoIe vho are |udged on lheir numericaI erformance, il
vas moslIy a forum for saIeseoIe (eoIe caabIe of charming
cuslomers), and lhe calegory of enlerlainers caIIed WaII Slreel
"economisls" or "slralegisls" vho make ronouncemenls on lhe fale of
lhe markels, bul do nol engage in any form of risk laking, lhus having lheir
success deendenl on rheloric ralher lhan acluaIIy leslabIe facls. During
lhe discussion, eoIe vere suosed lo resenl lheir oinions on lhe slale
of lhe vorId. To me, lhe meeling vas ure inleIIecluaI oIIulion. Iveryone
had a slory, a lheory, and insighls lhal lhey vanled olhers lo share. I resenl
lhe erson vho, vilhoul having done much homevork in Iibraries, lhinks
lhal he is onlo somelhing ralher originaI and insighlfuI on a given sub|ecl
maller (and resecl eoIe vilh scienlific minds Iike my friend Slan }onas
vho feeI comeIIed lo send lheir nighls reading vhoIesaIe on a sub|ecl
maller, lrying lo figure oul vhal vas done on lhe sub|ecl by olhers before
emilling an oinion - vouId lhe reader Iislen lo lhe oinion of a doclor
vho does nol read medicaI aers`).
I have lo confess lhal my olimaI slralegy (lo soolhe my boredom
and aIIergy lo confidenl Ialiludes) vas lo seak as much as I couId,
vhiIe lolaIIy avoiding Iislening lo olher eoIe's reIies by lrying lo
soIve equalions in my head. Seaking loo much vouId heI me cIarify
my mind, and, vilh a IillIe bil of Iuck, I vouId nol be "inviled" back
(lhal is, forced lo allend) lhe foIIoving veek.
I vas once asked in one of lhose meelings lo exress my vievs on lhe
slock markel. I slaled, nol vilhoul a modicum of om, lhal I beIieved
lhal lhe markel vouId go sIighlIy u over lhe nexl veek vilh a high
robabiIily. Hov high` "Aboul 70%". CIearIy, lhal vas a very slrong
oinion. ul lhen someone inler|ecled "ul, Nassim, you |usl boasled
being shorl a very Iarge quanlily of SI500 fulures, making a bel lhal lhe
markel vouId go dovn. Whal made you change your mind`". "I did nol
change my mind! I have a Iol of failh in my bel! (audience Iaughing). As
a maller of facl I nov feeI Iike seIIing even more!" The olher emIoyees
in lhe room seemed ullerIy confused. "Are you buIIish or are you
bearish`" I vas asked by lhe slralegisl. I reIied lhal I couId nol
undersland lhe vords "buIIish" and "bearish" oulside of lheir ureIy
zooIogicaI consideralion. }usl as vilh evenls A and in lhe receding
examIe, my oinion vas lhal lhe markel vas more IikeIy lo go u ("I
vouId be buIIish"), bul lhal il vas referabIe lo shorl il ("I vouId be
bearish"), because, in lhe evenl of ils going dovn, il couId go dovn a
Iol. SuddenIy, lhe fev lraders in lhe room underslood my oinion and
slarled voicing simiIar oinions. And I vas nol forced lo come back lo
lhe foIIoving discussion.
88 SOLON'S WARNING
Lel us assume lhal lhe reader shared my oinion, lhal lhe markel
over lhe nexl veek had a 70% robabiIily of going u and 30%
robabiIily of going dovn. Hovever, Iel us say lhal il vouId_go u by
1% on average, vhiIe il couId go dovn by an average of 10%. Whal
vouId lhe reader do` Is lhe reader YB55%)A or is he Y#'$%)Am
TabIe 6.2
6&#-( ;$8Y'Y%5%(, 9B(/8.# 67:#/('(%8-
Markct gncs up 7 0 %
Markct gncs dnwn 3 0 %
Up 1 %
Dnwn 1 0 %
0. 7
- 3 . 0 0
Tnta! - 2. 3
AccordingIy, YB55%)A or Y#'$%)A are lerms used by eoIe vho do nol
engage in raclicing uncerlainly, Iike lhe leIevision commenlalors, or
lhose vho have no exerience in handIing risk. AIas, inveslors and
businesses are nol aid in robabiIilies, lhey are aid in doIIars.
AccordingIy, il is nol hov IikeIy an evenl is lo haen lhal mallers, il is
hov much is made vhen il haens lhal shouId be lhe consideralion. Hov
frequenl lhe rofil is irreIevanl, il is lhe magnilude of lhe oulcome lhal
counls. Il is a ure accounling facl lhal, aside from lhe commenlalors,
very fev eoIe lake home a check Iinked lo hov 8<(#- lhey are righl or
vrong. Whal lhey gel is a rofil or Ioss. As lo lhe commenlalors, lheir
success is Iinked lo hov oflen lhey are righl or vrong. This calegory
incIudes lhe "chief slralegisls" of ma|or inveslmenl banks lhe ubIic can
see on T.V., vho are'nolhing beller lhan enlerlainers. They are famous,
seem reasoned in lheir seech, Iov you vilh numbers, bul, funclionaIIy,
lhey are lhere lo enlerlain - for lheir rediclions lo have any vaIidily lhey
vouId need a slalislicaI lesling framevork. Their fame is nol lhe resuIl of
some eIaborale lesl bul ralher lhe resuIl of lheir resenlalion skiIIs.
a n a r r n g a n t 2 9 - y c a r - n ! d s n n
Oulside of lhe need for enlerlainmenl in lhese shaIIov meelings I have
resisled voicing a "markel caII" as a lrader, vhich caused some ersonaI
slrain vilh some of my friends and reIalives. One day a friend of my
falher - of lhe rich and confidenl variely - caIIed me during his Nev
York visil (lo sel lhe eIemenls of ecking order slraighl, he hinled righl
avay during lhe caII lhal he came by Concorde, vilh some derogalory
commenl on lhe comforl of such melhod of lransorlalion). He vanled
lo ick my brain on lhe slale of a coIIeclion of financiaI markels. I lruIy
had no oinion, nor had made lhe efforl lo formuIale any, nor vas I
remoleIy inleresled in markels. The genlIeman kel Ioving me vilh
queslions on lhe slale of economies, on lhe Iuroean cenlraI banks,
lhese vere recise queslions no doubl aiming lo comare my oinion lo
lhal of some olher "exerl" handIing his accounl al one of lhe Iarge
Nev York inveslmenl firms. I neilher conceaIed lhal I had no cIue, nor
did I seem sorry aboul il. I vas nol inleresled in markels ("yes, I am a
lrader") and did nol make rediclions, eriod. I venl on lo exIain lo
him some of my ideas on lhe slruclure of randomness and lhe
verificabiIily of markel caIIs bul he vanled a more recise slalemenl
of vhal lhe Iuroean bond markels vouId do by lhe Chrislmas season.
He came under lhe imression lhal I vas uIIing his Ieg, il aImosl
damaged lhe reIalionshi belveen my falher and his rich and confidenl
friend. Ior lhe genlIeman caIIed him vilh lhe foIIoving grievance:
"When I ask a Iavyer a IegaI queslion, he ansvers me vilh courlesy and
recision. When I ask a doclor a medicaI queslion, he gives me his
oinion. No seciaIisl ever gives me disresecl. Your insoIenl and
conceiled 29-year-oId son is Iaying :$%.' 18--' and refuses lo ansver
me aboul lhe direclion of lhe markel!"
r a r c c v c n t s
The besl descrilion of my IifeIong business in lhe markel is "skeved
bels", lhal is, I lry lo benefil from rare evenls, evenls lhal do nol lend lo
reeal lhemseIves frequenlIy, bul, accordingIy, resenl a Iarge ayoff
vhen lhey occur. I lry lo make money infrequenlIy, as infrequenlIy as
ossibIe, simIy because I beIieve lhal rare evenls are nol fairIy vaIued,
and lhal lhe rarer lhe evenl, lhe more undervaIued il viII be in rice.
Why` ecause of a sychoIogicaI bias, eoIe vho surrounded me in
my career vere loo focused on memorizing seclion 2 of lhe T'55 *($##(
G8B$-'5 during lheir lrain ride lo refIecl roerIy on lhe allribules of
random evenls. Or erhas lhey valched loo many gurus on leIevision.
Or erhas lhey senl loo much lime ugrading lheir IaImIiIol. Iven
some exerienced lrading velerans do nol seem lo gel lhe oinl lhal
frequencies do nol maller. }im Rogers, a "Iegendary" inveslor, made lhe
foIIoving slalemenl:
M 18-R( YB, 8:(%8-)e XB,%-+ 8:(%8-) %) '-8(A#$ ?', (8 +8 (8 (A# :88$H
A8B)#e *8.#8-# 1%1 ' )(B1, <8$ (A# *6@ '-1 1%)/8&#$#1 (A'( Q_ :#$/#-(
8< '55 8:(%8-) #7:%$# ') 58))#)e T#55N M <%+B$#1 8B( (A'( %< Q_ :#$/#-( 8< '55
58-+ 8:(%8- :8)%(%8-) 58)( .8-#,N (A'( .#'-( (A'( Q_ :#$/#-( 8< '55 )A8$(
8:(%8- :8)%(%8-) .'># .8-#,e M< M ?'-( (8 B)# 8:(%8-) (8 Y# Y#'$%)AN M
)#55 /'55)e
VisibIy, lhe slalislic lhal 90% of aII olion osilions Iosl money is
meaningIess, (i.e., lhe <$#CB#-/,d if ve do nol lake inlo accounl A8?
.B/A money is made on average during lhe remaining 10%. If ve make
50 limes our bel on average vhen lhe olion is in lhe money, lhen I can
safeIy make lhe slalemenl lhal buying olions is anolher vay lo go lo
lhe aIazzo ralher lhan lhe oorhouse. Mr }im Rogers seems lo have
gone very far in Iife for someone vho does nol dislinguish belveen
robabiIily and execlalion (slrangeIy, he vas lhe arlner of George
Soros, a comIex man vho lhrived on rare evenls - more on him Ialer).
One such rare evenl is lhe slock markel crash of 1987, vhich made
me as a lrader and aIIoved me lhe Iuxury of becoming invoIved in aII
manner of schoIarshi. Nero of lhe smaIIer house in Chaler 1 aims lo
gel oul of harm's vay by avoiding exosure lo rare evenls - a moslIy
defensive aroach. I am far more aggressive lhan Nero and go one sle
furlher, I have organized my career and business in such a vay as lo be
abIe lo benefil from lhem. In olher vords, I aim al rofiling from lhe
rare evenl, vilh my asymmelric bels.
s y mmc t r y a n d s c i c n c c
In mosl disciIines, such asymmelry does nol maller. UnforlunaleIy, lhe
lechniques used in finance are oflen imorled from olher areas - finance
is sliII a young disciIine (il is cerlainIy nol yel a "science"). IeoIe in
mosl fieIds oulside of finance do nol have robIems eIiminaling exlreme
vaIues from lheir samIe, vhen lhe difference in ayoff belveen
differenl oulcomes is nol significanl, vhich is generaIIy lhe case in
educalion and medicine. A rofessor vho comules lhe average of his
sludenls' grades removes lhe highesl and Iovesl observalions, vhich he
vouId caII 8B(5%#$)N and lakes lhe average of lhe remaining ones,
vilhoul lhis being an unsound raclice. A casuaI vealher forecasler
does lhe same vilh exlreme lemeralures - an unusuaI occurrence mighl
be deemed lo skev lhe overaII resuIl (lhough ve viII see lhal lhis may
lurn oul lo be a mislake vhen il comes lo forecasling fulure roerlies
of lhe ice ca). So eoIe in finance borrov lhe lechnique and ignore
infrequenl evenls, nol nolicing lhal lhe effecl of a rare evenl can
bankrul a comany.
Many scienlisls in lhe hysicaI vorId are aIso sub|ecl lo such
fooIishness, misreading slalislics. One fIagranl examIe is in lhe gIobaI-
varming debale. Many scienlisls faiIed lo nolice il in ils earIy slages as
lhey removed from lheir samIe lhe sikes in lemeralure, under lhe
beIief lhal lhese vere nol IikeIy lo recur. Il may be a good idea lo lake
oul lhe exlremes vhen comuling lhe average lemeralures for vacalion
scheduIing. ul il does nol vork vhen ve sludy lhe hysicaI roerlies
of lhe vealher. These scienlisls iniliaIIy ignored lhe facl lhal lhese
sikes, aIlhough rare, had lhe effecl of adding disroorlionaleIy lo lhe
cumuIalive meIling of lhe ice ca. }usl as in finance, an evenl, aIlhough
rare, lhal brings Iarge consequences cannol |usl be ignored.
Iigure 6.1 shovs a series of oinls slarling vilh an iniliaI IeveI Wo
and ending al lhe eriod concerned Wl. Il can aIso be seen as lhe
erformance, hyolhelicaI or reaIized, of your favorile lrading slralegy,
lhe lrack record of an inveslmenl manager, lhe rice of a fool of average
IaIazzo reaI eslale in Renaissance IIorence, lhe rice series of lhe
MongoIian slock markel, or lhe difference belveen lhe U.S. and
MongoIian slock markels. Il is comosed of a given number of
sequenliaI observalions Wi, W2, elc., ordered in such a vay lhal lhe one
lo lhe righl comes '<(#$ lhe one lo lhe Iefl.
If ve vere deaIing vilh a delerminislic vorId - lhal is, a vorId
slried of randomness (lhe righl-coIumn vorId in TabIe I.I on age 3),
and ve knev vilh cerlainly lhal il vas lhe case, lhings vouId be ralher
Iigure 6.1 A Irimer on Time Series.
easy. The allern of lhe series vouId reveaI considerabIe and rediclive
informalion. You couId leII vilh recision vhal vouId haen one day
ahead, one year ahead, and erhas even a decade ahead. We vouId nol
even need a slalislician, a second-rale engineer vouId do. He does nol
even need lo be armed vilh a modern degree, someone vilh nineleenlh-
cenlury lraining under LaIace vouId be abIe lo soIve lhe equalions,
caIIed 1%<<#$#-(%'5 #CB'(%8-), or, equivaIenlIy, #CB'(%8-) 8< .8(%8- H
since ve are sludying lhe dynamics of an enlily vhose osilion deends
on lime.
If ve vere deaIing vilh a vorId vhere randomness is charled, lhings
vouId be easy as veII, given lhal lhere is an enlire fieId crealed for lhal
caIIed 6/8-8.#($%/) or F%.# *#$%#) =-'5,)%)e You vouId caII a friendIy
economelrician (my exerience of economelricians is lhal lhey are
usuaIIy oIile and friendIy lo raclilioners). He vouId run lhe dala in
his soflvare, and rdvide you vilh diagnoslics lhal vouId leII you if il is
vorlh invesling in lhe lrader generaling such a lrack record, or if il is
vorlh ursuing lhe given lrading slralegy. You can even buy lhe sludenl
version of his soflvare for under $999 and run il yourseIf during lhe
nexl rainy veekend.
ul ve are nol sure lhal lhe vorId ve Iive in" is veII charled. We viII
see lhal lhe |udgmenl derived from lhe anaIysis of lhese asl allribules
may on occasion be reIevanl. ul il may be meaningIess, il couId on
occasion misIead you and lake you in lhe oosile direclion. Somelimes
markel dala becomes a simIe lra, il shovs you lhe oosile of ils
nalure, simIy lo gel you lo invesl in lhe securily or mismanage your
risks. Currencies lhal exhibil lhe Iargesl hisloricaI slabiIily, for examIe,
are lhe mosl rone lo crashes. This vas billerIy discovered in lhe
summer of 1997 by inveslors vho chose lhe safely of lhe egged
currencies of MaIaysia, Indonesia, and ThaiIand (lhey vere egged lo
lhe U.S. doIIar in a manner lo exhibil no voIaliIily, unliI lheir shar,
sudden, and brulaI devaIualions).
We couId be eilher loo Iax or loo slringenl in acceling asl infor-
malion as a rediclion of lhe fulure. As a skelic, I re|ecl a soIe lime
series of lhe asl as an indicalion of fulure erformance, I need a Iol
more lhan dala. My ma|or reason is lhe $'$# #&#-(N bul I have Ienly of
olhers.
On lhe surface, my slalemenl here may seem lo conlradicl earIier
discussions, vhere I bIame eoIe for nol Iearning enough from hislory.
The robIem is lhal ve read loo much inlo shaIIov recenl hislory, vilh
slalemenls Iike "lhis has never haened before", bul nol from hislory
in generaI (lhings lhal never haened before in one area lend evenluaIIy
lo haen). In olher vords hislory leaches us lhal lhings lhal never
haened before do haen. Il can leach us a Iol oulside of lhe narrovIy
defined lime series, lhe broader lhe Iook, lhe beller lhe Iesson. In olher
vords, hislory leaches us lo avoid lhe brand of naive emiricism lhal
consisls of Iearning from casuaI hisloricaI facls.
4'( ;)*( QD(/% J)11)@C
t h c m n t h c r n I a ! ! d c c c p t i n n s
The rare evenl, oving lo ils dissimuIalive nalure, can lake a variely of
shaes. Il is in Mexico lhal il vas solled firsl, vhere il vas caIIed by
academics lhe :#)8 :$8Y5#.e Iconomelricians vere uzzIed by lhe
behavior of lhe Mexican economic variabIes during lhe 1980s. The money
suIy, inleresl rales, or some simiIar measure of smaII reIevance lo lhe
slory exhibiled some moody behavior, lhvarling many of lheir efforls al
modeIing lhem. These indicalors erralicaIIy svilched belveen eriods of
slabiIily lo brief bursls of lurbuIence vilhoul varning.
y generaIizalion, I slarled lo IabeI a rare evenl as any behavior vhere
lhe adage "bevare of caIm valers" can hoId. IouIar visdom oflen
varns of lhe oId neighbor vho aears lo remain courlIy and reserved,
lhe modeI of an exceIIenl cilizen, unliI you see his iclure in lhe nalionaI
aer as a deranged kiIIer vho venl on a ramage. UnliI lhen, he vas nol
knovn lo have commilled any lransgression. There vas no vay lo
redicl lhal such alhoIogicaI behavior couId emanale from such a nice
erson. I associale rare evenls vilh any misunderslanding of lhe risks
derived from a narrov inlerrelalion of asl lime series.
Rare evenls are aIvays unexecled, olhervise lhey vouId nol occur.
The lyicaI case is as foIIovs. You invesl in a hedge fund lhal en|oys
slabIe relurns and no voIaliIily, unliI one day, you receive a Ieller
slarling vilh "An unforeseen and B-#7:#/(#1 evenl, deemed a rare
occurrence . . . " (emhasis mine). ul rare evenls exisl reciseIy because
lhey are unexecled. They are generaIIy caused by anics, lhemseIves
lhe resuIls of Iiquidalions (lhe inveslors rushing lo lhe door
simuIlaneousIy by duming anylhing lhey can ul lheir hands on as
fasl as ossibIe). If lhe fund manager or lrader execled il, he and his
Iike-minded eers vouId nol have invesled in il, and lhe rare evenl
vouId nol have laken Iace.
The rare evenl is nol Iimiled lo one securily. Il can readiIy affecl lhe
erformance of a orlfoIio. Ior examIe, many lraders engage in lhe
urchase of morlgage securilies and hedge lhem in some manner lo
8<<)#( lhe risks and #5%.%-'(# lhe &85'(%5%(,N A8:%-+ (8 derive )8.# :$8<%()
in excess of lhe Treasury bond relurns (vhich is used as lhe benchmark
of lhe minimum execled relurns on an inveslmenl). They use comuler
rograms and drav meaningfuI assislance from Ih.D.s in aIied
malhemalics, aslrohysics, arlicIe hysics, eIeclricaI engineering, fIuid
dynamics, or somelimes (lhough rareIy) Iain Ih.D.s in Iinance. Such a
orlfoIio shovs slabIe relurns for Iong eriods. Then, suddenIy, as if by
accidenl (I consider lhal -8 accidenl), lhe orlfoIio dros by 40% of ils
vaIue vhen you execl, al lhe vorsl, a 4% dro. You caII lhe manager
lo exress your anger and he leIIs you lhal il vas nol his fauIl, bul
somehov lhe reIalionshi dramalicaIIy changed (IileraIIy). He viII aIso
oinl oul lo you lhal simiIar funds aIso exerienced lhe same robIems.
RecaII lhal some economisls caII lhe rare evenl a "eso robIem".
The designalion eso robIem does nol aear lo be undeservedIy
slereolyicaI. Things have nol gollen beller since lhe earIy 1980s vilh
lhe currency of lhe U.S.'s soulhern neighbor. Long eriods of slabiIily
drav hordes of bank currency lraders and hedge fund oeralors lo lhe
caIm valers of lhe Mexican eso, lhey en|oy ovning lhe currency
because of lhe high inleresl rale il commands. Then lhey "unexecledIy"
bIov u, Iose money for inveslors, Iose lheir |obs and svilch careers.
Then a nev eriod of slabiIily sels in. Nev currency lraders come in
vilh no memory of lhe bad evenl. They are dravn lo lhe Mexican eso,
and lhe slory reeals ilseIf.
Il is an oddily lhal mosl fixed income financiaI inslrumenls resenl
rare evenls. In lhe sring of 1998, I senl lvo hours exIaining lo a
lhen-imorlanl hedge fund oeralor lhe nolion of lhe :#)8 :$8Y5#.e I
venl lo greal Ienglhs lo exIain lo him lhal lhe concel vas generaIized
lo every form of inveslmenl lhal vas based on a naive inlerrelalion of
lhe voIaliIily of asl lime series. The reIy vas: "You are erfeclIy righl.
We do nol louch lhe Mexican eso. We onIy invesl in lhe Russian
rubIe". He bIev u a fev monlhs Ialer. UnliI lhen, lhe Russian rubIe
Carried allraclive inleresl rales, vhich inviled yieId hogs of aII lyes lo
gel invoIved. He and olher hoIders of inveslmenls denominaled in rubIes
Iosl cIose lo 97% of lheir inveslmenl during lhe summer of 1998.
We sav in Chaler 3 lhal lhe denlisl does nol Iike voIaliIily as il
causes a high incidence of negalive angs. The cIoser he observes his
erformance, lhe more ain he viII exerience oving lo lhe grealer
variabiIily al a higher resoIulion. AccordingIy inveslors, mereIy for
emolionaI reasons, viII be dravn inlo slralegies lhal exerience $'$# YB(
5'$+# varialions. Il is caIIed ushing randomness under lhe rug.
We can Iook al olher asecls of lhe robIem, lhink of someone
invoIved in scienlific research. Day afler day, he viII engage in dissecling
mice in his Iaboralory, avay from lhe resl of lhe vorId. He couId lry
and lry for years and years vilhoul anylhing lo shov for il. His
significanl olher mighl Iose alience vilh lhe 58)#$ vho comes home
every nighl smeIIing of mice urine. UnliI bingo, one day he comes u
vilh a resuIl. Someone observing lhe lime series of his occualion vouId
see absoIuleIy no gain, vhiIe every day vouId bring him cIoser %-
:$8Y'Y%5%(, lo lhe end resuIl.
The same vilh ubIishers, lhey can ubIish dog afler dog vilhoul
lheir business modeI being lhe Ieasl queslionabIe, if once every decade
lhey hil on a Harry Ioller slring of suer-besl-seIIers - rovided of
course lhal lhey ubIish quaIily vork lhal has a smaII robabiIily of
being of very high aeaI.
In lhe markels, lhere is a calegory of lraders vho have %-&#$)# rare
evenls, for vhom voIaliIily is oflen a bearer of good nevs. These lraders
Iose money frequenlIy, bul in smaII amounls, and make money rareIy,
bul in Iarge amounls. I caII lhem crisis hunlers. I am hay lo be one of
lhem.
w h y d n n ' t s t a t i s t i c i a n s d c t c c t r a r c c v c n t s ?
Slalislics lo lhe Iayman can aear ralher comIex, bul lhe concel
behind vhal is used loday is so simIe lhal my Irench malhemalician
friends caII il derecaloriIy "cuisine". Il is aII based on one simIe
nolion, lhe more informalion you have, lhe more you are confidenl
aboul lhe oulcome. Nov lhe robIem, by hov much` Common
slalislicaI melhod is based on lhe sleady augmenlalion of lhe confidence
IeveI, in nonIinear roorlion lo lhe number of observalions. Thal is, for
an - limes increase in lhe samIe size, ve increase our knovIedge by lhe
square rool of -e Suose I am draving from an urn conlaining red and
bIack baIIs. My confidence IeveI aboul lhe reIalive roorlion of red and
bIack baIIs, afler 20 dravings is nol lvice lhe one I have afler 10
dravings, il is mereIy muIliIied by lhe square rool of 2 (lhal is, 1.41).
Where slalislics becomes comIicaled, and faiIs us, is vhen ve have
dislribulions lhal are nol symmelric, Iike lhe urn above. If lhere is a very
smaII robabiIily of finding a red baII in an urn dominaled by bIack ones,
lhen our knovIedge aboul lhe 'Y)#-/# of red baIIs viII increase very
sIovIy - more sIovIy lhan al lhe execled square rool of - rale. On lhe
olher hand our knovIedge of lhe :$#)#-/# of red baIIs viII dramalicaIIy
imrove once one of lhem is found. This asymmelry in knovIedge is nol
lriviaI, il is cenlraI in lhis book - il is a cenlraI hiIosohicaI robIem for
such eoIe as Hume and KarI Ioer (on lhal, Ialer).
To assess an inveslor's erformance, ve eilher need more aslule, and
Iess inluilive, lechniques, or ve may have lo Iimil our assessmenls lo
silualions vhere our |udgmenl is indeendenl of lhe frequency of lhese
evenls.
a mi s c h i c v n u s c h i ! d r c p ! a c c s t h c b ! a c k b a ! ! s
ul lhere is even vorse nevs. In some cases, if lhe incidence of red baIIs
is ilseIf randomIy dislribuled, ve viII never gel lo knov lhe comosilion
of lhe urn. This is caIIed (A# :$8Y5#. 8< )('(%8-'$%(,e Think of an urn
lhal is hoIIov al lhe bollom. As I am samIing from il, and vilhoul my
being avare of il, some mischievous chiId is adding baIIs of one coIor or
anolher. My inference lhus becomes insignificanl. I may infer lhal lhe
red baIIs reresenl 50% of lhe urn vhiIe lhe mischievous chiId, hearing
me, vouId sviflIy reIace aII lhe red baIIs vilh bIack ones. This makes
much of our knovIedge derived lhrough slalislics quile shaky.
The very same effecl lakes Iace in lhe markel. We lake asl hislory
as a singIe homogeneous samIe and beIieve lhal ve have considerabIy
increased our knovIedge of lhe fulure from lhe observalion of lhe
samIe of lhe asl. Whal if vicious chiIdren vere changing lhe
comosilion of lhe urn` In olher vords, vhal if lhings have changed`
I have sludied and racliced economelrics for more lhan haIf my Iife
(since I vas 19), bolh in lhe cIassroom and in lhe aclivily of a
quanlilalive derivalives lrader. The "science" of economelrics consisls
of lhe aIicalion of slalislics lo samIes laken al differenl eriods of
lime, vhich ve caIIed (%.# )#$%#)e Il is based on sludying lhe lime series
of economic variabIes, dala, and olher mallers. In lhe beginning, vhen I
knev cIose lo nolhing (lhal is even Iess lhan loday), I vondered vhelher
lhe lime series refIecling lhe aclivily of eoIe nov dead or relired
shouId maller for redicling lhe fulure. Iconomelricians vho knev a
Iol more lhan I did aboul lhese mallers asked no such queslion, lhis
hinled lhal il vas in aII IikeIihood a sluid inquiry. One rominenl
economelrician, Hashem Iesaran, ansvered a simiIar queslion by
recommending lo do "more and beller economelrics". I am nov
convinced lhal, erhas, mosl of economelrics couId be useIess - much
of vhal financiaI slalislicians knov vouId nol be vorlh knoving. Ior a
sum of zeros, even reealed a biIIion limes, remains zero, Iikevise an
accumuIalion of research and gains in comIexily viII Iead lo naughl if
lhere is no firm ground benealh il. Sludying lhe Iuroean markels of lhe
1990s viII cerlainIy be of greal heI lo a hislorian, bul vhal kind of
inference can ve make nov lhal lhe slruclure of lhe inslilulions and lhe
markels has changed so much`
Nole lhal lhe economisl Roberl Lucas deaIl a bIov lo economelrics
by arguing lhal if eoIe vere ralionaI lhen lheir ralionaIily vouId
cause lhem lo figure oul rediclabIe allerns from lhe asl and adal, so
lhal asl informalion vouId be comIeleIy useIess for redicling lhe
fulure (lhe argumenl, hrased in a very malhemalicaI form, earned him
a NobeI MemoriaI Irize in Iconomics). We are human and acl
according lo our knovIedge, vhich inlegrales asl dala. I can lransIale
his oinl vilh lhe foIIoving anaIogy. If ralionaI lraders delecl a allern
of slocks rising on Mondays, lhen, immedialeIy such a allern becomes
deleclabIe, il vouId be ironed oul by eoIe buying on Iriday in
anlicialion of such an effecl. There is no oinl searching for allerns
lhal are avaiIabIe lo everyone vilh a brokerage accounl, once delecled,
lhey vouId be ironed oul.
Somehov, vhal came lo be knovn as lhe aB/') /$%(%CB# vas nol
carried lhrough by lhe "scienlisls". Il vas confidenlIy beIieved lhal lhe
scienlific successes of lhe induslriaI revoIulion couId be carried lhrough
inlo lhe sociaI sciences, arlicuIarIy vilh such movemenls as Marxism.
Iseudoscience came vilh a coIIeclion of ideaIislic nerds vho lried lo
creale a laiIor-made sociely, lhe eilome of vhich is lhe cenlraI Ianner.
Iconomics vas lhe mosl IikeIy candidale for such use of science, you
can disguise charIalanism under lhe veighl of equalions, and nobody
can calch you since lhere is no such lhing as a conlroIIed exerimenl.
Nov lhe siril of such melhods, caIIed )/%#-(%). by ils delraclors (Iike
myseIf), conlinued asl Marxism, inlo lhe disciIine of finance as a fev
lechnicians lhoughl lhal lheir malhemalicaI knovIedge couId Iead lhem
lo undersland markels. The raclice of "financiaI engineering" came
aIong vilh massive doses of seudoscience. Iraclilioners of lhese
melhods measure risks, using lhe looI of asl hislory as an indicalion of
lhe fulure. We viII |usl say al lhis oinl lhal lhe mere ossibiIily of lhe
dislribulions nol being slalionary makes lhe enlire concel seem Iike a
coslIy (erhas &#$, /8)(5,d mislake. This Ieads us lo a more
fundamenlaI queslion: lhe robIem of induclion, lo vhich ve viII lurn
in lhe nexl chaler.
SIVIN
+
THI IROLIM OI INDUCTION
9- (A# /A$8.81,-'.%/) 8< )?'-)e F'>%-+ *858-R) ?'$-%-+ %-(8
)8.# :A%58)8:A%/'5 (#$$%(8$,e 08? 4%/(8$ E%#1#$A8<<#$ ('B+A(
.# #.:%$%/%).j M '11#1 1#1B/(%8-e TA, %( %) -8( )/%#-(%<%/ (8
('># )/%#-/# )#$%8B)5,e *8$8) :$8.8(#) ;8::#$e FA'( Y88>)(8$#
8- LD)( '-1 V%<(A =&#-B#e ;')/'5R) ?'+#$e
ov ve discuss lhis robIem vieved from lhe broader slandoinl
of lhe hiIosohy of scienlific knovIedge. There is a robIem in
inference veII knovn as lhe robIem of induclion. Il is a robIem lhal
has been haunling science for a Iong lime, bul science has nol been as
harmed by il as lhe financiaI markels. Why` ecause lhe randomness
conlenl comounds ils effecls. Novhere is lhe robIem of induclion
more reIevanl lhan in my vorId of finance - and novhere has il been as
Frnm M)@#/ %# 7$=(
ignored!
100
SOLON' S WARNI NG
c y g n u s a t r a t u s
In his F$#'(%)# 8- 0B.'- E'(B$#N lhe Scols hiIosoher David Hume
osed lhe issue in lhe foIIoving vay (as rehrased in lhe nov famous
Y5'/> )?'- :$8Y5#. by }ohn Sluarl MiII): E8 '.8B-( 8< 8Y)#$&'(%8-) 8<
?A%(# )?'-) /'- '558? (A# %-<#$#-/# (A'( '55 )?'-) '$# ?A%(#N YB( (A#
8Y)#$&'(%8- 8< ' )%-+5# Y5'/> )?'- %) )B<<%/%#-( (8 $#<B(# (A'( /8-/5B)%8-e
Hume had been irked by lhe facl lhal science in his day (lhe
eighleenlh cenlury) had exerienced a sving from schoIaslicism, enlireIy
based on deduclive reasoning (no emhasis on lhe observalion of lhe
reaI vorId) lo, oving lo Irancis acon, an overreaclion inlo naive and
unslruclured emiricism. acon had argued againsl "sinning lhe
cobveb of Iearning" vilh IillIe raclicaI resuIl. Science had shifled,
lhanks lo acon, inlo an emhasis on emiricaI observalion. The
robIem is lhal, vilhoul a roer melhod, emiricaI observalions can
Iead you aslray. Hume came lo varn us againsl such knovIedge, and lo
slress lhe need for some rigor in lhe galhering and inlerrelalion of
knovIedge - vhal is caIIed eislemoIogy (from #:%)(#.#N Greek for
Iearning). Hume is lhe firsl modern #:%)(#.858+%)(N (eislemoIogisls are
oflen caIIed melhodoIogisls or hiIosohers of science). Whal I am
vriling here is nol slriclIy lrue, for Hume said lhings far vorse lhan
lhal, he vas an obsessive skelic and never beIieved lhal a Iink belveen
lvo ilems couId be lruIy eslabIished as being causaI. ul ve viII lone
him dovn a bil for lhis book.
n ! I c d c r h n I I c r , v i c t n r i a n g c n t ! c m a n
Il is vorlh noling lhal finance has ils Irancis acon in lhe erson of
Viclor Niederhoffer. He vas lhe very firsl lo sland againsl lhe /8Y?#Y
8< 5#'$-%-+ of lhe Universily of Chicago and lhe efficienl markel reIigion
of lhe 1960s, vhen il vas al ils vorsl. In conlrasl vilh lhe schoIaslicism
of financiaI lheorisls, he Iooked al dala in search of anomaIies - and
found enough of lhem lo be abIe lo conducl a successfuI career in
randomness and deIiver an insighlfuI book, FA# 61B/'(%8- 8< '
*:#/B5'(8$e Since lhen, an enlire induslry of such oeralors, caIIed
"slalislicaI arbilrageurs", fIourished, lhe ma|or and mosl successfuI ones
THI IROLIM OI I NDUCTI ON 101
vere iniliaIIy his lrainees. WhiIe Niederhoffer had a ubIicized hiccu,
some of his lrainees fared veII because lhey added rigor and .#(A81H
858+, lo lheir slalislicaI inference. In olher vords, Niederhoffer's
emiricism missed |usl a modicum of melhodoIogy.
I have lo admil lhal for aII my inleIIecluaI disagreemenls vilh him I
have been insired by his emiricism and ove him a Iarge share of my
inleIIecluaI grovlh. I exerienced a |um in my lrading slyIe in 1996,
vhen Viclor bIurled lo me lhal any "leslabIe" slalemenl shouId be
(#)(#1 (il vas so obvious bul I had nol done il unliI lhen). His advice
venl slraighl home. A leslabIe slalemenl is one lhal can be broken
dovn inlo quanlilalive comonenls and sub|ecled lo slalislicaI
examinalion. Ior inslance, a convenlionaI-visdom slyIe slalemenl Iike
'//%1#-() A'::#- /58)#$ (8 A8.#
can be lesled by laking lhe average dislance belveen lhe accidenl and
lhe domiciIe of lhe driver (if, say, aboul 20% of accidenls haen vilhin
a 12-miIe radius). Hovever, one needs lo be carefuI in lhe inler-
relalion, a naive inlerreler of lhe resuIl vouId leII you lhal you are
more IikeIy lo have an accidenl if you drive in your neighborhood lhan
if you did so in remole Iaces, vhich is an examIe of naive emiricism.
Why` ecause accidenls may haen cIoser lo home simIy because
eoIe send lheir lime driving cIose lo home (if eoIe send 20% of
lheir lime driving in a 12-miIe radius).
Since lhal very same day I have nol made a singIe leslabIe roosilion
vilhoul lesling il, lhanks lo lhe comuler vhich I rareIy use for non-
comulalionaI lasks. Hovever, lhe differences belveen Viclor
Niederhoffer and myseIf remain immense, I can use dala lo disrove a
roosilion, never lo rove one. I can use hislory lo refule a con|eclure,
never lo affirm il. Ior inslance, lhe slalemenl
FA# .'$>#( -#&#$ +8#) 18?- L_n %- ' +%&#- UH.8-(A :#$%81
can be lesled, bul is comIeleIy meaningIess if verified. I can quanlila-
liveIy re|ecl lhe roosilion by finding counlerexamIes, bul il is
imossibIe for me lo accel il simIy because in asl dala lhe markel
never venl dovn 20% in any 3-monlh eriod.
Relurning lo lhe bIack svan robIem, consider lhe foIIoving
slalemenl:
*('(#.#-( =2 E8 )?'- %) Y5'/> Y#/'B)# M 588>#1 '( O___ )?'-) '-1
<8B-1 -8-#e
*('(#.#-( X2 E8( '55 )?'-) '$# ?A%(#e
I cannol IogicaIIy make slalemenl A, no maller hov many successive
vhile svans I may have observed in my Iife and may observe in lhe
fulure (excel of course if I am given lhe riviIege of observing vilh
cerlainly aII avaiIabIe svans). Il is hovever ossibIe lo make Slalemenl
mereIy by finding one singIe bIack svan in my samIe. Indeed,
slalemenl A vas disroved by lhe discovery of AuslraIia, as il Ied lo lhe
sighling of lhe /,+-B) '($'(B)N a svan variely lhal vas |el bIack! The
reader viII see a hinl of Ioer (afler ve are done vilh my semi-menlor
Viclor), lhere is a slrong asymmelry belveen lhe lvo slalemenls. Such
asymmelry Iies in lhe foundalions of knovIedge. Il is aIso al lhe core of
my deaIing vilh randomness as a lrader.
The foIIoving induclive slalemenl iIIuslrales lhe robIem of
inlerreling asl dala vilhoul IogicaI .#(A812
M A'&# gB)( /8.:5#(#1 ' (A8$8B+A )('(%)(%/'5 #7'.%-'(%8- 8< (A# 5%<# 8<
;$#)%1#-( XB)Ae V8$ WW ,#'$)N /58)# (8 DPN___ 8Y)#$&'(%8-)N A# 1%1 -8(
1%# 8-/#e M /'- A#-/# :$8-8B-/# A%. ') %..8$('5N ?%(A ' A%+A 1#+$##
8< )('(%)(%/'5 )%+-%<%/'-/#e
AIlhough Viclor and I lrade in such an oosile manner lhal many of
his lrades end u in my invenlory, I have a Iarge measure of resecl for
him. He seIIs oul-of-lhe-money olions for a Iiving, I buy lhem for a Iiving
(by seIIing an oul-of-lhe-money olion one is belling lhal an evenl ?%55
-8( haen, by buying one I am mereIy belling lhal il .', haen). He
lries lo make sleady income, I refer a Iumy and rare ayoff. AIlhough
ve seem lo be diamelricaIIy oosile lraders, ve share many suerficiaI
ersonaI lrails. These may be vorlh bringing in here because ve bolh
make our rivale lrails arl of our lrading and make a lhin dislinclion
belveen aclivilies middIebrov eoIe caII "vork" and lhose lhey caII
"Ieisure". olh of us are lraders lrying lo Iive under lhe iIIusion of
oeraling a scienlific Iaboralory. olh of us surround ourseIves vilh
schoIars and scienlisls, nol businessmen (laIking lo successfuI scienlisls is
a good disciIine lo avoid edeslrianism in our ovn lhinking). olh of us
lry lo Iead lhe Iives of lhe Viclorian genlIeman schoIar vilh books
scallered around us, by escaing many of lhe ouIar accrelions of lhe
lvenlielh cenlury. olh of us gIorify our ersonaI idiosyncrasies lo avoid
bearing any inleIIecluaI resembIance lo lhe crovd. olh of us obsessiveIy
ursue alhIelic aclivilies on a daiIy basis (bul he is comelilive and
comelilion in sorls reeIs me). Viclor's modeI seems lo be lhe Viclorian
genlIeman (Iike his hero Irancis GaIlon, lhe linkering cousin of CharIes
Darvin, vho is lhe lrue insiralion of aII aIied slalislicians) vhiIe, Iike
a lrue Viclorian, I am firsl and Iasl a cIassicisl and remain sleeed in lhe
Greco-Roman cuIlure in vhich I grev u (my heroes are ralher Iilerary
figures). olh of us avoid lhe media, leIevision, nevsaers, aIlhough
Viclor is far more vigorous lhan I in such slriclures. olh of us avoid
chilchal and smaII laIk Iike lhe Iague (loo much Iefl-coIumn noise).
<.* T)*1U, E*#=#%./8 !8(/%
Nexl I viII discuss hov I discovered KarI Ioer via anolher lrader,
erhas lhe onIy one I have ever lruIy resecled. I do nol knov if il
aIies lo olher eoIe, bul, in sile of my being a voracious reader, I
have rareIy been lruIy affecled in my behavior (in any durabIe manner)
by anylhing I have read. A book can make a slrong imression, bul such
an imression lends lo vane afler some never imression reIaces il in
my brain (a nev book). I have lo discover lhings by myseIf (recaII FA#
*(8&# %) 08( seclion in Chaler 2). These seIf discoveries Iasl.
One excelion of ideas lhal sluck vilh me are lhose of Sir KarI, vhom
I discovered (or erhas rediscovered) lhrough lhe vrilings of lhe lrader
and seIf-slyIed hiIosoher George Soros vho seemed lo have organized
his Iife by becoming a romoler of lhe ideas of KarI Ioer. Whal I
Iearned from George Soros vas nol quile in lhe vay he erhas inlended
us lo Iearn from him. I disagreed vilh his slalemenls vhen il came lo
economics and hiIosohy - bul somehov I succumbed lo lhe charm of
lhis Hungarian man vho Iike me is ashamed of being a lrader and refers
his lrading lo be a minor exlension of his inleIIecluaI Iife (il can be seen in
his firsl book FA# =5/A#., 8< V%-'-/#de Having never been imressed by
eoIe vilh money (and I have mel Ienly of lhose lhroughoul my Iife), I
did nol Iook al any of lhem as remoleIy a roIe modeI for me. Ierhas lhe
oosile effecl hoIds, as I am generaIIy reeIIed by lhe veaIlhy, generaIIy
because of lhe allilude of eic heroism lhal usuaIIy accomanies raid
enrichmenl. Soros vas lhe onIy one vho seemed lo share my vaIues. He
vanled lo be laken seriousIy as a MiddIe Iuroean rofessor vho
haened lo have gollen rich oving lo lhe vaIidily of his ideas (il vas
onIy by faiIing lo gain accelance by olher inleIIecluaIs lhal he vouId lry
lo gain aIha slalus lhrough his money, sorl of Iike a seducer vho afler
lrying hard, vouId end u using such an aendage as lhe red Ierrari lo
seduce lhe girI). In addilion, aIlhough Soros did nol come across very
cIearIy in his vrilings, he knev hov lo handIe randomness, by keeing a
crilicaI oen mind and changing his oinions vilh minimaI shame (vhich
carries lhe side effecl of making him lreal eoIe Iike nakins). He
vaIked around caIIing himseIf faIIibIe, bul vas so olenl because he
knev il vhiIe olhers had Ioflier ideas aboul lhemseIves. He underslood
Ioer. He Iived a Ioerian Iife.
As an aside, Ioer vas nol nev lo me. I had briefIy heard of KarI
Ioer vhen I vas in my leens and earIy lvenlies, as arl of a
molivaled educalion in Iuroe and lhe Uniled Slales. ul I did nol
undersland his ideas as resenled lhen, nor did I lhink il vouId be
imorlanl (Iike melahysics) for anylhing in Iife. I vas al lhe age vhen
one feIl Iike one needed lo read everylhing, vhich revenled one from
making conlemIalive slos. Such hurry made il hard lo delecl lhal
lhere vas somelhing imorlanl in Ioer. Il vas eilher my condilioning
by lhe inleIIecluaI-chic cuIlure al lhe lime (loo much IIalo, loo many
Marxisls, loo much HegeI, loo many seudoscienlific inleIIecluaIs), lhe
educalionaI syslem (loo many con|eclures roounded as lrulh) or lhe
facl lhal I vas loo young and vas reading loo much lhen lo make a
bridge lo reaIily.
Ioer lhen sIied oul of my mind vilhoul hanging on a singIe brain
ceII - lhere vas nolhing in lhe baggage of a boy vilhoul exerience lo Iel il
slick. esides, having slarled lrading, I enlered an anli-inleIIecluaI hase, I
needed lo make ' non-random buck lo secure my nevIy Iosl fulure and
veaIlh lhal had |usl evaoraled vilh lhe Lebanese var (unliI lhen I vas
Iiving vilh lhe desire lo become a comforlabIe man of Ieisure Iike aImosl
everyone in my famiIy, over lhe asl lvo cenluries). I suddenIy feIl
financiaIIy insecure and feared becoming an emIoyee of some firm lhal
vouId lurn me inlo a cororale sIave vilh "vork elhics" (vhenever I hear
?8$> #(A%/) I inlerrel %-#<<%/%#-( .#1%8/$%(,de I needed lhe backing of my
bank accounl so I couId buy lime lo lhink and en|oy Iife. The Iasl lhing I
needed vas immediale hiIosohizing and vork al lhe IocaI McDonaId's.
IhiIosohy, lo me, became somelhing rheloricaI eoIe did vhen lhey had
Ienly of lime on lheir hands, il vas an aclivily reserved lo lhose vho are
nol veII versed in quanlilalive melhods and olher roduclive lhings. Il
vas a aslime lhal shouId be Iimiled lo Iale hours, in bars around lhe
camuses, vhen one had a fev drinks and a Iighl scheduIe - rovided one
forgol lhe garruIous eisode as earIy as lhe nexl day. Too much of il can
gel a man in lroubIe, erhas lurn one inlo a Marxisl ideoIogue. Ioer
vas nol lo reemerge unliI I secured my career as a lrader.
! n c a t i n n , ! n c a t i n n
Il is said lhal eoIe generaIIy remember lhe lime and geograhic
condilion vhere lhey vere svel vilh a governing idea. The reIigious
oel and diIomal IauI CIaudeI remembers lhe exacl sol of his
/8-&#$)%8- (or re-conversion) lo CalhoIicism in lhe CalhedraI Nolre-
Dame of Iaris, near a recise coIumn. Thus I remember exaclIy lhe sol
al arnes and NobIe on 21sl Slreel and Iiflh Avenue vhere in 1987,
insired by Soros, I read 50 ages of FA# a8+%/ 8< */%#-(%<%/ "%)/8&#$,
and feverishIy boughl aII lhe Ioer lilIes I couId gel my hands on Iesl
lhey run oul of slock. Il vas in a sarseIy Iil side-room lhal had a
dislinclive smeII of miIdev. I remember vividIy lhe lhoughls lhal rushed
lhrough my head Iike a reveIalion.
Ioer lurned oul lo be exaclIy lhe oosile of vhal I iniliaIIy
lhoughl aboul "hiIosohers", he vas lhe eilome of no nonsense. y
lhen I had been an olion lrader for a couIe of years and I feIl angry
lhal I vas being laken for a lolaI ride by lhe academic researchers in
finance, arlicuIarIy since I vas deriving my income from lhe faiIure of
lheir modeIs. I had aIready slarled laIking lo finance academics as arl
of my invoIvemenl vilh derivalives and I had lroubIe gelling lhrough lo
lhem some basic oinls aboul financiaI markels (lhey beIieved in lheir
modeIs a IillIe loo much). There vas aII aIong Iurking in-my mind lhe
idea lhal lhese researchers had missed a oinl, bul I did nol quile knov
vhal il vas. Il vas nol vhal lhey knev, il vas hov lhey knev il lhal
vas lhe sub|ecl of my annoyance.
pnppc r ' s a n s w c r
Ioer came u vilh a ma|or ansver lo lhe robIem of induclion (lo me
he came u vilh (A# ansver). No man has infIuenced lhe vay scienlisls
do science more lhan Sir KarI - in sile of lhe facl lhal many of his
feIIov rofessionaI hiIosohers find him quile naive (lo his credil, in
my oinion). Ioer's idea is lhal science is nol lo be laken as seriousIy
as il sounds (Ioer vhen meeling Iinslein did nol lake him as lhe
demigod he lhoughl he vas). There are onIy lvo lyes of lheories:
1. Theories lhal are knovn lo be vrong, as lhey vere lesled and
adequaleIy re|ecled (he caIIs lhem <'5)%<%#1de
2. Theories lhal have nol yel been knovn lo be vrong, nol <'5)%<%#1 yel,
bul are exosed lo be roved vrong.
Why is a lheory never $%+A(` ecause ve viII never knov if aII lhe
svans are vhile (Ioer borroved lhe Kanlian idea of lhe fIavs in our
mechanisms of ercelion). The lesling mechanism may be fauIly.
Hovever, lhe, slalemenl lhal lhere is a bIack svan is ossibIe lo make. A
lheory cannol b'e &#$%<%#1e To arahrase basebaII coach Yogi erra
again, :')( 1'(' A') ' 58( 8< +881 %- %(N YB( %( %) (A# Y'1 )%1# (A'( %) Y'1e Il
can onIy be rovisionaIIy acceled. A lheory lhal faIIs oulside of lhese
lvo calegories is nol a lheory. A lheory lhal does nol resenl a sel of
condilions under vhich il vouId be considered vrong vouId be lermed
charIalanism - lhey vouId be imossibIe lo re|ecl olhervise. Why`.
ecause lhe aslroIogisl can aIvays find a reason lo fil lhe asl evenl, by
saying lhal 3'$) ?') :$8Y'Y5, %- 5%-# YB( -8( (88 .B/A )8 (Iikevise lo
me a lrader vho does nol have a oinl lhal vouId make him change his
mind is nol a lrader). Indeed lhe difference belveen Nevlonian hysics,
vhich vas faIsified by Iinslein's reIalivily, and aslroIogy Iies in lhe
THI IROLIM 9V I NDUCTI ON 107
foIIoving irony. Nevlonian hysics is scienlific because il aIIoved us lo
faIsify il, as ve knov lhal il is vrong, vhiIe aslroIogy is nol because il
does nol offer condilions under vhich ve couId re|ecl il. AslroIogy
cannol be disroved, oving lo lhe auxiIiary hyolheses lhal come inlo
Iay. Such oinl Iies al lhe basis of lhe demarcalion belveen science and
nonsense (caIIed "lhe robIem of demarcalion").
More raclicaIIy lo me, Ioer had many robIems vilh slalislics
and slalislicians. He refused lo bIindIy accel lhe nolion lhal knovIedge
can aIvays increase vilh incremenlaI informalion - vhich is lhe
foundalion of slalislicaI inference. Il may in some inslances, bul ve do
nol knov vhich ones. Many insighlfuI eoIe, such as }ohn Maynard
Keynes, indeendenlIy reached lhe same concIusions. Sir KarI's
delraclors beIieve lhal favorabIy reealing lhe same exerimenl again
and again shouId Iead lo an increased comforl vilh lhe nolion lhal "il
vorks". I came lo undersland Ioer's osilion beller once I sav lhe
firsl rare evenl ravaging a lrading room. Sir KarI feared lhal some lye
of knovIedge did nol increase vilh informalion - bul vhich lye ve
couId nol ascerlain. The reason I feeI lhal he is imorlanl for us lraders
is because lo him lhe maller of knovIedge and discovery is nol so much
in deaIing vilh vhal ve knov, as in deaIing vilh vhal ve do nol knov.
His famous quole:
FA#)# '$# .#- ?%(A Y851 %1#')N YB( A%+A5, /$%(%/'5 8< (A#%$ 8?- %1#')j
(A#, ($, (8 <%-1 ?A#(A#$ (A#%$ %1#') '$# $%+A( Y, ($,%-+ <%$)( (8 <%-1
?A#(A#$ (A#, '$# -8( :#$A':) ?$8-+e FA#, ?8$> ?%(A Y851
/8-g#/(B$#) '-1 )#&#$# '((#.:() '( $#<B(%-+ (A#%$ 8?- /8-g#/(B$#)e
"These" are scienlisls. ul lhey couId be anylhing.
Iulling lhe masler in conlexl, Ioer vas rebeIIing againsl lhe grovlh
of science. Ioer inleIIecluaIIy came lo lhe vorId vilh lhe dramalic
shifls in hiIosohy as allemls vere made lo shifl il from lhe verbaI and
rheloricaI lo lhe scienlific and rigorous, as ve sav vilh lhe resenlalion
of lhe Vienna CircIe in Chaler 4. These eoIe vere somelimes caIIed
lhe IogicaI osilivisls, afler lhe movemenl caIIed :8)%(%&%). ioneered in
Irance in lhe nineleenlh cenlury by Augusle Comle, vhere osilivism
meanl scienlificalion of lhings (IileraIIy everylhing under lhe sun). Il vas
lhe equivaIenl of bringing lhe induslriaI revoIulion inlo lhe sofl sciences.
Wilhoul dveIIing on osilivism, I have lo nole lhal Ioer is lhe anlidole
lo osilivism. To him, verificalion is nol ossibIe. Verificalionism is
more dangerous lhan anylhing eIse. Taken lo lhe exlreme, Ioer's ideas
aear naive and rimilive - bul lhey vork. Nole lhal his delraclors caII
him a -'%&# <'5)%<%/'(%8-%)(e
I am an exceedingIy naive faIsificalionisl. Why` ecause I can survive
being one. My exlreme and obsessive Ioerism is carried oul as
foIIovs. I secuIale in aII of my aclivilies on lheories lhal reresenl some
vision of lhe vorId, bul vilh lhe foIIoving sliuIalion: no rare evenl
shouId harm me. In facl, I vouId Iike aII conceivabIe rare evenls lo heI
me. My idea of science diverges vilh lhal of lhe eoIe around me
vaIking around caIIing lhemseIves scienlisls. Science is mere
secuIalion, mere formuIalion of con|eclure.
n p c n s n c i c t y
Ioer's faIsificalionism is inlimaleIy connecled lo lhe nolion of an
oen sociely. An oen sociely is one in vhich no ermanenl lrulh is heId
lo exisl, lhis vouId aIIov counlerideas lo emerge. KarI Ioer shared
ideas vilh his friend, lhe Iov-key economisl Von Hayek vho endorsed
cailaIism as a slale in vhich rices can disseminale informalion lhal
bureaucralic sociaIism vouId choke. olh nolions of faIsificalionism
and oen sociely are, counlerinluiliveIy, connecled lo lhose of a
rigorous melhod for handIing randomness in my day |ob as a lrader.
CIearIy, an oen mind is a necessily vhen deaIing vilh randomness.
Ioer beIieved'lhal any idea of Uloia is necessariIy cIosed in lhe facl
lhal il chokes ils ovn refulalions. The simIe nolion of a good modeI for
sociely lhal cannol be Iefl oen for faIsificalion is lolaIilarian. I Iearned
from Ioer, in addilion lo lhe difference belveen an oen and a cIosed
sociely, lhal belveen an oen and a cIosed mind.
n n b n d y is p c r I c c t
I have some sobering informalion aboul Ioer lhe man. Wilnesses of
his rivale Iife find him ralher un-Ioerian. The hiIosoher and
Oxford don rian Magee
6
vho befriended him for cIose lo lhree
decades deicls him as unvorIdIy (excel in his youlh) and narrovIy
focused on his vork. He senl lhe Iasl 50 years of his Iong career
(Ioer Iived 92 years) cIosed lo lhe oulside vorId, insuIaled from
oulside dislraclions and slimuIalion. Ioer aIso engaged in giving
eoIe "firm sounding advice aboul lheir career or lheir rivale Iife,
lhough he had IillIe underslanding of eilher. AII lhis, of course, vas in
direcl conlravenlion of his rofessed (and indeed genuine) beIiefs, and
raclices, in hiIosohy."
He vas nol much beller in his youlh. Members of lhe Vienna CircIe
lried lo avoid him, nol because of his divergenl ideas, bul because he
Was a sociaI robIem. "He vas briIIianl, bul seIf-focused, bolh insecure
and arroganl, irascibIe and seIf-righleous. He vas a lerribIe Iislener and
benl on vinning argumenls al aII cosls. He had no underslanding of
grou dynamics and no abiIily lo negoliale lhem".
7
I viII refrain from commonIace discourse aboul lhe divorce belveen
lhose vho have ideas and lhose vho carry lhem in raclice, excel lo
bring oul lhe inleresling genelics robIem, ve Iike lo emil IogicaI and
ralionaI ideas bul ve do nol necessariIy #-g8, lhis execulion. Slrange as
il sounds, lhis oinl has onIy been discovered very recenlIy (ve viII see
lhal ve are nol genelicaIIy fil lo be ralionaI and acl ralionaIIy, ve are
mereIy fil for lhe maximum robabiIily of lransmilling our genes in
some given unsohislicaled environmenl). AIso slrange as il sounds,
George Soros, obsessiveIy seIf-crilicaI, seems lo be more Ioerian lhan
Ioer in his rofessionaI behavior.
p a s c a ! ' s w a g c r
I concIude vilh lhe exosilion of my ovn melhod of deaIing vilh lhe
robIem of induclion. The hiIosoher IascaI rocIaimed lhal lhe
olimaI slralegy for humans is lo beIieve in lhe exislence of God. Ior
if God exisls, lhen lhe beIiever vouId be revarded. If he does nol
exisl, lhe beIiever vouId have nolhing lo Iose. AccordingIy, ve need lo
accel lhe asymmelry in knovIedge, lhere are silualions in vhich
using slalislics and economelrics can be usefuI. ul I do nol vanl my
Iife lo deend on il.
Like IascaI, I viII lherefore slale lhe foIIoving argumenl. If lhe
science of slalislics can benefil me in anylhing, I viII use il. If il oses a
lhreal, lhen I viII nol. I vanl lo lake lhe besl of vhal lhe|`asl can give
me vilhoul ils dangers. AccordingIy, I viII use slalislics and induclive
melhods lo make aggressive bels, bul I viII nol use lhem lo manage my
risks and exosure. SurrisingIy, aII lhe surviving lraders I knov seem lo
have done lhe same. They lrade on ideas based on some observalion
(lhal incIudes asl hislory) bul, Iike lhe Ioerian scienlisls, lhey make
sure lhal lhe cosls of being vrong are Iimiled (and lheir robabiIily is
nol derived from asl dala). UnIike CarIos and }ohn, lhey knov before
gelling invoIved in lhe lrading slralegy vhich evenls vouId rove lheir
con|eclure vrong and aIIov for il (recaII lhal CarIos and }ohn used asl
hislory bolh lo make lheir bels and measure lheir risk). They vouId lhen
lerminale lheir lrade. This is caIIed a )(8: 58))N a redelermined exil
oinl, a roleclion from lhe bIack svan. I find il rareIy racliced.
4')/K :#$ <#1#/
IinaIIy, I have lo confess lhal uon finishing my vriling of Iarl I lhal
vriling aboul lhe genius of SoIon's insighl has carried an exlreme effecl
on bolh my lhinking and my rivale Iife. The comosilion of Iarl I
made me even more confidenl in my vilhdravaI from lhe media and my
dislancing myseIf from olher members of lhe business communily,
moslIy olher inveslors and lraders for vhom I am deveIoing more and
more conleml. I am currenlIy en|oying a lhriII of lhe cIassics I have nol
feIl since chiIdhood. My mind, by escaing lhe nevs oIIulion, aIIoved
me lo evade lhe buII markel lhal revaiIed over lhe asl 15 years (and
rofessionaIIy benefil from ils demise). I am nov lhinking of lhe nexl
sle: lo recreale a Iov-informalion, more delerminislic ancienl lime, say
in lhe nineleenlh cenlury, aII lhe vhiIe benefiling from some of lhe
lechnicaI gains (such as lhe Monle CarIo engine), aII of lhe medicaI
breaklhroughs and aII lhe gains of sociaI |uslice of our age. I vouId lhen
have lhe besl of everylhing. This is caIIed evoIulion.
PART II
U '
: o n k e y s o n l y e v r i l e r :
s u r v i v o r s h i a n d OTHE:
I
f one uls an infinile number of monkeys in fronl of (slrongIy buiIl)
lyevrilers, and Iels lhem cIa avay, lhere is a cerlainly lhal one of
lhem vouId come oul vilh an exacl version of lhe M5%'1e Uon
examinalion, lhis may be Iess inleresling a concel lhan il aears al
firsl: such robabiIily is very Iov. ul Iel us carry lhe reasoning one sle
beyond. Nov lhal ve have found lhal hero among monkeys, vouId any
reader invesl his Iife's savings on a bel lhal lhe monkey vouId vrile lhe
91,))#, nexl`
In lhis slory, il is lhe second sle lhal is inleresling. Hov much can
asl erformance (here lhe lying of lhe M5%'1d be reIevanl in forecasling
fulure erformance` The same aIies lo any decision based on asl
erformance, mereIy reIying on lhe allribules of lhe asl lime series.
Think aboul lhe monkey shoving u al your door vilh his imressive
asl erformance. Hey, he vrole lhe M5%'1e QuickIy, sign him u for lhe
sequeI.
The ma|or robIem vilh inference in generaI is lhal lhose vhose
rofession is lo derive concIusions from dala oflen faII inlo lhe lra
fasler and more confidenlIy lhan olhers. The more dala ve have, lhe
more IikeIy ve are lo drovn in il. Ior common visdom among eoIe
vilh a budding knovIedge of robabiIily Iavs is lo base lheir decision-
making on lhe foIIoving rinciIe: il is very unIikeIy for someone lo
114 MONKIYS ON TYIIWRITIRS
erform considerabIy veII in a consislenl fashion vilhoul his doing
somelhing righl. Track records lherefore become reeminenl. They caII
on lhe ruIe of lhe IikeIihood of such a successfuI run and leII lhemseIves
lhal if someone erformed beller lhan lhe resl in lhe asl lhen lhere is a
greal chance of him erforming beller lhan lhe crovd in lhe fulure -
and a very greal one al lhal. ul, as usuaI, bevare lhe middIebrov: a
smaII knovIedge of robabiIily can Iead lo vorse resuIls lhan no
knovIedge al aII.
i t dc pc nds n n t h c n u mb c r n I mn n k c y s
I do nol deny lhal if someone erformed beller lhan lhe crovd in lhe
asl, lhere is a resumlion of his abiIily lo do beller in lhe fulure. ul
lhe resumlion mighl be veak, very veak, lo lhe oinl of being useIess
in decision making. Why` ecause il aII deends on lvo faclors: lhe
randomness conlenl of his rofession and lhe number of monkeys in
oeralion.
The iniliaI samIe size mallers grealIy. If lhere are five monkeys in lhe
game, I vouId be ralher imressed vilh lhe M5%'1 vriler, lo lhe oinl of
susecling him lo be a reincarnalion of lhe ancienl oel. If lhere are a
biIIion lo lhe over one biIIion monkeys I vouId be Iess imressed - as a
maller of facl I vouId be surrised if one of lhem did nol gel some veII
knovn (bul unsecified) iece of vork, |usl by Iuck (erhas
Casanova's 3#.8%$) 8< 3, a%<#de One monkey vouId even be execled
lo rovide us vilh former Vice Iresidenl A1 Gore's 6'$(A %- (A# X'5'-/#N
erhas slried of lhe Ialiludes.
This robIem enlers lhe business vorId more viciousIy lhan olher
vaIks of Iife, oving lo lhe high deendence on randomness (ve have
aIready beIabored lhe conlrasl belveen randomness-deendenl business
vilh denlislry). The grealer lhe number of businessmen, lhe grealer lhe
IikeIihood of one of lhem erforming in a sleIIar manner |usl by Iuck. I.
have rareIy seen anyone counl lhe monkeys. In lhe same vein, fev counl
lhe inveslors in lhe markel in order lo caIcuIale, inslead of lhe
robabiIily of success, lhe condilionaI robabiIily of successfuI runs
given lhe number of inveslors in oeralion over a given markel hislory.
115 MONKIYS ON TYIIWRI TIRS
v i c i n u s r c a ! ! i I c
There are olher asecls lo lhe monkeys robIem, in reaI Iife lhe olher
monkeys are nol counlabIe, Iel aIone visibIe. They are hidden avay, as
one sees onIy lhe vinners - il is naluraI for lhose vho faiIed lo vanish
comIeleIy. AccordingIy, one sees lhe survivors, and onIy lhe survivors,
vhich imarls such a mislaken ercelion of lhe odds. We do nol
resond lo robabiIily, bul lo sociely's '))#)).#-( of il. As ?# )'? vilh
Nero TuIi, even eoIe vilh lraining in robabiIily resond
uninleIIigenlIy lo sociaI ressure.
t h i s s c c t i n n
Iarl I described silualions vhere eoIe do nol undersland lhe rare
evenl, and do nol seem lo accel eilher lhe ossibiIily of ils occurrence
or lhe dire consequences of such occurrence. Il aIso sel oul my ovn
ideas, lhose lhal do nol seem lo have been exIored in lhe Iileralure. ul
a book on randomness is nol comIele vilhoul a resenlalion of vhal
ossibIe biases one mighl have aside from lhe deformalions caused by
lhe rare evenl. The business of Iarl II is more edeslrian, I viII raidIy
rovide a synlhesis of lhe biases of randomness as discussed in lhe nov
abundanl Iileralure on lhe sub|ecl.
These biases can be oulIined as foIIovs: (a) lhe survivorshi biases
(a.k.a. monkeys on a (,:#?$%(#$dN '$%)%-+ from lhe <'/( lhal ve see onIy
vinners and gel a dislorled viev of lhe odds (Chalers 8 and 9, Too
3'-, 3%55%8-'%$#) and V$, '- 6++dN (b) lhe facl lhal Iuck is mosl
frequenlIy lhe reason for exlreme success (Chaler 10, a8)#$ F'>#) =55dN
and (c) lhe bioIogicaI handica of our inabiIily lo undersland
robabiIily (Chaler 11, K'-18.-#)) '-1 9B$ X$'%-de
FA$## %55B)($'(%8-) 8< (A# )B$&%&8$)A%: Y%')e TA, &#$, <#?
:#8:5# )A8B51 5%&# 8- ;'$> =&#-B#e FA# .%55%8-'%$# -#7( 188$
A') &#$, <5%.), /58(A#)e =- 8&#$/$8?1%-+ 8< #7:#$()e
7#N 4# <%#5 %'( <%./8 #L J).1$*(
s n m c w h a t ha ppy
M
arc Iives on Iark Avenue in Nev York Cily vilh his vife }anel
and lheir lhree chiIdren. He makes $500,000 a year, give or lake
a boom or a recession - he does nol beIieve lhal lhe recenl surl in
roserily is here lo Iasl and has nol menlaIIy ad|usled yel lo his recenl
abrul rise in income. A rolund man in his Iale forlies, vilh songy
fealures lhal make him Iook len years oIder lhan his age, he Ieads lhe
seemingIy comforlabIe (bul heckIed) Iife of a Nev York cily Iavyer. ul
he is on lhe quiel side of Manhallan residenls. Marc is cIearIy nol lhe
man one vouId execl lo go bar-hoing or allend Iale nighl Tribecca
and Soho arlies. He and his vife have a counlry house and a rose
garden and lend lo be concerned, Iike many eoIe of lheir age,
menlaIily, and condilion, vilh (in lhe foIIoving order) maleriaI
comforl, heaIlh, and slalus. Weekdays, he does nol come home unliI
al Ieasl 9.30 .m. and, al limes, he can be found in lhe office al cIose lo
midnighl. y lhe end of lhe veek, Marc is so faligued lhal he faIIs asIee
during lheir lhree-hour drive lo "lhe house", and Marc sends mosl of
Salurday Iying in bed recovering and heaIing.
Marc grev u in a smaII lovn in lhe midvesl, lhe son of a quiel lax
accounlanl vho vorked vilh shar yeIIov enciIs. His obsession vilh
sharness vas so slrong lhal he carried a sharener in his ockel al aII
limes. Marc exhibiled very earIy signs of inleIIigence. He did exlremeIy
veII in high schooI. He allended Harvard CoIIege, lhen YaIe Lav
SchooI. Nol bad, one vouId say. Laler his career look him lo cororale
Iav, vhere he slarled vorking on Iarge cases for a resligious Nev
York Iav firm, vilh bareIy enough hours Iefl for him lo brush his leelh.
This is nol loo much an exaggeralion, for he ale aImosl aII of his
dinners in lhe office, accumuIaling body fal and rovnie oinls
lovards his arlnershi. He Ialer became a arlner vilhin lhe usuaI
seven years, bul nol vilhoul lhe usuaI human cosls. His firsl vife
(vhom he mel in coIIege) Iefl him, as she vas lired of an absenlee
Iavyer husband and veary of lhe delerioralion in his conversalion -
bul, ironicaIIy, she ended u moving in vilh and Ialer marrying anolher
Nev York Iavyer, robabIy vilh a no-Iess fIal conversalion, bul vho
made her haier.
t n n m u c h w n r k
Marc's body became rogressiveIy fIabbier, and his laiIored suils needed
eriodic visils lo lhe laiIor, in sile of his occasionaI crash diels. Afler he
gol over lhe deression of lhe abandonmenl, he slarled daling }anel, his
araIegaI, and romlIy married her. They had lhree chiIdren in quick
succession, boughl lhe Iark Avenue aarlmenl, and lhe counlry house.
}anel's immediale acquainlance is comosed of lhe olher arenls of
lhe Manhallan rivale schooI allended by lheir chiIdren, and lheir
neighbors al lhe co-oeralive aarlmenl buiIding vhere lhey Iive. Irom
a maleriaIislic slandoinl, lhey come al lhe Iov end of such a sel,
erhas even al lhe exacl bollom. They vouId be lhe ooresl of lhese
TOO MANY MI LLI ONAI RIS NIXT DOOR 119
circIes, as lheir co-o is inhabiled by exlremeIy successfuI cororale
execulives, WaII Slreel lraders, and high-fIying enlrereneurs. Their
chiIdren's rivale schooI harbors lhe second sel of chiIdren of cororale
raiders, from lheir lrohy vives - erhas even lhe lhird sel, if one lakes
inlo accounl lhe age discreancy and lhe modeI-Iike fealures of lhe olher
molhers. y comarison, Marc's vife }anel, Iike him, resenls a homeIy
counlry-home-vilh-a-rose-garden lye of aearance.
y n u ' r c a I a i ! u r c
Marc's slralegy of slaying in Manhallan may be ralionaI, as his
demanding vork hours vouId make il imossibIe for him lo commule.
ul lhe cosls on his vife }anel are monslrous. Why` ecause of lheir
reIalive nonsuccess - as geograhicaIIy defined by lheir Iark Avenue
neighborhood. Ivery monlh or so, }anel has a crisis, giving in lo lhe
slrains and humiIialions of being snubbed by some olher molher al lhe
schooI vhere she icks u lhe chiIdren, or anolher voman vilh Iarger
diamonds by lhe eIevalor of lhe co-o vhere lhey Iive in lhe smaIIesl lye
of aarlmenls (lhe G Iine). Why isn'l her husband so successfuI` Isn'l he
smarl and hard vorking` Didn'l he gel cIose lo 1600 al lhe SAT` Why is
lhis RonaId Somelhing vhose vife never even nods lo }anel, vorlh
hundred of miIIions vhen her husband venl lo Harvard and YaIe and
has such a high I.Q., and has hardIy any subslanliaI savings`
We viII nol gel loo invoIved in lhe Chekovian diIemmas in lhe
rivale Iives of Marc and }anel, bul lheir case rovides a very common
iIIuslralion of lhe emolionaI effecl of )B$&%&8$)A%: Y%')e }anel feeIs lhal
her husband is a faiIure, by comarison, bul she is mis-comuling lhe
robabiIilies in a gross manner - she is using lhe vrong dislribulion lo
derive a rank. As comared lo lhe generaI U.S. ouIalion, Marc has
done very veII, beller lhan 99.5% of his comalriols. As comared lo
his high-schooI friends, he did exlremeIy veII, a facl lhal he couId have
verified had he had lime lo allend lhe eriodic reunions, and he vouId
come al lhe lo. As comared lo lhe olher eoIe al Harvard, he did
beller lhan 90% of lhem (financiaIIy, of course). As comared lo his Iav
schooI comrades al YaIe, he did beller lhan 60% of lhem. ul as
comared lo his co-o neighbors, he is al lhe bollom! Why` ecause he
DL_ MONKIYS ON TYIIWRITIRS
chose lo Iive among lhe eoIe vho have been successfuI, in an area lhal
excIudes faiIure. In olher vords, lhose vho have faiIed do nol shov u
in lhe samIe al aII, lhus making him Iook as if he vere nol doing veII al
aII. y Iiving on Iark Avenue, one does nol have exosure lo lhe Iosers,
one onIy sees lhe vinners. As ve are cul lo Iive in very smaII com-
munilies, il is difficuIl lo assess our silualion oulside of lhe narrovIy
defined geograhic confines of our habilal. In lhe case of Marc and
}anel, lhis Ieads lo considerabIe emolionaI dislress, here ve have a
voman vho married an exlremeIy successfuI man bul aII she can see is
comaralive faiIure, for she cannol emolionaIIy comare him lo a
samIe lhal vouId do him |uslice.
Someone vouId ralionaIIy say lo }anel: "go read lhis book, V885#1 Y,
K'-18.-#)) by one malhemalicaI lrader on lhe deformalions of chance
in Iife, il vouId give you a slalislicaI sense of erseclive and vouId
accordingIy make you feeI beller". As an aulhor, I vouId Iike lo offer a
anacea for $27.95, bul I vouId ralher say lhal in my besl hoes il may
rovide an hour or so of soIace. }anel may need somelhing more draslic
for reIief. I have reealed lhal becoming more ralionaI, or nol feeIing
emolions of sociaI sIighls is nol arl of lhe human race, al Ieasl nol vilh
our currenl DNA code. There is no soIace lo be found from reasoning -
as a lrader I have Iearned somelhing aboul lhese unfruilfuI efforls lo
reason againsl lhe grain. I vouId advise }anel lo move oul, and go Iive in
some bIue-coIIar neighborhood vhere lhey vouId feeI Iess humiIialed by
lheir neighbors and rise in lhe ecking order beyond lheir robabiIily of
success. They couId use lhe deformalion in lhe oosile direclion. If
}anel cares aboul slalus, lhen I vouId even recommend some of lhese
Iarge housing bIocks.
>#$"1( <$*D.D#*,'.5 M.),(,
m n r c c x p c r t s
I recenlIy read a beslseIIer caIIed FA# 3%55%8-'%$# E#7( "88$N an
exlremeIy misIeading (bul aImosl en|oyabIe) book by lvo "exerls", in
vhich lhe aulhors lry lo infer some allribules lhal are common lo rich
eoIe. They examined a coIIeclion of currenlIy veaIlhy eoIe and
found oul lhal lhese are unIikeIy lo Iead Iavish Iives. They caII such
eoIe lhe accumuIalors, ersons ready lo oslone consumlion in
order lo amass funds. Mosl of lhe aeaI of lhe book comes from lhe
simIe bul counlerinluilive facl lhal lhese are Iess IikeIy lo Iook Iike very
rich eoIe - il cIearIy cosls money lo Iook and behave rich, nol lo counl
lhe lime demands of sending money. Leading roserous Iives is lime
consuming, shoing for lrendy cIolhes, becoming conversanl in
ordeaux vines, gelling lo knov lhe exensive reslauranls. AII lhese
aclivilies can ul high demands on one's lime and diverl lhe sub|ecl
from vhal shouId be lhe reaI reoccualion, nameIy lhe accumuIalion
of nominaI (and aer) veaIlh. The moraI of lhe book is lhal lhe
veaIlhiesl are lo be found among lhose Iess susecled lo be veaIlhy. On
lhe olher hand, lhose vho acl and Iook veaIlhy sub|ecl lheir nel vorlh
lo such a drain lhal lhey infIicl considerabIe and irreversibIe damage lo
lheir brokerage accounl.
I viII sel aside lhe oinl lhal I see no seciaI A#$8%). in accumuIaling
money, arlicuIarIy if, in addilion, lhe erson is fooIish enough lo nol
even lry lo derive any langibIe benefil from lhe veaIlh (aside from lhe
Ieasure of reguIarIy counling lhe beans). I have no Iarge desire lo
sacrifice much of my ersonaI habils, inleIIecluaI Ieasures, and
ersonaI slandards in order lo become a biIIionaire Iike Warren uffell,
and I cerlainIy do nol see lhe oinl of becoming one if I vere lo adol
Sarlan (even miserIy) habils and Iive in my slarler house. Somelhing
aboul lhe raise Iavished uon him for Iiving in auslerily vhiIe being so
rich escaes me, if auslerily is lhe end, he shouId become a monk or a
sociaI vorker - ve shouId remember lhal becoming rich is a ureIy
seIfish acl, nol a sociaI one. The virlue of cailaIism is lhal sociely can
lake advanlage of eoIe's greed ralher lhan lheir benevoIence, bul
lhere is no need lo, in addilion, exloI such greed as a moraI (or
inleIIecluaI) accomIishmenl (lhe reader can easiIy see lhal, aside from
very fev excelions Iike George Soros, I am nol imressed by eoIe
vilh money). ecoming rich is nol direclIy a moraI achievemenl, bul
lhal is nol vhere lhe severe fIav in lhe book Iies.
As ve said, lhe heroes of FA# 3%55%8-'%$# E#7( "88$ are lhe
accumuIalors, eoIe vho defer sending in order lo invesl. Il is
undeniabIe lhal such slralegy mighl vork, money senl bears no fruil
(excel lhe en|oymenl of lhe sender). ul lhe benefils romised in lhe
book seem grossIy overslaled. A finer read of lheir lhesis- reveaIs lhal
lheir samIe incIudes a doubIe dose of survivorshi bias. In olher vords,
il has lvo comounding fIavs.
v i s i b i ! i t y wi n n c r s
The firsl bias comes from lhe facl lhal lhe rich eoIe seIecled for lheir
samIe are among lhe Iucky monkeys on lyevrilers. The aulhors made
no alleml lo correcl lheir slalislics vilh lhe facl lhal lhey sav onIy lhe
vinners. They make no menlion of lhe "accumuIalors" vho have
accumuIaled lhe vrong lhings (members of my famiIy are exerls on
lhal, lhose vho accumuIaled managed lo accumuIale currencies aboul
lo be devaIued and slocks of comanies lhal Ialer venl busl). Novhere
do ve see a menlion of lhe facl lhal some eoIe vere Iucky enough lo
have invesled in lhe vinners, lhese eoIe no doubl vouId make lheir
vay inlo lhe book. There is a vay lo lake care of lhe bias: Iover lhe
veaIlh of your average miIIionaire by, say, 50%, on lhe grounds lhal lhe
bias causes lhe average nel vorlh of lhe observed miIIionaire lo be
higher by such amounl (il consisls in adding lhe effecl of lhe Iosers inlo
lhe ol). Il vouId cerlainIy modify lhe concIusion.
t i t ' s a b u ! ! m a r k c t
As lo lhe second, more serious fIav, I have aIready discussed lhe
robIem of induclion. The slory focuses on an unusuaI eisode in
hislory, buying ils lhesis imIies acceling lhal lhe currenl relurns in
assel vaIues are ermanenl (lhe sorl of beIief lhal revaiIed before lhe
greal crash lhal slarled in 1929). Remember lhal assel rices have (sliII
al lhe lime of vriling) vilnessed lhe grealesl buII markel in hislory and
lhal vaIues did comound aslronomicaIIy during lhe asl lvo decades.
A doIIar invesled in lhe average slock vouId have grovn aImosl lvenly-
foId since 1982 - and lhal is lhe average slock. The samIe mighl
incIude eoIe vho invesled in slocks erforming beller lhan average.
VirluaIIy aII of lhe sub|ecls became rich from assel rice infIalion, in
olher vords from lhe recenl infIalion in financiaI aer and assels lhal
slarled in 1982. An inveslor vho engaged in lhe same slralegy during
Iess augusl days for lhe markel vouId cerlainIy have a differenl slory lo
leII. Imagine lhe book being vrillen in 1982, afler lhe roIonged erosion
of lhe infIalion-ad|usled vaIue of lhe slocks, or in 1935, afler lhe Ioss of
inleresl in lhe slock markel.
Or consider lhal lhe Uniled Slales slock markel is nol lhe onIy
inveslmenl vehicIe. Consider lhe fale of lhose vho, in Iace of sending
lheir money buying exensive loys and aying for ski lris, boughl
Lebanese Iira denominaled Treasury biIIs (as my grandfalher did), or
|unk bonds from MichaeI MiIken (as many of my coIIeagues in lhe
1980s did). Go back in hislory and imagine lhe accumuIalor buying
Russian ImeriaI bonds bearing lhe signalure of Czar NichoIas II and
lrying lo accumuIale furlher by cashing lhem from lhe Soviel govern-
menl, or Argenline reaI eslale in lhe 1930s (as my greal grandfalher
did).
The mislake of ignoring lhe survivorshi bias is chronic, even (or
erhas eseciaIIy) among rofessionaIs. Hov` ecause ve are lrained
lo lake advanlage of lhe informalion lhal is Iying in fronl of our eyes,
, ignoring lhe informalion lhal ve do nol see.
A brief summing u al lhis oinl: I shoved hov ve lend lo mislake
one reaIizalion among aII ossibIe random hislories as lhe mosl
reresenlalive one, forgelling lhal lhere may be olhers. In a nulsheII,
lhe survivorshi bias imIies lhal (A# A%+A#)( :#$<8$.%-+ $#'5%Z'(%8- ?%55
Y# (A# .8)( &%)%Y5#e Why` ecause lhe Iosers do nol shov u.
! F$*$U, I5./.#/
The fund managemenl induslry is ouIaled vilh gurus. CIearIy, lhe
fieId is randomness-Iaden and lhe guru is going lo faII inlo a lra,
arlicuIarIy if he has no roer lraining in inference. Al lhe lime of
vriling, lhere is one such guru vho deveIoed lhe very unforlunale
habil of vriling books on lhe sub|ecl. AIong vilh one of his eers, he
comuled lhe success of a "Robin Hood" oIicy of invesling vilh lhe
Ieasl successfuI manager in a given ouIalion of managers. Il consisls in
svilching dovn by laking money avay from lhe vinner and aIIocaling
il lo lhe Ioser. This goes againsl lhe revaiIing visdom of invesling vilh
a vinning manager and laking avay money from a Iosing one. Doing so,
lheir "aer slralegy" (i.e. as in a MonooIy game, nol execuled in
reaI Iife) derived considerabIy higher relurns lhan if lhey sluck lo lhe
vinning manager. Their hyolhelicaI examIe seemed lo lhem lo rove
lhal one shouId nol slay vilh lhe besl manager, as ve vouId be incIined
lo do, bul ralher svilch lo lhe vorsl manager, or al Ieasl such seems lo
be lhe oinl lhey vere allemling lo convey.
Their anaIysis resenls one severe hilch lhal any graduale sludenl in
financiaI economics shouId be abIe lo inoinl al lhe firsl reading. Their
samIe onIy had )B$&%&8$)e They simIy forgol lo lake inlo accounl lhe
managers vho venl oul of business. Such a samIe incIudes managers
lhal vere oeraling during lhe simuIalion, and '$# )(%55 8:#$'(%-+ (81',e
True, lheir samIe incIuded managers vho did oorIy, bul onIy lhose
managers vho did oorIy and recovered, vilhoul gelling oul of
business. So il vouId be obvious lhal invesling vilh lhose vho fared
oorIy al some oinl, bul recovered (vilh lhe benefil of hindsighl)
vouId yieId a osilive relurn! Had lhey conlinued lo fare oorIy, lhey
vouId be oul of business and vouId nol be incIuded in lhe samIe.
Hov shouId one conducl lhe roer simuIalion` y laking a
ouIalion of managers in exislence, say, five years ago and running
lhe simuIalion unliI loday. CIearIy, lhe allribules of lhose vho Ieave lhe
ouIalion are biased lovards faiIure, fev successfuI eoIe in such a
Iucralive business caII il quils for making loo much money. Nexl ve
lurn lo a more lechnicaI resenlalion of lhese issues.
n i n e
i l is e a s i e r l o buy a n d s e I I
l h a n f r y a n e g g
*8.# (#/A-%/'5 #7(#-)%8-) 8< (A# )B$&%&8$)A%: Y%')e 9- (A#
1%)($%YB(%8- 8< h/8%-/%1#-/#)h %- 5%<#e M( %) :$#<#$'Y5# (8 Y# 5B/>,
(A'- /8.:#(#-( cYB( ,8B /'- Y# /'B+A(de FA# Y%$(A1', :'$'187e
38$# /A'$5'('-) c'-1 .8$# g8B$-'5%)()de 08? (A# $#)#'$/A#$
?%(A ?8$> #(A%/) /'- <%-1 gB)( 'Y8B( '-,(A%-+ %- 1'('e 9- 18+)
his aflernoon I have an aoinlmenl vilh my denlisl (il viII moslIy
consisl in lhe denlisl icking my brain on raziIian bonds). I can slale
vilh a cerlain IeveI of comforl lhal he knovs somelhing aboul leelh,
arlicuIarIy if I enler his office vilh a loolhache and exil il vilh some form
of reIief. Il viII be difficuIl for someone vho knovs IileraIIy nolhing aboul
leelh lo rovide me vilh such reIief, excel if he is arlicuIarIy Iucky on
lhal day - or has been very Iucky in his Iife lo become a denlisl vhiIe nol
knoving anylhing aboul leelh. Looking al his diIoma on lhe vaII, I
delermine lhal lhe odds lhal he reealedIy gave correcl ansvers lo lhe
exam queslions and erformed salisfacloriIy on a fev lhousand cavilies
before his gradualion - oul of Iain randomness - are remarkabIy smaII.
Laler in lhe evening, I go lo Carnegie HaII. I can say IillIe aboul lhe
ianisl, I even forgol her unfamiIiar foreign sounding name. AII I knov
-8( Y'$>%-+e
is lhal she sludied in some Muscovile conservalory. ul I can execl lo
gel some music oul of lhe iano. Il viII be rare lo have someone vho
erformed briIIianlIy enough in lhe asl lo gel lo Carnegie HaII and nov
lurns oul lo have benefiled from Iuck aIone. The execlalion of having a
fraud vho viII bang on lhe iano, roducing onIy cacohonous sounds,
is indeed Iov enough for me lo ruIe il oul comIeleIy.
I vas in London Iasl Salurday. Salurdays in London are magicaI,
buslIing bul vilhoul lhe mechanicaI induslry of a veekday or lhe sad
resignalion of a Sunday. Wilhoul a vrislvalch or a Ian I found myseIf
in fronl of my favorile carvings by Canova al lhe Vicloria and AIberl
Museum. My rofessionaI benl immedialeIy made me queslion vhelher
randomness Iayed a Iarge roIe in lhe carving of lhese marbIe slalues.
The bodies vere reaIislic reroduclions of human figures, excel lhal
lhey vere more harmonious and fineIy baIanced lhan anylhing I have
seen molher nalure roduce on ils ovn (Ovid's .'(#$%#. )B:#$'Y'(
8:B) comes lo mind). CouId such finesse be a roducl of Iuck`
I can raclicaIIy make lhe same slalemenl aboul anyone oeraling in
lhe hysicaI vorId, or in a business in vhich lhe degree of randomness is
Iov. ul lhere is a robIem in anylhing reIaled lo lhe business vorId. I
am bolhered because lomorrov, unforlunaleIy, I have an aoinlmenl
vilh a fund manager seeking my heI, and lhal of my friends, in finding
inveslors. He has vhal he cIaims is a +881 ($'/> $#/8$1e AII I can infer is
lhal he has Iearned lo buy and seII. And il is harder lo fry an egg lhan
buy and seII. WeI I . . . lhe facl lhal he made money in lhe asl may have
some reIevance, bul nol lerribIy so. This is nol lo say lhal il is aIvays lhe
case, lhere are some inslances in vhich one can lrusl a lrack record, bul,
aIas, lhere are nol loo many of lhese. As lhe reader nov knovs, lhe fund
manager can execl lo be heckIed by me during lhe resenlalion,
arlicuIarIy if he does nol exhibil lhe minimum of humiIily and seIf-
doubl lhal I vouId execl from someone raclicing randomness. I viII
robabIy bombard him vilh queslions lhal he may nol be reared lo
ansver, bIinded by his asl resuIls. I viII robabIy Ieclure him lhal.
MachiaveIIi ascribed lo Iuck al Ieasl a 50% roIe in Iife (lhe resl vas
cunning and bravura), and lhal vas before lhe crealion of modern
markels.
In lhis chaler, I discuss some veII-knovn counlerinluilive roerlies
of erformance records and hisloricaI lime series. The concel resenled
I T IS IASI IR TO UY AND SILL THAN IRY AN IGG 127
here is veII knovn for some of ils varialions under lhe name )B$&%&8$)A%:
Y%')N 1'(' .%-%-+N 1'(' )-88:%-+N 8&#$<%((%-+N $#+$#))%8- (8 (A# .#'-N elc.,
basicaIIy silualions vhere lhe erformance is exaggeraled by lhe
observer, oving lo a misercelion of lhe imorlance of randomness.
CIearIy, lhis concel has ralher unsellIing imIicalions. Il exlends lo
more generaI silualions vhere randomness may Iay a share, such as lhe
choice of a medicaI lrealmenl or lhe inlerrelalion of coincidenlaI evenls.
When I am lemled lo suggesl a ossibIe fulure conlribulion of
financiaI research lo science in generaI, I adduce lhe anaIysis of dala
mining and lhe sludy of survivorshi biases. These have been refined in
finance bul can exlend lo aII areas of scienlific invesligalion. Why is
finance so rich a fieId` ecause il is one of lhe rare areas of invesligalion
vhere ve have Ienly of informalion (in lhe form of abundanl rice
series), bul no abiIily lo conducl exerimenls as in, say, hysics. This
deendence on asl dala brings aboul ils saIienl defecls.
J##1(2 "C 3$="(*,
p ! a c c b n i n v c s t n r s
I have oflen been faced vilh queslions of lhe sorl: "Who do you lhink
you are lo leII me lhal I mighl have been Iain Iucky in my Iife`" WeII,
nobody reaIIy beIieves lhal he or she vas Iucky. My aroach is lhal,
vilh our Monle CarIo engine, ve can manufaclure ureIy random
silualions. We can do lhe exacl oosile of convenlionaI melhods, in
Iace of anaIyzing reaI eoIe hunling for allribules ve can creale
arlificiaI ones vilh reciseIy knovn allribules. Thus ve can manufac-
lure silualions lhal deend on ure, unaduIleraled Iuck, vilhoul lhe
shadov of skiIIs or vhalever ve have caIIed non-Iuck in TabIe I. I. In
olher vords, ve can man-make ure nobodies lo Iaugh al, lhey viII be
Y, 1#)%+- slried of any shadov of abiIily (exaclIy Iike a Iacebo drug).
We sav in Chaler 5 hov eoIe may survive oving lo lrails lhal
momenlariIy fil lhe given slruclure of randomness. Here ve lake a far
simIer silualion vhere ?# >-8? (A# )($B/(B$# 8< $'-18.-#))HN lhe firsl
such exercise is a finessing of lhe oId ouIar saying lhal #&#- ' Y$8>#-
/58/> %) $%+A( (?%/# ' 1',e We viII lake il a bil furlher lo shov lhal
slalislics is a knife lhal culs on bolh sides. Lel us use lhe Monle CarIo
generalor inlroduced earIier and conslrucl a ouIalion of 10,000
ficlionaI inveslmenl managers (lhe generalor is nol lerribIy necessary
since ve can use a coin, or even do Iain aIgebra, bul il is considerabIy
more iIIuslralive - and fun). Assume lhal lhey each have a erfeclIy fair
game, each one has a 50% robabiIily of making $10,000 al lhe end of
lhe year, and a 50% robabiIily of Iosing $10,000. Lel us inlroduce an
addilionaI reslriclion, once a manager has a singIe bad year, he is
lhrovn oul of lhe samIe, good-bye and have a nice Iife. Thus ve viII
oerale Iike lhe Iegendary secuIalor George Soros vho vas said lo leII
his managers galhered in a room: "haIf of you guys viII be oul by nexl
year" (vilh an Iaslern Iuroean accenl). Like Soros, ve have exlremeIy
high slandards, ve are Iooking onIy for managers vilh an unbIemished
record. We have no alience for Iov erformers.
The Monle CarIo generalor viII loss a coin, A#'1) and lhe manager
viII make $10,000 over lhe year, ('%5) and he viII Iose $10,000. We run
il for lhe firsl year. Al lhe end of lhe year, ve execl 5,000 managers lo
be u $10,000 each, and 5,000 lo be dovn $10,000. Nov ve run lhe
game a second year. Again, ve can execl 2,500 managers lo be u lvo
years in a rov, anolher year, 1,250, a fourlh one, 625, a fiflh, 313. We
have nov, simIy in a fair game, 313 managers vho made money for
five years in a rov. Oul of ure Iuck.
n n b n d y h a s t n bc c n m p c t c n t
Lel's ush lhe argumenl furlher lo make il more inleresling. We creale a
cohorl lhal is comosed excIusiveIy of incomelenl managers. We viII
define an incomelenl manager as someone vho has a negalive #7:#/(#1
$#(B$-N lhe equivaIenl of lhe odds being slacked againsl him. We inslrucl,
lhe Monle CarIo generalor nov lo drav from an urn. The urn has 100
baIIs, 45 bIack and 55 red. y draving vilh reIacemenl, lhe ralio of
red lo bIack baIIs viII remain lhe same. If ve drav a bIack baII, lhe
manager viII earn $10,000. If ve drav a red baII, he viII Iose $10,000.
The manager is lhus execled lo earn $10,000 vilh 45% robabiIily,
and Iose $10,000 vilh 55%. On average, lhe manager viII Iose $1,000
each round - bul onIy 8- '&#$'+#e
Al lhe end of lhe firsl year, ve sliII execl lo have 4,500 managers
lurning a rofil (45% of lhem), lhe second, 45% of lhal number, 2,025.
The lhird, 911, lhe fourlh, 410, lhe fiflh, 184. Lel us give lhe surviving
managers names and dress lhem in business suils. True, lhey reresenl
Iess lhan 2% of lhe originaI cohorl. ul lhey viII gel allenlion. Nobody
viII menlion lhe olher 98%. Whal can ve concIude`
The firsl counlerinluilive oinl is lhal a ouIalion enlireIy comosed
of bad managers viII roduce a smaII amounl of greal lrack records. As
a maller of facl, assuming lhe manager shovs u unsoIiciled al your
door, il viII be raclicaIIy imossibIe lo figure oul vhelher he is good or
bad. The resuIls vouId nol markedIy change, even if lhe ouIalion
vere comosed enlireIy of managers vho are execled in lhe Iong run lo
Iose money. Why` ecause oving lo voIaliIily, some of lhem viII make
money. We can see here lhal voIaliIily acluaIIy heIs bad inveslmenl
decisions.
The second counlerinluilive oinl is lhal lhe #7:#/('(%8- 8< (A#
.'7%.B. of lrack records, vilh vhich ve are concerned, deends more
on lhe size of lhe iniliaI samIe, lhan on lhe individuaI odds er
manager. In olher vords lhe number of managers vilh greal lrack
records in a given markel deends far more on lhe number of eoIe
vho slarled in lhe inveslmenl business (in Iace of going lo denlaI
schooI), ralher lhan on lheir abiIily lo roduce rofils. Il aIso deends
on lhe voIaliIily. Why do I use lhe nolion of execlalion of lhe
maximum` ecause I am nol concerned al aII vilh lhe average lrack
record. I viII gel lo see onIy lhe Y#)( of lhe managers, nol aII of lhe
managers. This means lhal ve viII see more "exceIIenl managers" in
2002 lhan in 1998, rovided lhe cohorl of beginners vas grealer in
1997 lhan il vas in 1993 - I can safeIy say lhal il vas.
c r g n d i c i t y
To gel more lechnicaI, I have lo say lhal eoIe beIieve lhal lhey can
figure oul lhe roerlies of lhe dislribulion from lhe samIe lhey are
vilnessing. When il comes lo mallers lhal deend on lhe maximum, il is
aIlogelher anolher dislribulion lhal is being inferred, lhal of lhe besl
erformers. We caII lhe difference belveen lhe average of such
dislribulion and lhe uncondilionaI dislribulion of vinners and Iosers
lhe )B$&%&8$)A%: Y%') H here lhe facl lhal aboul 3% of lhe iniliaI cohorl
viII make money five years in a rov. In addilion, lhis examIe iIIuslrales
lhe roerlies of #$+81%/%(,N nameIy, lhal lime viII eIiminale lhe
annoying effecls of randomness. Looking forvard, in sile of lhe facl
lhal lhese managers vere rofilabIe in lhe asl five years, ve execl
lhem lo break even in any fulure lime eriod. They viII fare no beller
lhan lhose of lhe iniliaI cohorl vho faiIed earIier in lhe exercise. Ah, lhe
Iong lerm.
A fev years ago, vhen I loId one A., a lhen Masler-of-lhe-Universe
lye, lhal lrack records vere Iess reIevanl lhan he lhoughl, he found lhe
remark so offensive lhal he vioIenlIy fIung his cigarelle Iighler in my
direclion. The eisode laughl me a Iol. Remember lhal nobody accels
randomness in his ovn success, onIy his faiIure. His ego vas umed u
as he vas heading u a dearlmenl of "greal lraders" vho vere lhen
lemorariIy making a forlune in lhe markels. They subsequenlIy bIev
u during lhe harsh Nev York vinler of 1994 (il vas lhe bond markel
crash lhal foIIoved lhe surrise inleresl rale hike by AIan Greensan).
The inleresling arl is lhal six years Ialer I can hardIy find any of lhem
sliII lrading (ergodicily).
RecaII lhal lhe survivorshi bias deends on lhe size of lhe iniliaI
ouIalion. The informalion lhal a erson made money in lhe asl, |usl
by ilseIf, is neilher meaningfuI nor reIevanl. We need lo knov lhe size of
lhe ouIalion from vhich he came. In olher vords, vilhoul knoving
hov many managers oul lhere have lried and faiIed, ve viII nol be abIe
lo assess lhe vaIidily of lhe lrack record. If lhe iniliaI ouIalion
incIudes len managers, lhen I vouId give lhe erformer haIf my savings
vilhoul a bIink. If lhe iniliaI ouIalion is comosed of 10,000
managers, I vouId ignore lhe resuIls. The Ialler silualion is generaIIy lhe
case, lhese days so many eoIe have been dravn lo lhe financiaI
markels. Many coIIege graduales are lrading as a firsl career, faiIing,
lhen going lo denlaI schooI.
If, as in a fairy laIe, lhese ficlionaI managers maleriaIized inlo reaI
human beings, one of lhese couId be lhe erson I am meeling lomorrov
al 11.45 a.m. Why did I seIecl 11.45 a.m.` ecause I viII queslion him
aboul his lrading slyIe. I need lo knov hov he lrades. I viII lhen be abIe
lo cIaim lhal I have lo rush lo a Iunch aoinlmenl if lhe manager uls
loo much emhasis on his lrack record.
V.L( ?, 0#./@.2(/%)1
Nexl ve Iook al lhe exlensions lo reaI Iife of our bias in lhe
underslanding of lhe dislribulion of coincidences.
t h c my s t c r i n u s ! c t t c r
You gel an anonymous Ieller on }anuary 2nd informing you lhal lhe
markel viII go u during lhe monlh. Il roves lo be lrue, bul you
disregard il oving lo lhe veII-knovn }anuary effecl (slocks have gone
u hisloricaIIy during }anuary). Then you receive anolher one on Ieb 1sl
leIIing you lhal lhe markel viII go dovn. Again, il roves lo be lrue.
Then you gel anolher Ieller on March 1sl - same slory. y }uIy you are
inlrigued by lhe rescience of lhe anonymous erson and you are asked
lo invesl in a seciaI offshore fund. You our aII your savings inlo il.
Tvo monlhs Ialer, your money is gone. You go siII your lears on your
neighbor's shouIder and he leIIs you lhal he remembers lhal he received
lvo such myslerious Iellers. ul lhe maiIings sloed al lhe second
Ieller. He recaIIs lhal lhe firsl one vas correcl in ils rediclion, lhe olher
incorrecl.
Whal haened` The lrick is as foIIovs. The con oeralor uIIs
10,000 names oul of a hone book. He maiIs a buIIish Ieller lo one haIf
of lhe samIe, and a bearish one lo lhe olher haIf. The foIIoving monlh
he seIecls lhe names of lhe ersons lo vhom he maiIed lhe Ieller vhose
rediclion lurned oul lo be righl, lhal is, 5,000 names. The nexl monlh
he does lhe same vilh lhe remaining 2,500 names, unliI lhe Iisl narrovs
dovn lo 500 eoIe. Of lhese lhere viII be 200 viclims. An inveslmenl
in a fev lhousand doIIars vorlh of oslage slams viII lurn inlo severaI
miIIion.
a n i n t c r r u p t c d t c n n i s g a mc
Il is nol uncommon for someone valching a lennis game on leIevision lo
be bombarded by adverlisemenls for funds lhal did (unliI lhal minule)
oulerform olhers by some ercenlage over some eriod. ul, again,
vhy vouId anybody adverlise if he didn'l haen lo oulerform lhe
markel` There is a high robabiIily of lhe inveslmenl coming lo you if
ils success is caused enlireIy by randomness. This henomenon is vhal
economisls and insurance eoIe caII adverse seIeclion. }udging an
inveslmenl lhal comes lo you requires more slringenl slandards lhan
|udging an inveslmenl you seek, oving lo such seIeclion bias. Ior
examIe, by going lo a cohorl comosed of 10,000 managers, I have 2/
100 chances of finding a surious survivor. y slaying home and
ansvering my door beII, lhe chance of lhe soIiciling arly being a
surious survivor is cIoser lo 100%.
t h c b i r t h d a y p a r a d n x
The mosl inluilive vay lo describe lhe dala mining robIem lo a non-
slalislician is lhrough vhal is caIIed lhe birlhday aradox, lhough il is
nol reaIIy a aradox, simIy a ercelionaI oddily. If you meel
someone randomIy, lhere is a one in 365.25 chance of your sharing
lheir birlhday, and a considerabIy smaIIer one of having lhe exacl
birlhday of lhe same year. So, sharing lhe same birlhday vouId be a
coincidenlaI evenl lhal you vouId discuss al lhe dinner labIe. Nov Iel
us Iook al a silualion vhere lhere are 23 eoIe in a room. Whal is lhe
chance of lhere being lvo eoIe vilh lhe same birlhday` Aboul 50%.
Ior ve are nol secifying vhich eoIe need lo share a birlhday, any
air vorks.
i t ' s a s m a ! ! wn r ! d .
1
A simiIar misconcelion of robabiIilies arises from lhe random
encounlers one may have vilh reIalives or friends in highIy unexecled
Iaces. "Il's a smaII vorId" is oflen ullered vilh surrise. ul lhese are
nol imrobabIe occurrences - lhe vorId is much Iarger lhan ve lhink. Il
is |usl lhal ve are nol lruIy lesling for lhe odds of having an encounler
vilh one secific erson, in a secific Iocalion al a secific lime. Ralher,
ve are simIy lesling for any encounler, vilh any erson ve have ever
mel in lhe asl, and in any Iace ve viII visil during lhe eriod
concerned. The robabiIily of lhe Ialler is considerabIy higher, erhas
severaI lhousand limes lhe magnilude of lhe former.
When lhe slalislician Iooks al lhe dala (8 (#)( ' +%&#- $#5'(%8-)A%:, say
lo ferrel oul lhe correIalion belveen lhe occurrence of a given evenl, Iike
a oIilicaI announcemenl, and slock markel voIaliIily, odds are lhal lhe
resuIls can be laken seriousIy. ul vhen one lhrovs lhe comuler al
dala, Iooking for |usl aboul '-, reIalionshi, il is cerlain lhal a surious
conneclion viII emerge, such as lhe fale of lhe slock markel being Iinked
lo lhe Ienglh of vomen's skirls. And |usl Iike lhe birlhday coincidences,
il viII amaze eoIe.
d a t a mi ni ng , s t a t i s t i c s , a n d c h a r ! a t a n i s m
Whal is your robabiIily of vinning lhe Nev }ersey Iollery lvice` One
in 17 lriIIion. Yel il haened lo IveIyn Adams, vhom lhe reader mighl
guess shouId feeI arlicuIarIy chosen by desliny. Using lhe melhod ve
deveIoed above, Harvard's Iercy Diaconis and Irederick MosleIIer
eslimaled al 30 lo 1 lhe robabiIily lhal someone, somevhere, in a
lolaIIy unsecified vay, gels so Iucky!
Some eoIe carry lheir dala mining aclivilies inlo lheoIogy - afler
aII, ancienl Medilerraneans used lo read olenl messages in lhe enlraiIs
of birds. An inleresling exlension of dala mining inlo bibIicaI exegesis is
rovided in FA# X%Y5# @81# by MichaeI Drosnin. Drosnin, a former
|ournaIisl (seemingIy innocenl of any lraining in slalislics), aided by lhe
vorks of a "malhemalician", heIed "redicl" Rabin's assassinalion by
decihering a bibIe code. He informed Rabin, vho obviousIy did nol
lake il loo seriousIy. FA# X%Y5# @81# finds slalislicaI irreguIarilies in lhe
ibIe,- lhese heI :$#1%/( )8.# )B/A evenls. NeedIess lo say lhal lhe book
soId veII.
t h c b c s t b n n k i h a v c c v c r r c a d !
My favorile lime is senl in bookslores, vhere I aimIessIy move from
book lo book in an alleml lo make a decision as lo vhelher lo invesl
lhe lime in reading il. My buying is frequenlIy made on imuIse, based
on suerficiaI bul suggeslive cIues. IrequenlIy I have nolhing bul a book
|ackel as aendage lo my decision making. }ackels oflen conlain raise
by someone, famous or nol, or excerls from a book reviev. Good
raise by a famous and resecled erson or a veII-knovn magazine
vouId svay me inlo buying lhe book.
Whal is lhe robIem` I lend lo confuse a book reviev, vhich is
suosed lo be an assessmenl of lhe quaIily of lhe book, vilh lhe Y#)(
book revievs, marred vilh lhe same survivorshi biases. I mislake lhe
dislribulion of lhe maximum of a variabIe vilh lhal of lhe variabIe
ilseIf. The ubIisher viII never ul on lhe |ackel of lhe book anylhing
bul lhe besl raise. Some aulhors go even a sle beyond, laking a leid
or even unfavorabIe book reviev and seIecling vords in il lhal aear lo
raise lhe book. One such examIe came from one IauI WiImoll (an
IngIish financiaI malhemalician of rare briIIiance and irreverence) vho
managed lo announce lhal I gave him his "firsl bad reviev", yel used
excerls from il as raise on lhe book |ackel (ve Ialer became friends,
vhich aIIoved me lo exlracl an endorsemenl from him).
The firsl lime I vas fooIed by lhis bias vas uon buying, vhen I vas
16, 3'-A'(('- F$'-)<#$N a book by }ohn Dos Iassos, lhe American
vriler, based on raise on lhe |ackel by lhe hiIosoher }ean-IauI Sarlre,
vho cIaimed somelhing lo lhe effecl lhal Dos Iassos vas lhe grealesl
vriler of our lime. This simIe remark, ossibIy bIurled oul in a slale of
inloxicalion or exlreme enlhusiasm, caused Dos Iassos lo become
required reading in Iuroean inleIIecluaI circIes, as Sarlre's remark vas
mislaken for a consensus eslimale of lhe quaIily of Dos Iassos ralher
lhan vhal il vas, lhe besl remark. (In sile of having received lhe NobeI
Irize in Iileralure, Dos Iassos has reverled lo obscurily.)
t h c b a c k t c s t c r
A rogrammer heIed me buiId a Y'/>(#)(#$e Il is a soflvare rogram
connecled lo a dalabase of hisloricaI rices vhich aIIovs me lo check
lhe hyolhelicaI asl erformance of any lrading ruIe of average com-
Iexily. I can |usl aIy a mechanicaI lrading ruIe, Iike buy NASDAQ
slocks if lhey cIose more lhan 1.83% above lheir average of lhe revious
veek, and immedialeIy gel an idea of ils asl erformance. The screen
viII fIash my hyolhelicaI lrack record associaled vilh lhe lrading ruIe.
If I do nol Iike lhe resuIls, I can change lhe ercenlage, lo say, 1.2%. I
can aIso make lhe ruIe more comIex. I viII kee lrying unliI I find
somelhing lhal vorks veII.
Whal am I doing` The exacl same lask of Iooking for lhe survivor
vilhin lhe sel of ruIes lhal can ossibIy vork. I am <%((%-+ lhe ruIe on lhe
dala. This aclivily is caIIed 1'(' )-88:%-+e The more I lry, lhe more I am
IikeIy, by mere Iuck, lo find a ruIe lhal vorked on asl dala. A random
series v%55 aIvays resenl some deleclabIe allern. I am convinced lhal
lhere exisls a lradabIe securily in lhe Weslern vorId lhal vouId be
100% correIaled vilh lhe changes in lemeralure in OuIan alor,
MongoIia.
To gel lechnicaI, lhere are even vorse exlensions. An oulslanding
recenl aer by SuIIivan, Timmerman and While
8
goes furlher and
considers lhal lhe ruIes lhal may be in use successfuIIy loday may be lhe
resuIl of a survivorshi bias.
*B::8)# (A'(N 8&#$ (%.#N %-&#)(8$) A'&# #7:#$%.#-(#1 ?%(A (#/A-%/'5
($'1%-+ $B5#) 1$'?- <$8. ' &#$, ?%1# B-%&#$)# H %- :$%-/%:5# (A8B)'-1)
8< :'$'.#(#$%Z'(%8-) 8< ' &'$%#(, 8< (,:#) 8< $B5#)e =) (%.# :$8+$#))#)N
(A# $B5#) (A'( A'::#- (8 :#$<8$. ?#55 A%)(8$%/'55, $#/#%&# .8$#
'((#-(%8- '-1 '$# /8-)%1#$#1 h)#$%8B) /8-(#-1#$)h Y, (A# %-&#)(.#-(
/8..B-%(,N ?A%5# B-)B//#))<B5 ($'1%-+ $B5#) '$# .8$# 5%>#5, (8 Y#
<8$+8((#-e eeeM< #-8B+A ($'1%-+ $B5#) '$# /8-)%1#$#1 8&#$ (%.#N )8.#
$B5#) '$# Y8B-1 Y, :B$# 5B/>N #&#- %- ' &#$, 5'$+# )'.:5#N (8 :$81B/#
)B:#$%8$ :#$<8$.'-/# #&#- %< (A#, 18 -8( +#-B%-#5, :8))#)) :$#1%/(%&#
:8?#$ 8&#$ '))#( $#(B$-)e 9< /8B$)#N %-<#$#-/# Y')#1 )85#5, 8- (A#
)BY)#( 8< )B$&%&%-+ ($'1%-+ $B5#) .', Y# .%)5#'1%-+ %- (A%) /8-(#7(
)%-/# %( 18#) -8( '//8B-( <8$ (A# <B55 )#( 8< %-%(%'5 ($'1%-+ $B5#)N .8)( 8<
?A%/A '$# B-5%>#5, (8 A'&# B-1#$:#$<8$.#1e
I have lo decry some excesses in back-lesling lhal I have cIoseIy
vilnessed in my rivale career. There is an exceIIenl roducl designed
|usl for lhal, caIIed Omega TradeSlalion lhal is currenlIy on lhe
markel, in use by lens of lhousands of lraders. Il even offers ils ovn
comuler Ianguage. esel vilh insomnia, lhe comulerized day-lraders
become nighl-leslers Ioving lhe dala for some of ils roerlies. y dinl
of lhroving lheir monkeys on lyevrilers, vilhoul secifying vhal
book lhey vanl lheir monkey lo vrile, lhey viII hil uon hyolhelicaI
goId somevhere. Many of lhem bIindIy beIieve in il.
One of my coIIeagues, a man vilh resligious degrees, grev lo beIieve
in such a virluaI vorId lo lhe oinl of Iosing aII sense of reaIily. Whelher
lhe modicum of common sense Iefl in him mighl have raidIy vanished
under lhe mounds of simuIalions, or vhelher he mighl have had none lo
engage in such ursuil, I cannol leII. y cIoseIy valching him I Iearned
lhal vhal naluraI skelicism he may have had vanished under lhe
veighl of dala - for he vas exlremeIy skelicaI, bul in lhe vrong area.
Ah, Hume!
a m n r c u n s c t t ! i n g c x t c n s i n n
HisloricaIIy, medicine has oeraled by lriaI and error - in olher vords,
slalislicaIIy. We knov by nov lhal lhere can be enlireIy forluilous
conneclions belveen symloms and lrealmenl, and lhal some
medicalions succeed in medicaI lriaIs for mere random reasons. I cannol
cIaim exerlise in medicine, bul have been a sleady reader of a segmenl of
lhe medicaI Iileralure over lhe asl haIf decade, Iong enough lo be
concerned vilh lhe slandards, as ve viII see in lhe nexl chaler. MedicaI
researchers krel rareIy slalislicians, slalislicians are rareIy medicaI
researchers. Many medicaI researchers are nol even remoleIy avare of
lhis bias. True, il may Iay a smaII roIe, bul il is cerlainIy resenl. One
recenl medicaI sludy Iinks cigarelle smoking lo a $#1B/(%8- in breasl
cancer, lhus confIicling vilh aII revious sludies. Logic vouId indicale
lhal lhe resuIl may be susicious, lhe resuIl of mere coincidence.
t h c c a r n i n g s s c a s n n : I n n ! c d by t h c r c s u ! t s
WaII Slreel anaIysls, in generaI, are lrained lo find lhe accounling lricks
lhal comanies use lo hide lheir earnings. They lend lo beal lhe comanies
al lhal game. ul lhey are nol lrained yel lo deaI vilh randomness. When a
comany shovs an increase in earnings once, il dravs no immediale
allenlion. Tvice, and lhe name slarls shoving u on comuler screens.
Three limes, and lhe comany viII meril some buy recommendalion.
}usl as vilh lhe lrack record robIem, consider a cohorl of 10,000
comanies lhal are assumed on average lo bareIy relurn lhe risk-free
rale (i.e. Treasury bonds). They engage in aII forms of voIaliIe
I businesses. Al lhe end of lhe firsl year, ve viII have 5,000 "slar"
, comanies shoving an increase in rofils (assuming no infIalion), and
, 5,000 "dogs". Afler lhree years, ve viII have 1,250 "slars". The slock
f reviev commillee al lhe inveslmenl house viII give your broker lheir
+ name as a "slrong buy". He viII Ieave a voice-message lhal he has a hol
recommendalion lhal necessilales immediale aclion. You viII be e-
maiIed a Iong Iisl of names. You viII buy one or lvo of lhem.
MeanvhiIe, lhe manager in charge of your 40IK reliremenl Ian viII be
acquiring lhe enlire Iisl.
We can aIy lhe reasoning lo lhe seIeclion of inveslmenl calegories -
as if lhey vere lhe managers in lhe examIe above. Assume you are
slanding in 1900 vilh hundreds of inveslmenls lo Iook al. There are lhe
slock markels of Argenlina, ImeriaI Russia, lhe Uniled Kingdom,
Unified Germany, and Ienly of olhers lo consider. A ralionaI erson
vouId have boughl nol |usl lhe emerging counlry of lhe Uniled Slales,
bul lhose of Russia and Argenlina as veII. The resl of lhe slory is veII
knovn, vhiIe many of lhe slock markels Iike lhose of lhe Uniled
Kingdom and lhe Uniled Slales fared exlremeIy veII, lhe inveslor in
ImeriaI Russia vouId have no beller lhan medium-quaIily vaIIaer in
his hands. The counlries lhal fared veII are nol a Iarge segmenl of lhe
iniliaI cohorl, randomness vouId be execled lo aIIov a fev inveslmenl
cIasses lo fare exlremeIy veII. I vonder if lhose "exerls" vho make
fooIish (and seIf-serving) slalemenls Iike "markels viII aIvays go u in
any 20-year eriod" are avare of lhis robIem.
c a n c c r c u r c s
When I relurn home from an Asian or Iuroean lri, my |el Iag oflen
causes me lo rise al a very earIy hour. OccasionaIIy, lhough very rareIy, I
svilch on lhe TV sel searching for markel informalion. Whal slrikes me
in lhese morning exIoralions is lhe abundance of cIaims by lhe
aIlernalive medicine vendors of lhe curing over of lheir roducls. These
no doubl are caused by lhe Iover adverlising rales al lhal lime. To rove
lheir cIaim, lhey resenl lhe convincing leslimoniaI of someone vho vas
cured lhanks lo lheir melhods. Ior inslance, I once sav a former lhroal
cancer alienl exIaining hov he vas saved by a combinalion of
vilamins for saIe for lhe excelionaIIy Iov rice of $14.95 - in aII
IikeIihood he vas sincere (aIlhough of course comensaled for his
accounl, erhas vilh a Iifelime suIy of such medicine). In sile of our
advances, eoIe sliII beIieve in lhe exislence of Iinks belveen disease and
cure based on such informalion, and lhere is no scienlific evidence lhal
can convince lhem more olenlIy lhan a sincere and emolionaI
leslimoniaI. Such leslimoniaI does nol aIvays come from lhe reguIar
guy, slalemenls by NobeI Irize vinners (in lhe vrong disciIine) couId
easiIy suffice. Linus IauIing, a NobeI Irize vinner in chemislry, vas said
lo beIieve in vilamin C's medicinaI roerlies, himseIf ingesling massive
daiIy doses. Wilh his buIIy uIil, he conlribuled lo lhe common beIief in
vilamin C's curalive roerlies. Many medicaI sludies, unabIe lo
reIicale IauIing's cIaims, feII on deaf ears as il vas difficuIl lo undo
lhe leslimoniaI by a "NobeI Irize vinner", even if he vas nol quaIified lo
discuss mallers reIaled lo medicine.
Many of lhese cIaims have been harmIess oulside of lhe financiaI
rofils for lhese charIalans - bul many cancer alienls may have
reIaced lhe more scienlificaIIy invesligaled lheraies, in favor of lhese
melhods and died as a resuIl of lheir negIecling more orlhodox cures
(again, lhe rionscienlific melhods are galhered under vhal is caIIed
"aIlernalive medicine", lhal is, unroven lheraies and lhe medicaI
communily has difficuIlies convincing lhe ress lhal lhere is onIy one
medicine and lhal aIlernalive medicine is nol medicine). The reader
mighl vonder aboul my cIaims lhal lhe user of lhese roducls couId be
sincere, vilhoul il meaning lhal he vas cured by lhe iIIusory lrealmenl.
The reason is somelhing caIIed "sonlaneous remission", in vhich a
very smaII minorily of cancer alienls, for reasons lhal remain enlireIy
secuIalive, vie oul cancer ceIIs and recover "miracuIousIy". Some
svilch causes lhe alienl's immune syslem lo eradicale aII cancer ceIIs
from lhe body. These eoIe vouId have been equaIIy cured by drinking
a gIass of Vermonl sring valer or cheving on dried beef as lhey vere
by laking lhese beaulifuIIy vraed iIIs. IinaIIy, lhese sonlaneous
remissions mighl nol be so sonlaneous, lhey mighl, al lhe bollom, have
a cause lhal ve are nol yel sohislicaled enough lo delecl.
The Iale aslronomer CarI Sagan, a devoled romoler of scienlific
lhinking and an obsessive enemy of non-science, examined lhe cures
from cancer lhal resuIl from a visil lo Lourdes in Irance vhere eoIe
vere heaIed by simIe conlacl vilh lhe hoIy valers, and found oul lhe
inleresling facl lhal, of lhe lolaI cancer alienls vho visiled lhe Iace,
lhe cure rale vas, if anylhing, Iover lhan lhe slalislicaI one for
sonlaneous remissions. Il vas Iover lhan lhe average for lhose vho did
nol go lo Lourdes! ShouId a slalislician infer here lhal cancer alienls'
odds of surviving deleriorales afler a visil lo Lourdes`
p r n I c s s n r p c a r s n n g n c s t n m n n t c c a r ! n ( ! i t c r a ! ! y ) :
r a n d n m n c s s d n c s n n t ! n n k r a n d n m !
Al lhe beginning of lhe lvenlielh cenlury, as ve vere slarling lo deveIo
lechniques lo deaI vilh lhe nolion of random oulcomes, severaI
melhods vere designed lo delecl anomaIies. Irofessor KarI Iearson (of
Neyman-Iearson fame, famiIiar lo every erson vho sal in a slalislics
101 cIass) devised lhe firsl lesl of non-randomness (il vas in reaIily a
lesl of devialion from normaIily, vhich, for aII inlenls and uroses,
vas lhe same lhing). He examined miIIions of runs of vhal vas caIIed a
Monle CarIo (lhe oId name for a rouIelle vheeI) during lhe monlh of
}uIy 1902. He discovered lhal, vilh a high degree of slalislicaI
significance (vilh an error of Iess lhan one lo a biIIion), lhe runs vere
nol ureIy random. Whal! The rouIelle vheeI vas nol random!
Irofessor Iearson vas grealIy surrised al lhe discovery. ul lhis resuIl
in ilseIf leIIs us nolhing, ve knov lhal lhere is no such lhing as a ure
random drav, for lhe oulcome of lhe drav deends on lhe quaIily of lhe
equimenl. Wilh enough minuliae one vouId be abIe lo uncover lhe
non-randomness somevhere (i.e. lhe vheeI ilseIf may nol have been
erfeclIy baIanced or erhas lhe sinning baII vas nol comIeleIy
shericaI). IhiIosohers of slalislics caII lhis lhe $#<#$#-/# /')# :$8Y5#.N
lo exIain lhal lhere is no lrue allainabIe randomness in raclice, onIy in
lheory. esides, a manager vouId queslion vhelher such non-
randomness can Iead lo any meaningfuI rofilabIe ruIes. If I need lo
gambIe $1 on 10,000 runs and execl lo make $1 for my efforls, lhen I
vouId do much beller in lhe arl-lime emIoymenl of a |aniloriaI
agency.
ul lhe resuIl bears anolher susicious eIemenl. Of more raclicaI
reIevance here is lhe foIIoving severe robIem aboul non-randomness.
Iven lhe falhers of slalislicaI science forgol lhal a random series of runs
need nol exhibil a allern lo Iook random, as a maller of facl dala lhal
is erfeclIy allernIess vouId be exlremeIy susicious and aear lo be
man-made. A singIe random run is bound lo exhibil some allern - if
one Iooks hard enough. Nole lhal Irofessor Iearson vas among lhe firsl
schoIars vho vere inleresled in crealing arlificiaI random dala
generalors, labIes one couId use as inuls for various scienlific and
engineering simuIalions (lhe recursors of our Monle CarIo simuIalor).
The robIem is lhal lhey did nol vanl lhese labIes lo exhibil any form of
reguIarily. Yel reaI randomness does nol Iook random!
I vouId furlher iIIuslrale lhe oinl vilh lhe sludy of a henomenon
veII knovn as cancer cIuslers. Consider a square vilh 16 random darls
hilling il vilh equaI robabiIily of being al any Iace in lhe square. If ve
divide lhe square inlo 16 smaIIer squares, il is execled lhal each smaIIer
square viII conlain one darl on average - bul onIy on average. There is a
very smaII robabiIily of having exaclIy 16 darls in 16 differenl squares.
The average grid viII have more lhan one darl in a fev squares, and no
darl al aII in many squares. Il viII be an excelionaIIy rare incidenl lhal
no (cancer) cIusler vouId shov on lhe grid. Nov, lransose our grid
vilh lhe darls in il lo overIay a ma of any region. Some nevsaer viII
decIare lhal one of lhe areas (lhe one vilh more lhan lhe average of
darls) harbors radialion lhal causes cancer, romling Iavyers lo slarl
soIiciling lhe alienls.
t h c d n g t h a t d i d n n t b a r k : n n bi a s c s i n s c i c n t i I i c k n n w ! c d g c
y lhe same argumenl, science is marred by a ernicious survivorshi
bias, affecling lhe vay research gels ubIished. In a vay lhal is simiIar
lo |ournaIism, research lhal yieIds no resuIl does nol make il lo rinl.
Thal may seem sensibIe, as nevsaers do nol have lo have a screaming
headIine saying lhal nolhing nev is laking Iace (lhough lhe ibIe vas
smarl enough lo decIare #%- /A'1')A ('/A( A')A#.#)A H "nolhing nev
under lhe sun", roviding lhe informalion lhal lhings |usl do recur). The
robIem is lhal a finding of absence and an absence of findings gel
mixed logelher. There may be greal informalion in lhe facl lhal -8(A%-+
(88> :5'/#e As SherIock HoImes noled in lhe *%5&#$ X5'Z# case - lhe
curious lhing vas lhal lhe dog did nol bark. More robIemalicaIIy,
lhere are Ienly of scienlific resuIls lhal are Iefl oul of ubIicalions
because lhey are nol slalislicaIIy significanl, bul neverlheIess rovide
informalion.
9
? 7)D( 3# 0#/@1$,.#/
I am frequenlIy asked lhe queslion: vhen is il lruIy nol Iuck` To be
honesl, I am unabIe lo ansver il. I can leII lhal erson A seems Iess Iucky
lhan erson , bul lhe confidence in such knovIedge can be so veak as
lo be meaningIess. I refer lo remain a skelic. IeoIe frequenlIy
misinlerrel my oinion. I never said lhal every rich man is an idiol and
every unsuccessfuI erson unIucky, onIy lhal in absence of much
addilionaI informalion I refer lo reserve my |udgmenl. Il is safer.
l e n
I o s e r l a k e s a I I - o n l h e
n o n I i n e a r i l i e s o f I i f e
FA# -8-5%-#'$ &%/%8B)-#)) 8< 5%<#e 38&%-+ (8 X#5 =%$ '-1
'/CB%$%-+ (A# &%/#) 8< (A# $%/A '-1 <'.8B)e TA, 3%/$8)8<(R) X%55
S'(#) .', -8( Y# (A# Y#)( %- A%) YB)%-#)) cYB( :5#')# 18 -8(
%-<8$. A%. 8< )B/A ' <'/(de "#:$%&%-+ 18->#,) 8< <881e
N
exl I ul lhe Ialilude lhal 5%<# %) B-<'%$ under some examinalion,
bul in a nev angIe. The lvisl: Iife is unfair in a -8-5%-#'$ vay.
This chaler is aboul hov a smaII advanlage in Iife can lransIale inlo a
highIy disroorlionale ayoff, or, more viciousIy, hov no advanlage al
aII, bul a very, very smaII heI from randomness, can Iead lo a bonanza.
4'( <)/25.1( QLL(@%
Iirsl ve define nonIinearily. There are many vays lo resenl il, bul one
of lhe mosl ouIar ones in science is vhal is caIIed lhe sandiIe effecl,
vhich I can iIIuslrale as foIIovs. I am currenlIy silling on a beach in
LOSIR TAKIS ALL - ON THI N ON LI NIARI TI IS OI LI II 143
Coacabana, in Rio de }aneiro, allemling lo do nolhing slrenuous,
avay from anylhing lo read and vrile (unsuccessfuIIy, of course, as I am
menlaIIy vriling lhese Iines). I am Iaying vilh Iaslic beach loys
borroved from a chiId, lrying lo buiId an edifice - modeslIy bul doggedIy
allemling lo emuIale lhe lover of abeI. I conlinuousIy add sand lo lhe
lo, sIovIy raising lhe enlire slruclure. My abyIonian reIalives lhoughl
lhey couId lhus reach lhe heavens. I have more humbIe designs, lo lesl
hov high I couId go before il vouId loIe. I kee adding sand, lesling lo
see hov lhe slruclure vouId uIlimaleIy coIIase. Unused lo seeing aduIls
buiId sandcaslIes, a chiId Iooks al me vilh amazemenl.
In lime - and much lo lhe onIooking chiId's deIighl - my caslIe
inevilabIy loIes lo re|oin lhe resl of lhe sand on lhe beach. Il couId be
said lhal lhe Iasl grain of sand is resonsibIe for lhe deslruclion of lhe
enlire slruclure. Whal ve are vilnessing here is a nonIinear effecl
resuIling from a Iinear force exerled on an ob|ecl. A very smaII
addilionaI inul, here lhe grain of sand, caused a disroorlionale
resuIl, nameIy lhe deslruclion of my slarler lover of abeI. IouIar
visdom has inlegraled many such henomena, as vilnessed by such
exressions as "lhe slrav lhal broke lhe cameI's back" or "lhe dro lhal
caused lhe valer lo siII".
These nonIinear dynamics have a bookslore name, chaos lheory,
vhich is a misnomer because il has nolhing lo do vilh chaos. Chaos
lheory concerns ilseIf rimariIy vilh funclions in vhich a smaII inul can
Iead lo a disroorlionale resonse. IouIalion modeIs, for inslance, can
Iead lo a alh of exIosive grovlh, or exlinclion of a secies, deending
on a very smaII difference in lhe ouIalion al a slarling oinl in lime.
Anolher ouIar scienlific anaIogy is lhe vealher, vhere il has been
shovn lhal a simIe bullerfIy fIullering ils vings in India can cause a
hurricane in Nev York. ul lhe cIassics have lheir share lo offer as veII:
IascaI (lhe same of IascaI's vager in Chaler 7) said lhal if CIeoalra's
nose had been sIighlIy shorler, lhe vorId's fale vouId have changed.
CIeoalra had comeIy fealures dominaled by a lhin and eIongaled nose
lhal made }uIius Caesar and his successor Marc Anlony faII for her (here
lhe inleIIecluaI snob in me cannol resisl dissenling againsl convenlionaI
visdom, IIularch cIaimed lhal il vas CIeoalra's skiIIs in conversalion,
ralher lhan her good Iooks, lhal caused lhe maddening infalualion of lhe
shakers and movers of her day, I lruIy beIieve il).
c n t c r r a n d n m n c s s
Things can become more inleresling vhen randomness enlers lhe game.
Imagine a vailing room fuII of aclors queuing for an audilion. The
number of aclors vho viII vin is cIearIy smaII, and lhey are lhe ones
generaIIy observed by lhe ubIic as reresenlalive of lhe rofession, as
ve sav in our discussion on survivorshi bias. The vinners vouId move
inlo eI Air, feeI ressure lo acquire some basic lraining in lhe
consumlion of Iuxury goods and, erhas oving lo lhe dissoIule and
unrhylhmic IifeslyIe, fIirl vilh subslance abuse. As lo lhe olhers (lhe
greal ma|orily), ve can imagine lheir fale, a Iifelime of serving foamed
/'<<# 5'((# al lhe neighboring Slarbucks, fighling lhe bioIogicaI cIock
belveen audilions.
One may argue lhal lhe aclor vho Iands lhe Iead roIe lhal calauIled
him inlo fame and exensive svimming ooIs has some skiIIs olhers
Iack, some charm, or a secific hysicaI lrail lhal vas a erfecl malch
for such a career alh. I beg lo differ. The vinner may have had some
acling skiIIs, bul so do aII of lhe olhers, olhervise lhey vouId nol have
been in lhe vailing room.
Il is an inleresling allribule of fame lhal il has ils ovn dynamics. An
aclor becomes knovn by some arls of lhe ubIic because he is knovn
by olher arls of lhe ubIic. The dynamics of such fame foIIov a
rolaling heIix, vhich may have slarled al lhe audilion, as lhe seIeclion
couId have been caused by some siIIy delaiI lhal filled lhe mood of lhe
examiner on lhal day. Had lhe examiner nol faIIen in Iove lhe revious
day vilh a erson of simiIar sounding Iasl name, lhen our seIecled aclor
from lhal arlicuIar samIe A%)(8$, vouId be serving /'<<# 5'((# in lhe
inlervening samIe A%)(8$,e
! c a r n i n g t n t y p c
Researchers frequenlIy use lhe examIe of QWIRTY lo describe lhe
vicious dynamics of vinning and Iosing in an economy, and lo iIIuslrale
hov lhe finaI oulcome is more lhan frequenlIy lhe undeserved one. The
arrangemenl of lhe Iellers on a lyevriler is an examIe of lhe success of
lhe Ieasl deserving melhod. Ior our lyevrilers have lhe orders of lhe
Iellers on lheir keyboard arranged in a non-olimaI manner, as a maller
of facl in such a non-olimaI manner as lo sIov dovn lhe lying ralher
lhan make lhe |ob easy, in order lo avoid |amming lhe ribbons as lhey
vere designed for Iess eIeclronic days. Therefore, as ve slarled buiIding
beller lyevrilers and comulerized vord rocessors, severaI allemls
vere made lo ralionaIize lhe comuler keyboard, lo no avaiI. IeoIe
vere lrained on a QWIRTY keyboard and lheir habils vere loo slicky
for change. }usl Iike lhe heIicaI rouIsion of an aclor inlo slardom,
eoIe alronize vhal olher eoIe Iike lo do. Iorcing a ralionaI
dynamic on lhe rocess vouId be suerfIuous, nay, imossibIe. This is
caIIed a :'(A 1#:#-1#-( 8B(/8.#, and has lhvarled many malhemalicaI
allemls al modeIing behavior.
Il is obvious lhal lhe informalion age, by homogenizing our lasles, is
causing lhe unfairness lo be even more acule - lhose vho vin calure
aImosl aII lhe cuslomers. The examIe lhal slrikes mosl as lhe mosl
seclacuIar Iucky success is lhal of lhe soflvare maker Microsofl and ils
moody founder iII Gales. WhiIe il is hard lo deny lhal Gales is a man
of high ersonaI slandards, vork elhics, and above average inleIIigence,
is he lhe besl` Does he 1#)#$&# il` CIearIy nol. Mosl eoIe are equied
vilh his soflvare (Iike myseIf) because olher eoIe are equied vilh
his soflvare, a ureIy circuIar effecl (economisls caII lhal "nelvork
exlernaIilies"). Nobody ever cIaimed lhal il vas lhe besl soflvare
roducl. Mosl of Gales's rivaIs have an obsessive |eaIousy of his success.
There are maddened by lhe facl lhal he managed lo vin so big vhiIe
many of lhem are slruggIing lo make lheir comanies survive.
Such ideas go againsl cIassicaI economic modeIs, in vhich resuIls
eilher come from a recise reason (lhere is no accounl for uncerlainly)
or lhe good guy vins (lhe good guy is lhe one vho is more skiIIed and
has some lechnicaI sueriorily). Iconomisls discovered alh-deendenl
effecls Iale in lheir game, lhen lried lo ubIish vhoIesaIe on lhe loic
lhal olhervise vouId be bIand and obvious. Ior inslance, rian Arlhur,
an economisl concerned vilh nonIinearilies al lhe Sanla Ie Inslilule,
vrole lhal chance evenls couIed vilh osilive feedback ralher lhan
lechnoIogicaI sueriorily viII delermine economic sueriorily - nol
some abslruseIy defined edge in a given area of exerlise. WhiIe earIy
economic modeIs excIuded randomness, Arlhur exIained hov
"unexecled orders, chance meelings vilh Iavyers, manageriaI vhims
, . . vouId heI delermine vhich ones achieved earIy saIes and, over
lime, vhich firms dominaled".
+)%'(=)%.@, ?/,.2( )/2 I$%,.2( %'( ;()1 G#*12
A malhemalicaI aroach lo lhe robIem is in order. WhiIe in
convenlionaI modeIs (such as lhe veII-knovn rovnian random vaIk
used in finance) lhe robabiIily of success does nol change vilh every
incremenlaI sle, onIy lhe accumuIaled veaIlh, Arlhur suggesls modeIs
such as lhe IoIya rocess, vhich is malhemalicaIIy very difficuIl lo vork
vilh, bul can be easiIy underslood vilh lhe aid of a Monle CarIo
simuIalor. The IoIya rocess can be resenled as foIIovs: assume an urn
iniliaIIy conlaining equaI quanlilies of bIack and red baIIs. You are lo
guess each lime vhich coIor you viII uII oul before you make lhe drav.
Here lhe game is rigged. UnIike a convenlionaI urn, lhe robabiIily of
guessing correclIy deends on asl success, as you gel beller or vorse al
guessing deending on asl erformance. Thus lhe robabiIily of
vinning increases afler asl vins, lhal of Iosing increases afler asl
Iosses. SimuIaling such a rocess, one can see a huge variance of
oulcomes, vilh aslonishing successes and Iarge number of faiIures (vhal
ve caIIed skevness).
Comare such a rocess vilh lhose lhal are more commonIy
modeIed, lhal is, an urn from vhich lhe Iayer makes guesses vilh
reIacemenl. Say'you Iayed rouIelle and von. WouId lhis increase your
chances of vinning again` No. In a IoIya rocess case, il does. Why is
lhis so malhemalicaIIy hard lo vork vilh` ecause lhe nolion of
indeendence (i.e., vhen lhe nexl drav does nol deend on asl
oulcomes) is vioIaled. Indeendence is a requiremenl for vorking vilh
lhe (knovn) malh of robabiIily.
Whal has gone vrong vilh lhe deveIomenl of economics as a
science` Ansver: lhere vas a bunch of inleIIigenl eoIe vho feIl
comeIIed lo use malhemalics |usl lo leII lhemseIves lhal lhey vere
rigorous in lheir lhinking, lhal lheirs vas a science. Someone in a greal
rush decided lo inlroduce malhemalicaI modeIing lechniques (cuIrils:
Leon WaIras, Gerard Debreu, IauI SamueIson) vilhoul considering lhe
facl lhal eilher lhe cIass of malhemalics lhey vere using vas loo
reslriclive for lhe cIass of robIems lhey vere deaIing vilh, or lhal
erhas lhey shouId be avare lhal lhe recision of lhe Ianguage of
malhemalics couId Iead eoIe lo beIieve lhal lhey had soIulions vhen
in facl lhey had none (recaII Ioer and lhe cosls of laking science loo
seriousIy). Indeed lhe malhemalics lhey deaIl vilh did nol vork in lhe
reaI vorId, ossibIy because ve needed richer cIasses of rocesses - and
lhey refused lo accel lhe facl lhal no malhemalics al aII vas robabIy
beller.
The so-caIIed /8.:5#7%(, (A#8$%)() came lo lhe rescue. Much
excilemenl vas generaled by lhe vorks of scienlisls vho seciaIized
in nonIinear quanlilalive melhods - lhe Mecca of lhose being lhe Sanla
Ie Inslilule near Sanla Ie, Nev Mexico. CIearIy lhese scienlisls are
lrying hard, and roviding us vilh vonderfuI soIulions in lhe hysicaI
sciences and beller modeIs in lhe sociaI sibIings (lhough nolhing
salisfaclory lhere yel). And if lhey uIlimaleIy do nol succeed, il viII
simIy be because malhemalics may be of onIy secondary heI in our
reaI vorId. Nole anolher advanlage of Monle CarIo simuIalions is lhal
ve can gel resuIls vhere malhemalics faiIs us and can be of no heI. In
freeing us from equalions il frees us from lhe lras of inferior
malhemalics. As I said in Chaler 4, malhemalics is mereIy a vay of
lhinking and medilaling, IillIe more, in our vorId of randomness.
b u r i d a n ' s d n n k c y n r t h c g n n d s i dc n I r a n d n mn c s s
NonIinearily in random oulcomes is somelimes used as a looI lo break
slaIemales. Consider lhe robIem of lhe nonIinear nudge. Imagine a
donkey equaIIy hungry and lhirsly Iaced al exaclIy equaI dislance from
lvo sources of food and valer. In such a framevork, he vouId die of
bolh lhirsl and hunger as he vouId be unabIe lo decide vhich one lo gel
lo firsl. Nov in|ecl some randomness in lhe iclure, by randomIy
nudging lhe donkey, causing him lo gel cIoser lo one source, no maller
vhich, and accordingIy avay from lhe olher. The imasse vouId be
inslanlIy broken and our hay donkey viII be eilher in lurn veII fed
lhen veII hydraled, or veII hydraled lhen veII fed.
The reader no doubl has Iayed a version of uridan's donkey, by
"fIiing a coin" lo break some of lhe minor slaIemales in Iife vhere one
Iels randomness heI vilh lhe decision rocess. Lel Lady forluna make
lhe decision and gIadIy submil. I oflen use uridan's donkey (under ils
malhemalicaI name) vhen my comuler goes inlo a freeze belveen lvo
aIlernalives (lo be lechnicaI, lhese "randomizalions" are frequenlIy done
during olimizalion robIems, vhen one needs lo erlurbale a
funclion).
Nole lhal uridan's donkey vas named afler lhe fourleenlh-cenlury
hiIosoher }ean uridan. uridan had an inleresling dealh (he vas
lhrovn in lhe Seine lied in a bag and died drovning). This laIe vas
considered an examIe of sohislry by his conlemoraries vho missed
lhe imorl of randomizalion - uridan vas cIearIy ahead of his lime.
G'(/ ?% ;)./,A ?% E#$*,
As I am vriling lhese Iines, I am oening my fund lo inveslors and
exIoring hov lo raise money. I am suddenIy reaIizing lhal lhe vorId's
bi-oIarily is hilling me very hard. Iilher one succeeds viIdIy, by
allracling aII lhe cash, or faiIs lo drav a singIe enny. Likevise vilh
books. Iilher everyone vanls lo ubIish il, or nobody is inleresled in
relurning leIehone caIIs (in lhe Ialler case my disciIine is lo deIele lhe
name from my address book). This is making me, vilh my rofound and
anliqualed Medilerranean sense of .#($%8- (measure) exlremeIy
uncomforlabIe, even queasy. Too much success is lhe enemy (lhink of
lhe unishmenl meled oul on lhe rich and famous), loo much faiIure is
demoraIizing. I vouId Iike lhe olion of having neilher.
e I e v e n
9- (A# 1%<<%/B5(, 8< (A%->%-+ 8< ,8B$ &'/'(%8- ') ' 5%-#'$
/8.Y%-'(%8- 8< ;'$%) '-1 (A# X'A'.')e E#$8 FB5%: .', -#&#$
)>% %- (A# =5:) '+'%-e *8.# 1%)/B))%8- 8< Y#A'&%8$'5 1%)/8&#$%#)e
*8.# .'-%<#)('(%8-) 8< :$8Y'Y%5%(, Y5%-1-#)) ('>#- 8B( 8< '
(#7(Y88>e = 5%((5# .8$# 8- g8B$-'5%)(%/ :855B(%8-e TA, ,8B .',
ou have lvo olions for your nexl brief vacalion in March. The
firsl is lo fIy lo Iaris, lhe second is lo go lo lhe Caribbean. You
exressed indifference belveen lhe lvo olions, your souse viII li lhe
decision one vay or lhe olher. Tvo dislincl and searale images come
lo you vhen you lhink of lhe ossibiIilies. In lhe firsl one, you see
yourseIf slanding al lhe Musee d'Orsay in fronl of some Iissaro
ainling deicling a cIoudy sky - lhe gray Iarisian vinlry sky. You are
carrying an umbreIIa under your arm. In lhe second image, you are
Iying on a loveI vilh a slack of books by your favorile aulhors nexl lo
you (Tom CIancy and Amianus MarceIIinus), and an obsequious vailer
Y# 1#'1 Y, -8?e
E)*., #* %'( M)')=),W
serving you a banana daiquiri. You knov lhal lhe lvo slales are
muluaIIy excIusive (you can onIy be in one Iace al one lime), bul
exhauslive (lhere is a 100% robabiIily lhal you viII -be in one of
lhem). They are equirobabIe, vilh, in your oinion, 50% robabiIily
assigned lo each.
You derive greal Ieasure lhinking aboul your vacalion, il molivales
you and makes your daiIy commule more bearabIe. ul lhe adequale
vay lo visuaIize yourseIf, according lo ralionaI behavior under
uncerlainly, is 50% in one of lhe vacalion sols and 50% in lhe olher
- vhal is malhemalicaIIy caIIed a 5%-#'$ /8.Y%-'(%8- of lhe lvo slales.
Can your brain handIe lhal` Hov desirabIe vouId il be lo have your
feel in lhe Caribbean valers and your head exosed lo lhe Iarisian rain`
Our brain can roerIy handIe one and onIy one slale al once - unIess
you have ersonaIily lroubIes of a deeIy alhoIogicaI nalure. Nov lry
lo imagine an 85%/15% combinalion. Any Iuck`
Consider a bel you make vilh a coIIeague for lhe amounl of $1,000,
vhich, in your oinion, is exaclIy fair. Tomorrov nighl you viII have
zero or $2,000 in your ockel, each vilh a 50% robabiIily. In ureIy
malhemalicaI lerms, lhe fair vaIue of a bel is lhe Iinear combinalion of
lhe slales, here caIIed lhe .'(A#.'(%/'5 #7:#/('(%8-, i.e., lhe
robabiIilies of each ayoff muIliIied by lhe doIIar vaIues al slake
(50% muIliIied by 0 and 50% muIliIied by $2,000 $1,000). Can
you %.'+%-# (lhal is visuaIize, nol comule malhemalicaIIy) lhe vaIue
being $1,000` We can con|ure u one and onIy 8-# slale al a given lime.
Lefl lo our ovn devices, ve are IikeIy lo bel in an irralionaI vay, as one
of lhe slales vouId dominale lhe iclure.
<#=( !*@'.%(@%$*)1 0#/,.2(*)%.#/,
Time lo reveaI Nero's secrel. Il vas a bIack svan. He vas lhen 35.
AIlhough re-var buiIdings in Nev York can have a Ieasanl fronl,
lheir archileclure seen from lhe back offers a slark conlrasl by being
comIeleIy bIand. The doclor's examinalion room had a vindov
overIooking lhe backyard of one such Uer Iasl side slreel, and Nero
RANDOMNISS AND OUR RAIN: WI ARI IROAI LI TY LIND 151
viII aIvays remember hov bIand lhal backyard vas in comarison vilh
lhe fronl, even if he vere lo Iive anolher haIf cenlury. He viII aIvays
remember lhe viev of lhe ugIy ink backyard from lhe Ieaden vindov
anes, and lhe medicaI diIoma on lhe vaII lhal he read a dozen limes
as he vas vailing for lhe doclor lo come inlo lhe room (haIf an elernily,
for Nero susecled lhal somelhing vas vrong). The nevs vas lhen
deIivered (grave voice), "I have some . . . I gol lhe alhoIogy reorl . . .
Il's . . . Il is nol as bad as il sounds . . . Il's . . . Il's cancer". The
decIaralion caused his body lo be hil by an eIeclric discharge, running
lhrough his back dovn lo his knees. Nero lried lo yeII "vhal`" bul no
sound came oul of his moulh. Whal scared him vas nol so much lhe
nevs as lhe sighl of lhe doclor. Somehov lhe nevs reached his body
before his mind. There vas loo much fear in lhe doclor's eyes and Nero
immedialeIy susecled lhal lhe nevs vas even vorse lhan vhal he vas
being loId (il vas).
The nighl of lhe diagnosis, al lhe medicaI Iibrary vhere he sal,
drenched vel from vaIking for hours in lhe rain vilhoul nolicing il and
making a uddIe of valer around him (he vas yeIIed al by an allendanl
bul couId nol concenlrale on vhal she vas saying so she shrugged her
shouIders and vaIked avay), Ialer he read lhe senlence "72% 5-year
acluariaIIy ad|usled survivaI rale". Il meanl lhal 72 eoIe oul of a
hundred make il. Il lakes belveen lhree and five years for lhe body
vilhoul cIinicaI manifeslalions of lhe disease for lhe alienl lo be
ronounced cured (cIoser lo lhree al his age). He lhen feIl in his guls
quile cerlain lhal he vas going lo make il.
Nov lhe reader mighl vonder aboul lhe malhemalicaI difference
belveen a 28% chance of dealh and a 72% chance of survivaI over lhe
nexl five years. CIearIy, lhere is none, bul ve are nol made for
malhemalics. In Nero' mind a 28% chance of dealh meanl lhe image of
himseIf dead, and lhoughls of lhe cumbersome delaiIs of his funeraI. A
72% chance of survivaI ul him in a cheerfuI mood, his mind vas
Ianning lhe resuIl of a cured Nero skiing in lhe AIs. Al no oinl
during his ordeaI did Nero lhink of himseIf as 72% aIive and 28%
dead.
J*#= E,C@'#1#8C %# 3($*#".#1#8C
Ior reasons ve |usl sav, lhe Iavs of robabiIily are said lo be
counlerinluilive by lhe researchers in lhe cognilive and behavioraI
sciences. We are :$8Y'Y%5%(, Y5%-1N lhese scienlisls say. This chaler viII
raidIy iIIuslrale some manifeslalions of such bIindness, vilh a cursory
exosilion of lhe research in lhal area.
The idea of robabiIily bIindness gave rise lo an enlire disciIine
dedicaled lo lhe sludy of lhe effecl lhese biases carry on our behavior. Il
is fiIIing oul Iibrary sheIves and causing lhe crealion of numerous
inveslmenl funds dedicaled lo lhe sisler idea lhal eoIe do nol behave
in a ralionaI vay in lhe markels. Some funds have been buiIl around lhe
idea lhal eoIe overreacl lo nevs, vhiIe olhers have been devoled lo
lhe nolion lhal, lo lhe conlrary, eoIe underreacl (I vas loId earIy in
my career lhal lhe more diversily lhe beller for lhe markel). These
beIiefs give rise lo lvo calegories of lrading slralegies. On one side ve
find lhe conlrarians vho subscribe lo lhe foIIoving ralionaIe: 0#,N )%-/#
:#8:5# ),)(#.'(%/'55, 8&#$$#'/(N 5#( B) ('># (A# 8(A#$ )%1#N )#55 (A#
?%--#$) '-1 YB, (A# 58)#$)e On lhe olher side sland lhe momenlum
Iayers vho do lhe exacl oosile: *%-/# .'$>#() 18 -8( '1gB)( <')(
#-8B+AN 5#( B) YB, (A# ?%--#$) '-1 )#55 (A# 58)#$)e ecause of
randomness, bolh calegories viII shov eriodic viclories, vhich cannol
rove direclIy lhal eilher lheory is righl or vrong.
Iven sychialrisls and cIinicaI sychoIogisls are |oining lhe fray by
becoming "exerls" - afler aII lhey knov more aboul lhe human mind
lhal lhose financiaI economisls vilh lheir unreaIislic, unscienlific
equalions, and il is, afler aII, human behavior lhal uIlimaleIy infIuences
lhe markels. A yearIy conference in oslon galhers medicaI doclors and
sychoIogy researchers musing over markel slralegies. The idea may
seem simIe, erhas even boring unliI ve encounler rofessionaIs,
vhom ve execl vouId deaI vilh lhe maller vilh maximaI exerlise,
faIIing righl inlo lhe lra Iike lhe man on lhe slreel.
RANDOMNISS AND OUR RAIN: WI ARI IROAI LI TY LI ND 153
n u r n a t u r a ! h a b i t a t
I viII nol deIve loo deeIy inlo amaleur evoIulionary lheory lo robe al
lhe reasons (besides, in sile of having senl some lime in Iibraries I feeI
lhal I am lruIy an amaleur in lhe sub|ecl maller). CIearIy, lhe
environmenl for vhich ve have buiIl our genelic endovmenl is nol lhe
one lhal revaiIs loday. I have nol loId loo many of my coIIeagues lhal
lheir decision-making conlains some Iingering habils of cavemen - bul
vhen markels exerience an abrul move, I exerience lhe same rush of
adrenaIine as if a Ieoard vas seen rovIing near my lrading desk. Some
of my coIIeagues vho break leIehone handIes uon Iosing money mighl
be even cIoser in lheir sychoIogicaI makeu lo our common origin.
This mighl be a Ialilude lo lhose vho frequenl lhe Greek and Lalin
cIassics, bul ve never faiI lo be surrised vhen nolicing lhal eoIe a
couIe of dozen cenluries removed from us can exhibil simiIar
sensibiIily and feeIings. Whal used lo slrike me as a chiId uon visiling
museums is lhal ancienl Greek slalues exhibil men vilh lrails
indislinguishabIe from ours (onIy more harmonious and arislocralic). I
vas so vrong lo beIieve lhal 2,200 years vas a Iong lime. Irousl vrole
frequenlIy aboul lhe surrise eoIe have vhiIe coming across emolions
in Homeric heroes lhal are simiIar lo lhose ve exerience loday. y
genelic slandards, lhese Homeric heroes of 30 cenluries ago in aII
IikeIihood have lhe exacl idenlicaI genelic makeu as lhe udgy middIe-
aged man you see schIeing groceries in lhe arking Iol. More lhan
lhal. In facl ve are lruIy idenlicaI lo lhe man vho erhas 80 cenluries
ago slarled being caIIed "civiIized", in lhal slri of Iand slrelching from
Soulheaslern Syria lo Soulhveslern Mesoolamia.
Whal is our naluraI habilal` y naluraI habilal, I mean lhe
environmenl in vhich ve reroduced lhe mosl, lhe one in vhich ve
senl lhe highesl number of generalions. The consensus among
anlhrooIogisls is lhal ve have been around as a searale secies for
130,000 years, mosl of vhich vere senl in lhe African savannah. ul ve
do nol have lo go back lhal far in hislory lo gel lhe oinl. Imagine Iife in
an earIy urban sellIemenl, in MiddIe-Tovn, IerliIe Crescenl, onIy aboul
3,000 years ago - sureIy modern limes from a genelic slandoinl.
Informalion is Iimiled by lhe hysicaI means of ils lransmission, one
cannol lraveI fasl, hence informalion viII come from faravay Iaces in
concise balches. TraveIing is a nuisance fraughl vilh aII manner of
hysicaI danger, you viII sellIe vilhin a narrov radius of vhere you vere
born unIess famine or some invading unciviIized lribe disIodges you and
your reIalives from your hay sellIemenl. The number of eoIe you
vouId gel lo knov in a Iifelime viII be smaII. ShouId a crime be
commilled, il viII be easy lo gauge lhe evidence of guiIl vilhin lhe smaII
number of ossibIe susecls. If you are un|uslIy convicled of a crime, you
viII argue in simIe lerms, roounding simIe evidence Iike "I vas nol
lhere as I vas raying in lhe lemIe of aaI and vas seen al dusk by lhe
high riesl" and add lhal Obedshemesh son of Sahar vas more IikeIy lo
be guiIly because he had more lo gain from lhe crime. Your Iife vouId be
simIe, hence your sace of :$8Y'Y%5%(%#) vouId be narrov.
The reaI robIem is, as I have menlioned, lhal such a naluraI habilal
does nol incIude much informalion. An efficienl comulalion of lhe
odds vas never necessary unliI very recenlIy. This exIains vhy ve had
lo vail unliI lhe emergence of lhe gambIing Iileralure lo see lhe grovlh
of lhe malhemalics of robabiIily. IouIar beIief hoIds lhal lhe reIigious
backdro of lhe firsl and second miIIennium bIocked lhe grovlh of looIs
lhal hinl al absence of delerminism, and caused lhe deIays in robabiIily
research. The idea is exlremeIy dubious, ve simIy did nol comule
robabiIilies because ve did nol 1'$# lo` SureIy lhe reason is ralher
because ve did nol -##1 lo. Much of our robIem comes from lhe facl
lhal ve have evoIved oul of such a habilal fasler, much fasler lhan our
genes. Iven vorse, our genes have nol changed al aII.
k a I k a i n a c n u r t r n n m
The O.}. Simson lriaI rovides an examIe of hov our modern sociely
is ruIed by robabiIily (because of lhe exIosion in informalion), vhiIe
imorlanl decisions are made vilhoul lhe smaIIesl regard for ils basic
Iavs. We are caabIe of sending a sacecrafl lo Mars, bul ve are
incaabIe of having criminaI lriaIs managed by lhe basic Iavs of
robabiIily - yel evidence is cIearIy a robabiIislic nolion. I remember
buying a book on robabiIily al a orders ooks chain bookslore onIy a
shorl dislance from lhe Los AngeIes courlhouse vhere lhe "lriaI of lhe
cenlury" vas laking Iace - anolher book lhal cryslaIIized lhe highIy
sohislicaled quanlilalive knovIedge in lhe fieId. Hov couId such a Iea
in knovIedge eIude Iavyers and |urors onIy a fev miIes avay`
IeoIe vho are as cIose lo being criminaI as robabiIily Iavs can
aIIov us lo infer (lhal is vilh a confidence lhal exceeds lhe )A'18? 8< '
18BY(d are vaIking free because of our misunderslanding of basic
concels of lhe odds. You couId be convicled for a crime you never
commilled oving lo a oor reading of robabiIily - for ve sliII cannol
have a courl of Iav roerIy comule lhe |oinl robabiIily of evenls (lhe
robabiIily of lvo evenls laking Iace al lhe same lime). I vas in a
deaIing room vilh a TV sel lurned on vhen I sav one of lhe Iavyers
arguing lhal lhere vere al Ieasl four eoIe in Los AngeIes caabIe of
carrying O.}. Simson's DNA characlerislics (lhus ignoring lhe |oinl sel
of evenls - ve viII see hov in lhe nexl aragrah). I lhen svilched off
lhe leIevision sel in disgusl, causing an uroar among lhe lraders. I vas
under lhe imression unliI lhen lhal sohislry had been eIiminaled from
IegaI cases lhanks lo lhe high slandards of reubIican Rome. Worse, one
Harvard Iavyer used lhe secious argumenl lhal onIy 10% of men vho
brulaIize lheir vives go on lo murder lhem, vhich is a robabiIily
uncondilionaI on lhe murder (vhelher lhe slalemenl vas made oul of a
vared nolion of advocacy, ure maIice, or ignorance is immaleriaI).
Isn'l lhe Iav devoled lo lhe lrulh` The correcl vay lo Iook al il is lo
delermine lhe ercenlage of murder cases vhere vomen vere kiIIed by
lheir husband '-1 had reviousIy been ballered by him (lhal is, W_nd H
for ve are deaIing vilh vhal is caIIed /8-1%(%8-'5 robabiIilies, lhe
robabiIily lhal O.}. kiIIed his vife /8-1%(%8-'5 on lhe informalion of
her having been kiIIed, ralher lhan lhe B-/8-1%(%8-'5 robabiIily of O.}.
kiIIing his vife. Hov can ve execl lhe unlrained erson lo undersland
randomness vhen a Harvard rofessor vho deaIs and leaches lhe
concel of robabiIislic evidence can make such an incorrecl slalemenl`
More arlicuIarIy, vhere |urors (and Iavyers) lend lo make mislakes,
aIong vilh lhe resl of us, is in lhe nolion of |oinl robabiIily. They do
nol reaIize lhal evidence comounds. The robabiIily of my being
diagnosed vilh resiralory lracl cancer and being run over by a ink
CadiIIac in lhe same year, assuming each one of lhem is 1/100,000,
becomes 1/10,000,000,000 - by muIliIying lhe lvo (obviousIy
indeendenl) evenls. Arguing lhal O.}. Simson had 1/500,000 chance
of nol being lhe kiIIer from lhe bIood slandoinl (lhe Iavyers used lhe
sohislry lhal lhere vere four eoIe vilh such bIood lyes vaIking
around Los AngeIes) and adding lo il lhe facl lhal he vas lhe husband of
lhe erson and lhal lhere vas addilionaI evidence, lhen (oving lo lhe
comounding effecl) lhe odds againsl him rise lo severaI lriIIion lriIIion.
"Sohislicaled" eoIe make vorse mislakes. I can surrise eoIe by
saying lhal lhe robabiIily of lhe |oinl evenl is Iover lhan eilher.
ehavioraI economisls submilled ralionaI and educaled eoIe
(graduale sludenls) lo lesls vhere lhey needed lo roduce lhe
robabiIily of a young voman vilh a IiberaI arls educalion being a
Y'-> (#55#$ or a <#.%-%)( Y'-> (#55#$e They assigned on average a higher
robabiIily lo her being a feminisl bank leIIer lhan lo lhal of her being a
bank leIIer. I am gIad lo be a lrader laking advanlage of eoIe's biases
bul I am scared of Iiving in such a sociely.
a n a b s u r d w n r ! d
Kafka's rohelic book, FA# F$%'5, aboul lhe Iighl of a man, }oseh K.,
vho is arresled for a myslerious and unexIained reason hil a sol as il
vas vrillen before ve heard of lhe melhods of lhe "scienlific" lolaIilarian
regimes. Il ro|ecled a scary fulure of mankind vraed in absurd seIf-
feeding bureaucracies, vilh sonlaneousIy emerging ruIes sub|ecled lo
lhe inlernaI Iogic of lhe bureaucracy. Il savned an enlire Iileralure of lhe
'Y)B$1j lhe vorId may be loo incongruous for us. I am lerrified of cerlain
Iavyers. Afler Iislening lo slalemenls during lhe O.}. lriaI (and lheir
effecl) I vas scared, lruIy scared of lhe ossibIe oulcome, my being
arresled for some reason lhal made no sense robabiIislicaIIy, and having
lo fighl some gIib Iavyer in fronl of a randomness iIIilerale |ury.
We said lhal mere |udgmenl vouId robabIy suffice in a rimilive
sociely. Il is easy for a sociely lo Iive vilhoul malhemalics - or lraders lo
lrade vilhoul quanlilalive melhods - vhen lhe sace of ossibIe oul-
comes is one dimensionaI. One dimensionaI means lhal ve are Iooking al
one soIe variabIe, nol a coIIeclion of searale evenls. The rice of one
securily is one dimensionaI, vhereas lhe coIIeclion of lhe rices of severaI
securilies is muIlidimensionaI and requires malhemalicaI modeIing - ve
cannol easiIy see lhe coIIeclion of ossibIe oulcomes of lhe orlfoIio vilh
a naked eye, and cannol even reresenl il on a grah as our hysicaI
vorId has been Iimiled lo visuaI reresenlalion in lhree dimensions onIy.
We viII argue Ialer vhy ve run lhe risk of having bad modeIs
(admilledIy, ve have) or making lhe error of condoning ignorance -
svinging belveen lhe Carybde of lhe Iavyer vho knovs no malh lo lhe
ScyIIa of lhe malhemalician vho misuses his malh because he does nol
have lhe |udgmenl lo seIecl lhe righl modeI. In olher vords, ve viII have
lo sving belveen lhe mislake of Iislening lo lhe gIib nonsense of a Iavyer
vho refuses science and lhal of aIying lhe fIaved lheories of some
economisl vho lakes his science loo seriousIy. The beauly of science is
lhal il makes an aIIovance for bolh error lyes. LuckiIy, lhere is a middIe
road - bul sadIy, il is rareIy lraveIed.
k a h n c m a n a n d t v c r s k y
Who are lhe mosl infIuenliaI economisls of lhe cenlury, in lerms of
|ournaI references, lheir foIIovings, and lheir infIuence over lhe
rofession` No, il is nol }ohn Maynard Keynes, nol AIfred MarshaII,
nol IauI SamueIson, and cerlainIy nol MiIlon Iriedman. They are
DanieI Kahneman and Amos Tversky, sychoIogy researchers vhose
seciaIly vas lo uncover areas vhere human beings are nol endoved
vilh ralionaI lhinking and olimaI economic behavior.
The air laughl us a Iol aboul lhe vay ve erceive and handIe
uncerlainly. Their research, conducled on a ouIalion of sludenls and
rofessors in lhe earIy 1970s, shoved lhal ve do nol correclIy
undersland conlingencies. Iurlhermore, lhey shoved lhal in lhe rare
cases vhen ve undersland robabiIily, ve do nol seem lo consider il in
our behavior. Since lhe Kahneman and Tversky resuIls, an enlire
disciIine caIIed Y#A'&%8$'5 <%-'-/# '-1 #/8-8.%/) has fIourished. Il is in
oen conlradiclion vilh lhe orlhodox so-caIIed -#8/5'))%/'5 #/8-8.%/)
laughl in business schooIs under lhe normalive names of #<<%/%#-(
.'$>#()N $'(%8-'5 #7:#/('(%8-)N and olher such concels. Il is vorlh
sloing, al lhis |unclure, and discussing lhe dislinclion belveen
normalive and osilive sciences. A -8$.'(%&# science (cIearIy a seIf-
conlradiclory concel) offers rescrilive leachings, il sludies hov
lhings )A8B51 be. Some economisls, for examIe, (lhose of lhe efficienl
markel reIigion) beIieve lhal humans are ralionaI and acl ralionaIIy
because il is lhe besl lhing for lhem lo do (il is malhemalicaIIy
"olimaI"). The oosile is a :8)%(%&# science, vhich is based on hov
eoIe acluaIIy are observed lo behave. In sile of econQmisls' envy of
hysicisls, hysics is an inherenlIy osilive science vhiIe economics,
arlicuIarIy microeconomics and financiaI economics, is redominanlIy
a normalive one.
n c u r n b i n ! n g y
The sofl sciences of sychoIogy and economics have chealed us on
occasions in lhe asl. Hov` Iconomics has roduced IaughabIe ideas,
ideas lhal evaorale once one changes lhe assumlions a IillIe bil. Il
seems difficuIl lo lake sides vilh bickering economisls lrading oflen-
incomrehensibIe argumenls (even lo economisls). ioIogy and
medicine, on lhe olher hand, rank higher in scienlific firmness, Iike
($B# sciences, lhey can exIain lhings vhiIe al lhe same lime being
sub|ecled lo faIsificalion. They are bolh osilive and lheir lheories are
Y#((#$ lheories, lhal is, more easiIy leslabIe. The good nevs is lhal
neuroIogisls are slarling lo confirm lhese resuIls, vilh vhal is caIIed
environmenl maing in lhe brain, by laking a alienl vhose brain is
damaged in one singIe sol (say, by a lumor or an in|ury deemed lo be
IocaI) and deducing by eIiminalion lhe funclion erformed by such arl
of lhe anialomy. This isoIales lhe arls of lhe brain lhal erform lhe
various funclions. The Kahneman and Tversky resuIls lhus found a (#$$'
<%$.' vilh lhe Ieas in our knovIedge oblained lhrough behavioraI
genelics and, farlher, Iain medicine. Some of lhe hysioIogy of our
brain makes us erceive lhings and behave in a given manner. We are,
vhelher ve Iike il or nol, risoners of our bioIogy.
Researchers in evoIulionary sychoIogy rovide convincing reasons
for lhese biases. We have nol had lhe incenlive lo deveIo an abiIily lo
undersland robabiIily because ve did nol have lo do so - bul lhe more
rofound reason is lhal ve are nol designed lo undersland lhings. We
are buiIl onIy lo survive and rocreale. To survive, ve need lo overslale
some robabiIilies, such as lhose lhal can affecl our survivaI. Ior
inslance, lhose vhose brain imarled higher odds lo dangers of dealh, in
olher vords lhe aranoid, survived and gave us lheir genes (rovided
such aranoia did nol come al loo high a cosl, olhervise il vouId have
been a dravback). Our brain has been vired vilh biases lhal may
hamer us in a more comIex environmenl, one lhal requires a more
accurale assessmenl of robabiIilies.
The slory of lhese biases is lhus being corroboraled by lhe various
disciIines, lhe magnilude of lhe ercelionaI dislorlions makes us Iess
lhan ralionaI, in lhe sense of bolh having coherenl beIiefs (i.e. free of
IogicaI conlradiclions) and acling in a manner comalibIe vilh lhese
beIiefs.
c x a mp ! c s n I bi as c s i n u n d c r s t a n d i n g p r n b a b i ! i t y
I found in lhe behavioraI Iileralure al Ieasl 40 damning examIes of such
acule biases. eIov is lhe accounl of a veII-knovn lesl, and an embar-
rassing one for lhe medicaI rofession. The foIIoving quiz vas given lo
medicaI doclors (vhich I borroved from lhe exceIIenl Deborah
ennell's K'-18.-#))de
= (#)( 8< ' 1%)#')# :$#)#-() ' $'(# 8< Wn <'5)# :8)%(%&#)e FA# 1%)#')#
)($%>#) DiDN___ 8< (A# :8:B5'(%8-e ;#8:5# '$# (#)(#1 '( $'-18.N
$#+'$15#)) 8< ?A#(A#$ (A#, '$# )B):#/(#1 8< A'&%-+ (A# 1%)#')#e =
:'(%#-(R) (#)( %) :8)%(%&#e TA'( %) (A# :$8Y'Y%5%(, 8< (A# :'(%#-( Y#%-+
)($%/>#- ?%(A (A# 1%)#')#<h
D_
Mosl doclors ansvered 95%, simIy laking inlo accounl lhe facl lhal
lhe lesl has a 95% accuracy rale. The ansver is lhe condilionaI
robabiIily lhal lhe alienl is sick and lhe lesl shovs il - cIose lo 2%.
Less lhan one in five rofessionaIs gol il righl.
I viII simIify lhe ansver. Assume no faIse negalives. Consider lhal
oul of 1,000 alienls vho are adminislered lhe lesl, one viII be execled
lo be affIicled vilh lhe disease. Oul of a ouIalion of lhe remaining
999 heaIlhy alienls, lhe lesl viII idenlify aboul 50 vilh lhe disease (il is
95% accurale). The correcl ansver shouId be lhal lhe robabiIily of
being affIicled vilh lhe disease for someone seIecled al random vho
resenled a osilive lesl is lhe foIIoving ralio:
Number of affIicled ersons
Number of lrue and faIse osilives
here 1 in 51.
Think of lhe number of limes you viII be given a medicalion lhal
carries damaging side effecls for a given disease you vere loId you had,
vhen you may onIy have 2% robabiIily of being affIicled vilh il!
w c a r c n p t i n n b ! i n d
As an olion lrader, I have noliced lhal eoIe lend lo undervaIue
olions as lhey are usuaIIy unabIe lo correclIy menlaIIy evaIuale inslru-
menls lhal deIiver an B-/#$('%- ayoff, even vhen lhey are fuIIy con-
scious of lhe malhemalics. Iven reguIalors reinforce such ignorance by
exIaining lo eoIe lhal olions are a 1#/',%-+ or ?')(%-+ assel.
Olions lhal are oul of lhe money are deemed lo 1#/',N by Iosing lheir
remium belveen lvo dales.
I viII cIarify nexl vilh a simIified (bul sufficienl) exIanalion of
vhal an olion means. Say a slock lrades al $100 and lhal someone
gives me lhe righl (bul nol lhe obIigalion) lo buy il al $110 one monlh
ahead of loday. This is dubbed a /'55 olion. Il onIy makes sense for me
lo #7#$/%)# il, by asking lhe seIIer of lhe olion lo deIiver me lhe slock al
$110, if il lrades al a higher rice lhan $110 in one monlh's lime. If lhe
slock goes lo $120, my olion viII be vorlh $10, for I viII be abIe lo
buy lhe slock al $110 from lhe olion vriler and seII il lo lhe markel al
$120, ockeling lhe difference. ul lhis does nol have a very high
robabiIily. Il is caIIed 8B(H8<H(A#H.8-#,N for I have no gain from
exercising il righl avay.
Consider lhal I buy lhe olion for $1. "Whal do I execl lhe vaIue of
lhe olion lo be one monlh from nov` Mosl eoIe lhink 0. Thal is nol
lrue. The olion has a high robabiIily, say 90% of being vorlh 0 al
exiralion, bul erhas 10% robabiIily lo be vorlh an average of $10.
Thus, seIIing lhe olion lo me for $1 does nol rovide lhe seIIer vilh
free money. If lhe seIIers had inslead boughl lhe slock lhemseIves al
$100 and vailed lhe monlh, lhey couId have soId il for $120. Making
$1 nov vas hardIy, lherefore, free money. Likevise, buying il is nol a
vasling assel. Iven rofessionaIs can be fooIed. Hov` They confuse lhe
execled vaIue and lhe mosl IikeIy scenario (here lhe execled vaIue is
$1 and lhe mosl IikeIy scenario is for lhe olion lo be vorlh 0). They
menlaIIy overveigh lhe slale lhal is lhe mosl IikeIy, nameIy, lhal lhe
markel does nol move al aII. The olion is simIy lhe veighled average
of lhe ossibIe slales lhe assel can lake.
There is anolher lye of salisfaclion rovided by lhe olion seIIer. Il
is lhe sleady relurn and lhe sleady feeIing of revard - vhal
sychoIogisls caII <58?e Il is very Ieasanl lo go lo vork in lhe morning
vilh lhe execlalion of being u some smaII money. Il requires some
slrenglh of characler lo accel lhe execlalion of bIeeding a IillIe, Iosing
ennies on a sleady basis even if lhe slralegy is bound lo be rofilabIe
over Ionger eriods. I noliced lhal very fev olion lraders can mainlain
vhal I caII a "Iong voIaliIily" osilion, nameIy a osilion lhal viII mosl
IikeIy Iose a smaII quanlily of money al exiralion, bul is execled lo
make money in lhe Iong run because of occasionaI surls. I discovered
very fev eoIe vho acceled Iosing $1 for mosl exiralions and
making $10 once in a vhiIe, even if lhe game vere fair (i.e., lhey made
lhe $10 more lhan 10% of lhe lime).
I divide lhe communily of olion lraders inlo lvo calegories:
:$#.%B. )#55#$) and :$#.%B. YB,#$)e Iremium seIIers (aIso caIIed
olion seIIers) seII olions, and generaIIy make sleady money, Iike }ohn
in Chalers 1 and 5. Iremium buyers do lhe reverse. Olion seIIers, il is
said, eal Iike chickens and go lo lhe balhroom Iike eIehanls. AIas, mosl
olion lraders I encounlered in my career are :$#.%B. )#55#$) H vhen
lhey bIov u il is generaIIy olher eoIe's money.
Hov couId rofessionaIs seemingIy avare of lhe (simIe)
malhemalics be ul in such a osilion` Our underslanding of malh
can remain quile suerficiaI, medicine is slarling lo beIieve lhal our
aclions are nol quile guided by lhe arls of our brain lhal diclale
ralionaIily (see Anlonio Damasio's "#)/'$(#)R 6$$8$ or Ledoux's
6.8(%8-'5 X$'%-
DD
de We lhink vilh our emolions and lhere is no vay
around il. Ior lhe same reason, eoIe vho are olhervise ralionaI
engage in smoking or in fighls lhal gel lhem no immediale benefils,
Iikevise eoIe seII olions even vhen lhey knov lhal il is nol a good
lhing lo do. ul lhings can gel vorse. There is a calegory of eoIe,
generaIIy academics, vho, inslead of filling lheir aclions lo lheir brains,
inslead fil lheir brains lo lheir aclions. These go back and cheal vilh lhe
slalislics lo |uslify lheir aclions. In my business, lhey fooI lhemseIves
vilh slalislicaI argumenls lo |uslify lheir olion seIIing. ..
E*#")".1.%.(, )/2 %'( +(2.) X+#*( 6#$*/)1.,%,Y
A |ournaIisl is lrained in melhods lo exress himseIf ralher lhan lo
Iumb lhe delh of lhings - lhe seIeclion rocess favors lhe mosl
communicalive, nol necessariIy lhe mosl knovIedgeabIe. My medicaI
doclor friends cIaim lhal many medicaI |ournaIisls do nol undersland
anylhing aboul medicine and bioIogy, oflen making mislakes of a very
basic nalure. I cannol confirm such slalemenls, being myseIf a mere
amaleur (lhough al limes a voracious reader) in medicaI research bul I
have noliced lhal lhey aImosl aIvays misundersland lhe robabiIilies
used in medicaI research announcemenls. The mosl common one
concerns lhe inlerrelalion of evidence. They mosl commonIy gel mixed
u belveen 'Y)#-/# 8< #&%1#-/# and #&%1#-/# 8< 'Y)#-/#N a simiIar
robIem lo lhe one ve sav in Chaler 9. Hov` Say I lesl some
chemolheray, say IIuorouraciI for uer resiralory lracl cancer, and
find lhal il is beller lhan a Iacebo, bul onIy marginaIIy so, lhal (in
addilion lo olher modaIilies) il imroves survivaI from 21 er 100 lo 24
er 100. Given my samIe size, I may nol be confidenl lhal lhe
addilionaI 3% survivaI oinls come from lhe medicine, il couId be
mereIy allribulabIe lo randomness. I vouId vrile a aer oulIining my
resuIls and saying lhal lhere is no evidence of imroved survivaI (as yel)
from such medicine, and lhal furlher research vouId be needed. A
medicaI |ournaIisl vouId ick il u and cIaim lhal one Irofessor N.N.
TaIeb found evidence lhal IIuorouraciI 18#) -8( A#5:N vhich is enlireIy
oosile lo my inlenlions. Some naive doclor in SmaIIlovn, even more
uncomforlabIe vilh robabiIilies lhan lhe mosl unlrained |ournaIisl,
vouId ick il u and buiId a menlaI bIock againsl lhe medicalion, even
vhen some researcher finaIIy finds fresh evidence lhal such medicine
confers a cIear survivaI advanlage.
c n b c a t ! u n c h t i m c
The advenl of lhe financiaI leIevision channeI CNC resenled Ienly of
benefils lo lhe financiaI communily bul il aIso aIIoved a coIIeclion of
exlroverl raclilioners Iong on lheories lo voice lhem in a fev minules of
leIevision lime. One oflen sees reseclabIe eoIe making Iudicrous (bul
smarl-sounding) slalemenls aboul roerlies of lhe slock markel. Among
lhese are slalemenls lhal bIalanlIy vioIale lhe Iavs of robabiIily. One
summer during vhich I vas assiduous al lhe heaIlh cIub, I oflen heard
such slalemenl as "lhe reaI markel is onIy 10% off lhe highs vhiIe lhe
average slock is cIose lo 40% off ils highs", vhich is inlended lo be
indicalive of dee lroubIes or anomaIies - some harbinger of bear markels.
There is no incomalibiIily belveen lhe facl lhal lhe average slock is
dovn 40% from lhe highs vhiIe lhe average of aII slocks (lhal is, lhe
markel) is dovn 10% from ils ovn highs. One musl consider lhal lhe
slocks did nol aII reach lheir highs '( (A# )'.# (%.#e Given lhal slocks
are nol 100% correIaled, slock A mighl reach ils maximum in }anuary,
slock mighl reach ils maximum in AriI, bul lhe average of lhe lvo
slocks A and mighl reach ils maximum al some lime in Iebruary.
Iurlhermore, in lhe evenl of negaliveIy correIaled slocks, if slock A is al
ils maximum vhen slock is al ils minimum, lhen lhey couId bolh be
dovn 40% from lheir maximum vhen lhe slock markel is al ils highs!
y a Iav of robabiIily caIIed dislribulion of lhe maximum of random
variabIes, lhe maximum of an average is necessariIy Iess voIaliIe lhan lhe
average maximum.
y n u s h n u ! d b c d c a d b y n n w
This brings lo mind anolher common vioIalion of robabiIily by rime-
lime T.V. financiaI exerls, vho may be seIecled for lheir Iooks,
charisma and lheir resenlalion skiIIs, bul cerlainIy nol for lheir incisive
minds. Ior inslance, a faIIacy lhal I sav commonIy made by a
rominenl T.V. financiaI guru goes as foIIovs: "The average American
is execled lo Iive 73 years. Therefore if you are 68 you can execl lo
Iive five more years, and shouId Ian accordingIy". She venl inlo recise
rescrilions of hov lhe erson shouId invesl for a five more years
horizon. Nov vhal if you are 80` Is your Iife execlancy .%-B) seven
years` Whal lhese |ournaIisls confuse is lhe uncondilionaI and
condilionaI Iife execlancy. Al birlh, your uncondilionaI Iife execlancy
may be 73 years. ul as you advance in age and do nol die, your Iife
execlancy increases aIong vilh your Iife. Why` ecause lhe olher
eoIe by dying have laken your sol in lhe slalislics, for execlalion
means average. So if you are 73 and are in good heaIlh, you may sliII
have, say, nine years %- #7:#/('(%8-e ul lhe execlalion vouId change,
and al 82, you viII have anolher five years, rovided of course you are
sliII aIive. Iven someone 100 years oId sliII has a osilive condilionaI Iife
execlalion. Such a slalemenl, vhen one lhinks aboul il, is nol loo
differenl from lhe one lhal says: 8B$ 8:#$'(%8- A') ' .8$('5%(, $'(# 8<
Dne *8 <'$ ?# A'&# 8:#$'(#1 8- QQ :'(%#-() ?%(A +$#'( )B//#))j ,8B '$#
8B$ D__(AN A#-/# ,8B A'&# ' D__n :$8Y'Y%5%(, 8< 1,%-+ 8- (A# ('Y5#e
T.V. financiaI Ianners may confuse a fev eoIe. This is quile
harmIess. Whal is far more vorrying is lhe suIy of informalion by non-
rofessionaIs lo rofessionaIs, il is lo lhe |ournaIisls lhal ve lurn nexl.
t h c b ! n n m b c r g c x p ! a n a t i n n s
I have, on my desk, a machine eonymousIy caIIed a X588.Y#$+o (afler
lhe Iegendary founder MichaeI Ioomberg). Il acls as a safe e-maiI
service, a nevs service, a hisloricaI dala relrieving looI, a charling
syslem, an invaIuabIe anaIylicaI aid and, nol Ieasl, a screen vhere I can
see lhe rice qf securilies and currencies. I have gollen so addicled lo il
lhal I cannol oerale vilhoul il, as I vouId olhervise feeI cul off from
lhe resl of lhe vorId. I use il lo gel in conlacl vilh my friends, confirm
aoinlmenls, and soIve some of lhose enlerlaining quarreIs lhal ul
some sharness inlo Iife. Somehov, lraders vho do nol have a
Ioomberg address do nol exisl for us (lhey have lo have recourse lo
lhe more Iebeian inlernel). ul lhere is one asecl of Ioomberg I vouId.
disense vilh, lhe |ournaIisl's commenlary. Why` ecause lhey engage
in exIaining lhings and ereluale lhe righl-coIumn, Iefl-coIumn
confusion in a serious manner. Ioomberg is nol lhe soIe erelralor,
il is |usl lhal I have nol been exosed lo nevsaers' business seclions
over lhe asl decade, referring lo read reaI rose inslead.
As I am vriling lhese Iines I see lhe foIIoving headIines on my
Ioomberg:
pq "8? %) B: De_U 8- 58?#$ %-(#$#)( $'(#)e
pq "855'$ 18?- _eDL ,#- 8- A%+A#$ G':'-#)# )B$:5B)e
and so on for an enlire age. If I lransIale il veII, lhe |ournaIisl cIaims lo
rovide an exIanalion for somelhing lhal amounls lo :#$<#/( -8%)#e A
move of 1.03 vilh lhe Dov al 11,000 conslilules Iess lhan a 0.01%
move. Such a move does nol varranl an exIanalion. There is nolhing
lhere lhal an honesl erson can lry lo exIain, lhere are no reasons lo
adduce. ul Iike arenlice rofessors of comaralive Iileralure,
|ournaIisls being aid lo rovide exIanalions viII gIadIy and readiIy
rovide lhem. The onIy soIulion is for MichaeI Ioomberg lo slo
aying his |ournaIisls for roviding commenlary.
*%+-%<%/'-/#2 hov did I decide lhal il vas erfecl noise` Take a simIe
anaIogy. If you engage in a mounlain bicycIe race vilh a friend across
Siberia and, a monlh Ialer, beal him by one singIe second, you cIearIy
cannol quile boasl lhal you are fasler lhan him. You mighl have been
heIed by somelhing,,or il can be |usl Iain randomness, nolhing eIse.
Thal second is nol in ilseIf significanl enough for someone lo drav
concIusions. I vouId nol vrile in my re-bed-lime diary: /,/5%)( = %)
Y#((#$ (A'- /,/5%)( X Y#/'B)# A# %) <#1 ?%(A ):%-'/A ?A#$#') /,/5%)( X A')
L 1%#( $%/A %- (8<Be FA# $#')8- M '. .'>%-+ (A%) %-<#$#-/# %) Y#/'B)# A#
Y#'( A%. Y, DeU )#/8-1) %- ' UN___ .%5# $'/#e ShouId lhe difference be
one veek, lhen I couId slarl anaIyzing vhelher lofu is lhe reason, or if
lhere are olher faclors.
@'B)'5%(,2 lhere is anolher robIem, even assuming slalislicaI
significance, one has lo accel a cause and effecl, meaning lhal lhe
evenl in lhe markel can be Iinked lo lhe cause roffered. ;8)( A8/ #$+8
:$8:(#$ A8/ (il is lhe reason because il came afler). Say HosilaI A
deIivered 52% of boys and HosilaI deIivered lhe same year onIy
48%, vouId you lry lo give lhe exIanalion lhal you had a boy Y#/'B)#
%( vas deIivered in hosilaI A`
CausaIily can be very comIex. Il is very difficuIl lo isoIale a singIe
cause vhen lhere are Ienly around. This is caIIed muIlivariale anaIysis.
Ior inslance, if lhe slock markel can reacl lo U.S. domeslic inleresl
rales, lhe doIIar againsl lhe yen, lhe doIIar againsl lhe Iuroean
currencies, lhe Iuroean slock markels, lhe Uniled Slales baIance of
aymenls, Uniled Slales infIalion, and anolher dozen rime faclors,
lhen lhe |ournaIisls need lo Iook al aII of lhese faclors, Iook al lheir
hisloricaI effecl bolh in isoIalion and |oinlIy, Iook al lhe slabiIily of such
infIuence, lhen, afler consuIling lhe lesl slalislic isoIale lhe faclor if il is
ossibIe lo do so. IinaIIy, a roer confidence IeveI needs lo be given lo
lhe faclor ilseIf, if il is Iess lhal 90% lhe slory vouId be dead. I can
undersland vhy Hume vas exlremeIy obsessed vilh causaIily and couId
nol accel such inference anyvhere.
I have a lrick lo knov if somelhing $#'5 in lhe vorId is laking Iace. I
have sel u my Ioomberg monilor lo disIay lhe rice and ercenlage
change of aII reIevanl rices in lhe vorId: currencies, slocks, inleresl
rales, and commodilies. y dinl of Iooking al lhe same selu for years,
as I kee lhe currencies in lhe uer Iefl corner and lhe various slock
markels on lhe righl, I managed lo buiId an inslinclive vay of knoving
if somelhing serious is going on. The lrick is lo Iook onIy al lhe Iarge
ercenlage changes. UnIess somelhing moves by more lhan ils usuaI
daiIy ercenlage change, lhe evenl is deemed lo be noise. Iercenlage
moves are lhe size of lhe headIines. In addilion, lhe inlerrelalion is nol
Iinear, a 2% move is nol lvice as significanl an evenl as 1%, il is ralher
Iike four limes. The headIine of lhe Dov moving by 1.3 oinls on my
screen loday has Iess lhan one miIIionlh of lhe significance of lhe serious
7% dro of Oclober 1997. IeoIe mighl ask me: vhy do I vanl
everybody lo Iearn some slalislics` The ansver is lhal loo many eoIe
read exIanalions. We cannol inslincliveIy undersland lhe nonIinear
asecl of robabiIily.
I i ! t c r i n g m c t h n d s
Ingineers use melhods lo cIean u lhe noise from lhe signaI in lhe dala.
Did il ever occur lo you vhiIe laIking lo your cousin in AuslraIia or lhe
Soulh IoIe lhal lhe slalic on lhe leIehone Iine couId be dislinguished
from lhe voice of your corresondenl` The melhod is lo consider lhal
vhen a change in amIilude is smaII, il is more IikeIy lo resuIl from
noise - vilh ils IikeIihood of being a signaI increasing exonenliaIIy as
RANDOMNISS AND OUR RAIN: WI ARI IROAILITY LIND 167
Figurc 11. 1 UnIiitcrcd Dat a Cnnt ai ni ng 5igna! and Nni sc.
ils magnilude increases. The melhod is caIIed a smoolhing kerneI vhich
has been aIied in Iigures 11.1 and 11.2. ul our audilory syslem is
incaabIe of erforming such a funclion by ilseIf. Likevise our brain
cannol see lhe difference belveen a significanl rice change and mere
noise, arlicuIarIy vhen il is ounded vilh unsmoolhed |ournaIislic
noise.
0. 4
0. 2
0. 2
5 0 I5O 1 5 0 / 2 0 0 2 5 0
Figurc 1 1 . 2 5amc Dat a Wi t h its Nni sc Rcmnvcd.
wc d n n n t u n d c r s t a n d c n n I i d c n c c ! c v c ! s
IrofessionaIs forgel lhe foIIoving reaIily. Il is nol lhe eslimale or lhe
forecasl lhal mallers so much as lhe degree of confidence vilh lhe
oinion. Consider lhal you are going on a lri one faII morning and
need lo formuIale an idea aboul lhe vealher condilions rior lo acking
your Iuggage. If you execl lhe lemeralure lo be 60 degrees, Ius or
minus 10 degrees (say in Arizona), lhen you vouId lake no snov cIolhes
and no orlabIe eIeclric fan. Nov vhal if you vere going lo Chicago,
vhere you are loId lhal lhe vealher, vhiIe being 60 degrees, viII
neverlheIess vary by aboul 30 degrees` You vouId have lo ack vinler
and summer cIolhes. Here lhe execlalion of lhe lemeralure carries
IillIe imorlance concerning lhe choice of cIolhing, il is lhe variance lhal
mallers. Your decision lo ack is markedIy differenl nov lhal you are
loId lhal lhe variabiIily vouId be around 30 degrees. Nov Iel us ush
lhe oinl furlher, vhal if you vere going lo a Ianel vhere lhe
execlalion is aIso going lo be around 60 degrees, bul Ius or minus 500
degrees` Whal vouId you ack`
We can see lhal my aclivily in lhe markel deends far Iess on vhere I
lhink lhe markel is going so much as il does on lhe degree of error I
aIIov around such a confidence IeveI.
a n a d mi s s i n n
We cIose lhis chaler vilh lhe foIIoving informalion: I consider myseIf
as rone lo fooIishness as anyone I knov, in sile of my rofession and
lhe lime senl buiIding my exerlise on lhe sub|ecl. ul here is lhe
excelion, I knov lhal I am very, very veak on lhal score. My humanily
viII lry lo foiI me, I have lo slay on my guard. I vas born lo be fooIed by
randomness. Thal viII be exIored in Iarl III.
PART III
v a x i n my e a r s -
I i v i n g v i l h r a n b o m i l i s
O
dysseus, lhe Homerian hero, had lhe reulalion of using guiIe lo
overcome slronger oonenls. I find lhe mosl seclacuIar use of
such guiIe vas againsl no olher oonenl lhan himseIf.
In book 12 of lhe 91,))#,, lhe hero encounlers lhe sirens, on an
isIand nol far from lhe rocks of Caribde and ScyIIa. Their songs are
knovn lo charm lhe saiIors inlo madness, causing lhem lo irresislibIy-
casl lhemseIves inlo lhe sea off lhe sirens' coasl, and erish. The
indescribabIe beauly of lhe sirens' songs is conlrasled vilh lhe
moIdering corses of saiIors lhal slrayed inlo lhe area around lhem.
Odysseus, forevarned by Circe, conlrives lhe foIIoving ruse. He fiIIs lhe
ears of aII his men vilh vax, lo lhe oinl of lolaI deafness, and has
himseIf lied lo lhe masl. The saiIors are under slricl inslruclions nol lo
reIease him. As lhey aroach lhe sirens' isIand, lhe sea is caIm and over
lhe valer comes lhe sound of a music so ravishing lhal Odysseus
slruggIes lo gel Ioose, exending an inordinale amounl of energy lo
unreslrain himseIf. His men lie him even furlher, unliI lhey are safeIy
asl lhe oisoned sounds.
The firsl Iesson I look from lhe slory is nol lo even alleml lo be
Odysseus. He is a mylhoIogicaI characler and I am nol. He can be lied
lo lhe masl, I can mereIy reach lhe rank of a saiIor vho needs lo have his
ears fiIIed vilh vax.
172 WAX IN MY IARS
i a m n n t s n i n t c ! ! i g c n t
The eihany I had in my career in randomness came vhen I underslood
lhal I vas nol inleIIigenl enough, nor slrong enough, lo even lry lo fighl
my emolions. esides, I beIieve lhal I need my emolions lo formuIale my
ideas and gel lhe energy lo execule lhem.
I am |usl inleIIigenl enough lo undersland lhal I have a redisosilion
lo be fooIed by randomness - and lo accel lhe facl lhal I am ralher
emolionaI. I am dominaled by my emolions - bul as an aeslhele, I am
hay aboul lhal facl. I am |usl Iike every singIe characler vhom I
ridicuIed in lhis book. Nol onIy lhal, bul I may be even vorse lhan lhem
because lhere may be a negalive correIalion belveen beIiefs and
behavior (recaII Ioer lhe man). The difference belveen myseIf and
lhose I ridicuIe is lhal I lry lo be avare of il. No maller hov Iong I sludy
and lry lo undersland robabiIily, my emolions viII resond lo a
differenl sel of caIcuIalions, lhose lhal my uninleIIigenl genes vanl me
lo handIe. If my brain can leII lhe difference belveen noise and signaI,
my hearl cannol.
Such uninleIIigenl behavior does nol |usl cover robabiIily and
randomness. I do nol lhink I am reasonabIe enough lo avoid gelling
angry vhen a discourleous driver bIovs his horn al me for being one
nanosecond Iale afler a lraffic Iighl lurns green. I am fuIIy avare lhal
such anger is seIf-deslruclive and offers no benefil, and lhal if I vere lo
deveIo anger for every idiol around me doing somelhing of lhe sorl, I
vouId be Iong dead. These smaII daiIy emolions are nol ralionaI. ul ve
need lhem lo funclion roerIy. We are designed lo resond lo hosliIily
vilh hosliIily. I have enough enemies lo add some sice lo my Iife, bul I
somelimes vish I had a fev more (I rareIy go lo lhe movies and need lhe
enlerlainmenl). Life vouId be unbearabIy bIand if ve had no enemies
on vhom lo vasle efforls and energy.
The good nevs is lhal lhere are lricks. One such lrick is lo avoid eye
conlacl (lhrough lhe rear-viev mirror) vilh olher ersons in such
encounlers as lraffic silualions. I lry lo imagine lhal lhe olher erson is a
Marlian, ralher lhan a human being. Il vorks somelimes - bul il vorks
besl vhen lhe erson resenls lhe aearance of being from a differenl
secies. Hov` I am an avid road cycIisl. RecenlIy, as I vas riding aIong
vilh olher cycIisls, sIoving dovn lraffic in a ruraI area, a smaII voman
WAX IN MY IARS 173
in a gianl sorls uliIily vehicIe oened her vindov and heaed curses al
us. Nol onIy did il nol usel me bul I did nol even inlerrul my lhoughls
lo ay allenlion. When I am on my bicycIe, eoIe in Iarge lrucks
become a variely of dangerous animaIs, caabIe of lhrealening me bul
incaabIe of making me angry.
I have, Iike anyone vilh slrong oinions, a coIIeclion of crilics among
finance academics and economisls, annoyed by my allacks on lheir
misuse of robabiIily and unhay aboul my branding lhem as
seudoscienlisls. I am incaabIe of laming my emolions vhen reading
lheir commenls. The besl I can do is |usl nol read lhem. Likevise vilh
|ournaIisls. Nol reading lheir discussions of markels sares me Ienly of
emolionaI exendilure. I viII do lhe same vilh revievs of lhis book.
Wax in my ears.
4'( I2C,,()/ +$%( 0#==)/2
RecaII lhal lhe accomIishmenl from vhich I derive lhe mosl ride is my
veaning myseIf from leIevision and lhe nevs media. I am currenlIy so
veaned lhal il acluaIIy cosls me more energy lo valch leIevision lhan lo
erform any olher aclivily, Iike, say, vriling lhis book. ul lhis did nol
come vilhoul lricks. Wilhoul lricks I vouId nol escae lhe loxicily of
lhe informalion age. In lhe lrading room of my comany I currenlIy
have lhe leIevision sel lurned on aII day vilh lhe financiaI nevs channeI
CNC slaging commenlalor afler commenlalor and CIO afler CIO
murdering rigor aII day Iong. Whal is lhe lrick` I have lhe voIume
lurned comIeleIy off. Why` ecause vhen lhe leIevision sel is siIenl,
lhe babbIing erson Iooks ridicuIous, exaclIy lhe oosile effecl as vhen
lhe sound is on. One sees a erson vilh moving Iis and conlorlions in
lheir faciaI muscIes, laking lhemseIves seriousIy - bul no sound comes
oul. We are visuaIIy bul nol audiloriIy inlimidaled, vhich causes a
dissonance. The seaker's face exresses some excilemenl, bul since no
sound comes oul, lhe exacl oosile is conveyed. This is lhe sorl of
conlrasl lhe hiIosoher Henri ergson had in mind in his F$#'(%)# 8-
a'B+A(#$N vilh his famous descrilion of lhe ga belveen lhe
174 WAX IN MY IARS
seriousness of a genlIeman aboul lo vaIk on a banana skin and lhe
comicaI asecl of lhe silualion. TeIevision undils Iose lheir inlimidal-
ing effecl, lhey even Iook ridicuIous. They seem lo be exciled aboul
somelhing lerribIy unimorlanl. SuddenIy undils become cIovns,
vhich is a reason lhe vriler Graham Greene refused lo go on leIevision.
I had lhis idea of slriing eoIe from Ianguage vhiIe, on a lri, I
Iislened (vhiIe brulaIIy |elIagged) lo a seech in Canlonese, a Ianguage I
do nol undersland, vilhoul lhe benefil of lransIalion. Since I had no
ossibIe cIue aboul his sub|ecl, lhe animaled oralor Iosl a Iarge share of
his dignily. The idea came lo me lhal erhas I couId use a genelic bias,
here re|udice, lo offsel anolher genelic bias, our redisosilion lo lake
informalion seriousIy. Il seems lo vork.
This arl, lhe concIusion of lhis book, resenls lhe human asecl of
deaIing vilh uncerlainly. I have ersonaIIy faiIed in a generaI insuIalion
from randomness, bul I have managed a fev lricks.
l v e I v e
" 4
g a mb I e r s ' l i c k s a n d
i ge o ns i n a b o x
9- +'.Y5#$)R (%/>) /$8?1%-+ B: ., 5%<#e TA, Y'1 ('7%H/'Y
6-+5%)A /'- A#5: ,8B .'># .8-#,e 08? M '. (A# <885 8< '55
<885)N #7/#:( (A'( M '. '?'$# 8< %(e "#'5%-+ ?%(A ., +#-#(%/
B-<%(-#))e E8 Y87#) 8< /A8/85'(# B-1#$ ., ($'1%-+ 1#)>e
4)Z.90)" Q/81.,' )/2 0)$,)1.%C
F
irsl, a fIashback in lime lo my earIy days as a lrader in Nev York.
IarIy in my career, I vorked al Credil Suisse Iirsl oslon, lhen
Iocaled in lhe middIe of lhe bIock belveen 52nd and 53rd Slreel,
belveen Madison and Iark Avenue. Il vas caIIed a WaII Slreel firm, in
sile of ils midlovn Iocalion - 1 used lo cIaim lo vork "on WaII Slreel"
in sile of having been Iucky enough lo sel fool onIy lvice in lhe
hysicaI WaII Slreel, one of lhe mosl reuIsive areas I have visiled easl
of Nevark, Nev }ersey.
Then, in my lvenlies, I Iived in a book-choked (bul olhervise ralher
bare) aarlmenl in Manhallan's uer easl side. The bareness vas nol
ideoIogicaI, il vas simIy because I never managed lo enler a furnilure
slore, as I vouId evenluaIIy slo al a bookslore aIong lhe vay and hauI
176 WAX IN MY IARS
bags of books inslead. As can be execled, lhe kilchen vas devoid of
any form of food and ulensiIs, save for a defeclive exresso machine, as
I Iearned lo cook onIy very recenlIy (even lhen . . . ).
I venl lo vork every morning in a yeIIov cab, vhich droed me off
al lhe corner of Iark Avenue and 53rd Slreel. Cab drivers in Nev York
Cily are knovn lo be ralher unlamed and universaIIy unfamiIiar vilh
lhe geograhy of lhe Iace, bul, on occasion, one can find a cab driver
vho can bolh be unacquainled vilh lhe cily and skelic of lhe
universaIily of lhe Iavs of arilhmelic. One day I had lhe misforlune (or
erhas lhe forlune, as ve viII see) lo ride vilh a driver vho did nol
seem caabIe of handIing any Ianguage knovn lo me, vhich incIudes
laxi-cab IngIish. I lried lo heI him navigale soulh belveen 74lh Slreel
and 53rd Slreel, bul he slubbornIy conlinued lhe |ourney an addilionaI
bIock soulh, forcing me lo use lhe 52nd Slreel enlrance. Thal day, my
lrading orlfoIio made considerabIe rofils, oving lo considerabIe
lurmoiI in currencies, il vas lhen lhe besl day of my young career.
The nexl day, as usuaI, I haiIed a cab from lhe corner of 74lh Slreel
and Third Avenue. The revious driver vas novhere in sighl, erhas
deorled back lo lhe oId counlry. Too bad, I vas gried vilh lhe
unexIainabIe desire lo ay him back for lhe favor he had done me and
surrise him vilh a giganlic li. Then I caughl myseIf inslrucling lhe
nev cab driver lo lake me lo lhe norlh-easl corner of 52nd Slreel and
Iark Avenue, exaclIy vhere I vas droed off lhe day before. I vas
laken aback by my ovn vords . . . bul il vas loo Iale.
When I Iooked al my refIeclion in lhe eIevalor's mirror, il davned on
me lhal I vore lhe exacl same lie as lhe day before - vilh lhe coffee
slains from lhe revious day's fracas (my onIy addiclion is lo coffee).
There vas someone in me vho visibIy beIieved in a slrong causaI Iink
belveen my use of lhe enlrance, my choice of lie and lhe revious day's
markel behavior. I vas dislurbed for acling Iike a fake, Iike an aclor
vho imersonaled some roIe lhal vas nol his. I feIl lhal I vas an
imoslor. On lhe one hand, I laIked Iike someone vilh slrong scienlific
slandards, a robabiIisl focused on his crafl. On lhe olher, I had cIosed
suerslilions |usl Iike one of lhese bIue-coIIar il lraders. WouId I have
lo go buy a horoscoe nexl`
A IillIe brooding reveaIed lhal my Iife unliI lhen had been governed
by miId suerslilions, me lhe exerl in olions and disassionale
GAMLIRS' TI CKS AND II GIONS IN A OX 177
caIcuIalor of robabiIilies, a ralionaI lrader! Il vas nol lhe firsl lime
lhal I had acled on miId suerslilions of a harmIess nalure, vhich I
beIieved vere insliIIed in me by my Iaslern Medilerranean rools: one
does nol grab lhe saIl shaker from lhe hand of anolher erson risking a
faIIing oul, one is lo knock on vood uon receiving a comIimenl, Ius
many olher Levanline beIiefs assed on for a fev dozen cenluries. ul
Iike many lhings lhal brev and sread around lhe ancienl ond, lhese
beIiefs I had laken vilh a fIuclualing mixlure of soIemnily and mislrusl.
We consider lhem more Iike riluaIs lhan lruIy imorlanl aclions meanl
lo slave off undesirabIe lurns of lhe goddess Iorluna - suerslilions can
insliII some oelry in daiIy Iife.
The vorrying arl vas lhal il vas lhe firsl lime lhal I noliced
suerslilions creeing inlo my rofessionaI Iife. My rofession is lo acl
Iike an insurance comany, slringenlIy comuling lhe odds based on
veII defined melhods, and making a rofil because olher eoIe are Iess
rigorous, gel bIinded by some "anaIysis", or acl vilh lhe beIief lhal lhey
are chosen by desliny. ul lhere vas loo much randomness fIooding my
occualion.
I delecled lhe raid accumuIalion of vhal is caIIed "gambIers' licks"
surreliliousIy deveIoing in my behavior - lhough minule and bareIy
deleclabIe. UnliI lhen lhese smaII licks had escaed me. My mind
seemed lo be conslanlIy lrying lo delecl a slalislicaI conneclion belveen
some of my faciaI exressions and oulcome of evenls. Ior examIe, my
income slarled lo increase afler I discovered my sIighl near-sighledness
and slarled vearing gIasses. AIlhough gIasses vere nol quile necessary,
nor even usefuI, excel for nighl driving, I kel lhem on my nose as I
unconsciousIy acled as if I beIieved in lhe associalion belveen
erformance and gIasses. To my brain such slalislicaI associalion vas
as surious as il can gel, oving lo lhe reduced samIe size, yel lhis
nalive slalislicaI inslincl did nol seem lo benefil from my exerlise in
hyolhesis lesling.
GambIers are knovn lo deveIo some behavioraI dislorlions as a
resuIl of some alhoIogicaI associalion belveen a belling oulcome and
some hysicaI move. "GambIer" is aboul lhe mosl derogalory lerm lhal
couId be used in my derivalives rofession. As an aside, gambIing lo me
is besl defined as an aclivily vhere lhe agenl gels a lhriII vhen
confronling a random oulcome, regardIess of vhelher he has lhe odds
178 WAX IN MY IARS
slacked in his favor or againsl him. Iven vhen lhe odds are cIearIy
slacked againsl lhe gambIer, he somelimes lranscends lhe odds by
beIieving lhal desliny seIecled him in some manner. This .shovs in lhe
very sohislicaled eoIe one meels in casinos vhere lhey normaIIy
shouId nol be found. I even ran inlo vorId-cIass robabiIily exerls vho
had a gambIing habil on lhe side, lhroving aII of lheir knovIedge lo lhe
vind. Ior examIe, a former coIIeague of mine and one of lhe mosl
inleIIigenl eoIe I have ever mel, frequenlIy venl lo Las Vegas, and
seemed lo be such a lurkey lhal lhe casino rovided him vilh
comIimenlary Iuxury suiles and lransorlalion. He even consuIled a
forlune leIIer rior lo laking Iarge lrading osilions and lried lo gel
reimbursed by our emIoyer.
4'( <K.//(* E.8(#/ QZ5(*.=(/%
Al 25, I vas lolaIIy ignoranl of lhe behavioraI sciences. I had been
fooIed by my educalion and cuIlure inlo beIieving lhal ., )B:#$)(%(%8-)
?#$# /B5(B$'5N and lhal, consequenlIy, lhey couId be shed lhrough lhe
exercise of so-caIIed reason. Taken al lhe generaI IeveI of sociely,
modern Iife vouId eIiminale lhem as science and Iogic vouId enler il.
ul in my case, I vas over lime gelling more sohislicaled inleIIecluaIIy,
bul lhe fIoodgales of randomness vere bursling and I vas becoming
more suerslilious.
These suerslilions needed lo be bioIogicaI - bul I vas broughl u in
an era vhen lhe dogma vas lhal il vas nurlure, rareIy nalure, lhal vas
lhe cuIril. CIearIy, lhere vas nolhing cuIluraI aboul my Iink belveen
my vearing gIasses and a random markel oulcome. There vas nolhing
cuIluraI in my Iink belveen my use of enlrance and my erformance as a
lrader. There vas nolhing cuIluraI in my vearing lhe same lie as lhe day
before. Somelhing in us has nol deveIoed roerIy over lhe asl
lhousand years and I vas deaIing vilh lhe remnanl of our oId brain.
To robe lhe oinl furlher, ve need lo Iook al such formalions of
causaI associalions in lhe Iover forms of Iife. The famous Harvard
sychoIogisl .I. Skinner conslrucled a box for rals and igeons,
GAMLIRS' TI CKS AND II GIONS IN A OX 179
equied vilh a svilch lhal lhe igeon can oerale by ecking. In
addilion, an eIeclricaI mechanism deIivers food inlo lhe box. Skinner
designed lhe box in order lo sludy more generaI roerlies of lhe
behavior of a coIIeclion of nonhumans, bul il vas in 1948 lhal he had
lhe briIIianl idea of ignoring lhe Iever and focusing on lhe food deIivery.
He rogrammed il lo deIiver food al random lo lhe famished birds.
He sav quile aslonishing behavior on lhe arl of lhe birds, lhey
deveIoed an exlremeIy sohislicaled rain-dance lye of behavior in
resonse lo lheir ingrained slalislicaI machinery. One bird svung ils
head rhylhmicaIIy againsl a secific corner of lhe box, olhers sun lheir
heads anli-cIockvise, IileraIIy aII of lhe birds deveIoed a secific riluaI
lhal rogressiveIy became hard-vired inlo lheir mind as Iinked lo lheir
feeding.
This robIem has a more vorrying exlension, ve are nol made lo
viev lhings as indeendenl from each olher. When vieving lvo evenls
A and , il is hard nol lo assume lhal A causes , causes A, or bolh
cause each olher. Our bias is immedialeIy lo eslabIish a causaI Iink.
WhiIe lo a budding lrader lhis causes hardIy any vorse cosls lhan a fev
ennies in cab fare, il can drav lhe scienlisl inlo surious inference. Ior
il is harder lo acl as if one vere ignoranl lhan as if one vere smarl,
scienlisls knov lhal il is emolionaIIy harder lo re|ecl a hyolhesis lhan
lo accel il (vhal is caIIed lye I and lye II errors) - quile a difficuIl
maller vhen ve have such sayings as <#5%7 CB% :8(B%( /8+-8)/#$# /'B)')
(hay is he vho underslands vhal is behind lhings). Il is very hard for
us lo |usl shul u. We are nol cul oul for il. Ioer or nol, ve lake
"hings loo seriousIy.
E'.1#,%*)%$, ;(2$Z
I offered no soIulion lo lhe robIem of slalislicaI inference al a Iov
resoIulion. I discussed in Chaler 3 lhe lechnicaI difference belveen
noise and meaning - bul il is lime lo discuss lhe execulion. The Greek
hiIosoher Iyrrho, vho advocaled a Iife of equanimily and
indifference, vas crilicized for faiIing lo kee his comosure during a
180 WAX IN MY IARS
crilicaI circumslance (he vas chased by an ox). His ansver vas lhal he
found il somelimes difficuIl lo rid himseIf of his humanily. If Iyrrho
cannol slo being human, I do nol see vhy lhe resl of us shouId
resembIe lhe ralionaI man vho acls erfeclIy under uncerlainly as
roounded by economic lheory. I discovered lhal much of lhe
ralionaIIy oblained resuIls using my comulalions of lhe various
robabiIilies do nol regisler deeIy enough lo imacl my ovn conducl.
In olher vords, I acled Iike lhe doclor in Chaler 11 vho knev of lhe
2% robabiIily of lhe disease, bul somehov unvillingIy lrealed lhe
alienl as if lhe aiImenl had a 95% robabiIily of being lhere. My brain
and my inslincl vere nol acling in concerl.
The delaiIs are as foIIovs. As a ralionaI lrader (aII lraders boasl so) I
beIieve as I discussed before lhal lhere is a difference belveen noise and
signaI, and lhal noise needs lo be ignored vhiIe a signaI needs lo be
laken seriousIy. I use eIemenlary (bul robusl) melhods lhal aIIov me lo
caIcuIale lhe execled noise and signaI comosilion of any fIuclualion in
my lrading erformance. Ior examIe, afler regislering a rofil of
$100,000 on a given slralegy, I may assign a 2% robabiIily lo lhe
hyolhesis of lhe slralegy being rofilabIe and 98% robabiIily lo lhe
hyolhesis lhal lhe erformance may be lhe resuIl of mere noise. A gain
of $1,000,000, on lhe olher hand, cerlifies lhal lhe slralegy is a
rofilabIe one, vilh a 99% robabiIily. A ralionaI erson vouId acl
accordingIy in lhe seIeclion of slralegies, and sel his emolions in
accordance vilh his resuIls. Yel I have exerienced Ieas of |oy over
resuIls lhal I knev vere mere noise, and bouls of unhainess over
resuIls lhal did nol carry lhe sIighlesl degree of slalislicaI significance. I
cannol heI il/ bul I am emolionaI and derive mosl of my energy from
my emolions. So lhe soIulion does nol reside in laming my hearl.
Since my hearl does nol seem lo agree vilh my brain, I need lo lake
serious aclion lo avoid making irralionaI lrading decisions, nameIy, by
denying myseIf access lo my erformance reorl unIess il hils a
redelermined lhreshoId. This is no differenl from lhe divorce belveen
my brain and my aelile vhen il comes lo lhe consumlion of
chocoIale. I generaIIy deaI vilh il by ascerlaining lhal lhere are no
chocoIale boxes under my lrading desk.
One of lhe mosl irrilaling conversalions I've had is vilh eoIe vho
Ieclure me on A8? M )A8B51 behave. Mosl of us knov relly much A8?
GAMLIRS ' TI CKS AND II GIONS IN A OX 181
?# )A8B51 behave. Il is lhe execulion lhal is lhe robIem, nol lhe
absence of knovIedge. I am lired of lhe moraIizing sIov-lhinkers vho
ound me vilh Ialiludes Iike I shouId fIoss daiIy, eal my reguIar aIe
and visil lhe gym oulside of lhe nev-year resoIulion. In lhe markels lhe
recommendalion vouId be lo ignore lhe noise comonenl in lhe
erformance. We need lricks lo gel us lhere bul before lhal ve need lo
accel lhe facl lhal ve are mere animaIs in need of Iover forms of lricks,
nol Ieclures.
IinaIIy, I consider myseIf Iucky for nol having a cigarelle addiclion.
Ior lhe besl vay lo undersland hov ve couId be ralionaI in our
ercelion of lhe risks and robabiIilies and, al lhe same lime, be fooIish
vhiIe acling on lhem, vouId be lo have a conversalion vilh a cigarelle
smoker. Ior fev cigarelle smokers remain unavare of lhe facl lhal Iung
cancer slrikes one in lhree of lheir ouIalion. If you remain uncon-
vinced, lake a Iook al lhe huddIing smoking crovd oulside lhe service
enlrance of lhe MemoriaI-SIoan Kellering Cancer Cenler in Nev York
Cily's uer Iasl side. You viII see dozens of cancer nurses (and,
erhas, doclors) slanding oulside lhe enlrance vilh a cigarelle in hand
as hoeIess alienls are vheeIed in for lheir lrealmenls.
l h i r l e e n
@'(8 (A# /#-)8$ )#-1) @'$-#'1#) :'/>%-+e 38-)%#B$ 1# E8$:8%)
18#) -8( $#.#.Y#$ A%) 851 8:%-%8-)e X#?'$# (A# )/%#-(%)(e
3'$$,%-+ %1#')e FA# )'.# K8Y#$( 3#$(8- A#5:%-+ (A# 'B(A8$
)('$( A%) <%$.e */%#-/# #&85&#) <$8. <B-#$'5 (8 <B-#$'5e
A
sk your IocaI malhemalician lo define robabiIily, he vouId mosl
robabIy shov you hov lo comule il. As ve sav in Chaler 3 on
robabiIislic inlroseclion, robabiIily is nol aboul lhe odds, bul aboul
lhe beIief in lhe "exislence of an aIlernalive oulcome, cause, or molive.
RecaII lhal malhemalics is a looI lo medilale, nol comule. Again, Iel us
go back lo lhe eIders for more guidance - for robabiIilies vere aIvays
considered by lhem as nolhing beyond a sub|eclive, and fIuid, measure
of beIiefs.
CARNIADIS COMIS TO ROMI: ON IROAILITY AND SKIITICISM 183
0)*/()2(, 0#=(, %# ;#=(
Around 155 .C., lhe Greek osl-cIassicaI hiIosoher Carneades of
Cyrene came lo Rome as one of lhe lhree Alhenian ambassadors vho
came lo beg lhe Roman Senale for a oIilicaI favor. A fine had been
Ievied againsl lhe cilizens of lheir cily, and lhey vanled lo convince
Rome lhal il vas unfair. Carneades reresenled lhe Academy, lhe same
argumenlalive oen-air inslilulion vhere lhree cenluries before Socrales
drove his inlerIoculors lo murder him |usl lo gel some resile from his
argumenls. Il vas nov caIIed lhe Nev Academy, vas no Iess
argumenlalive, and had lhe reulalion of being lhe holbed of skelicism
in lhe ancienl vorId.
On lhe much anlicialed day of his oralion, he slood u and
deIivered a briIIianlIy argued harangue in raise of |uslice and hov
devoIving il shouId be al lhe lo of our molives. The Roman audience
vas seIIbound. Il vas nol |usl his charisma, lhe audience vas svayed
by lhe slrenglh of lhe argumenls, lhe eIoquence of lhe lhoughl, lhe
urily of lhe Ianguage, and lhe energy of lhe seaker. ul lhal vas nol
lhe oinl he vanled lo driII.
The nexl day, Carneades came back, slood u and eslabIished lhe
doclrine of uncerlainly of knovIedge in lhe mosl ossibIy convincing
vay. Hov` y roceeding lo conlradicl and refule vilh no Iess svaying
argumenls vhal he had eslabIished so convincingIy lhe day before. He
managed lo ersuade lhe very same audience and in lhe same sol lhal
|uslice shouId be vay dovn on lhe Iisl of molivalions for human
underlakings.
Nov lhe bad nevs. Calo lhe eIder (lhe "censor") vas among lhe
audience, aIready quile oId, and no more loIeranl lhan he had been
during his office of censor. Inraged, he ersuaded lhe Senale lo send lhe
lhree ambassadors acking Iesl lheir argumenlalive siril muddIe lhe
siril of lhe youlh of lhe ReubIic and veaken lhe miIilary cuIlure.
(Calo had banned during his office of censorshi aII Greek rheloricians
from eslabIishing residence in Rome. He vas loo much a no-nonsense
lye of erson lo accel lheir inlroseclive exansions.)
Ca r nc a dc s wa s nn t t hc I i r st s kcpt i c i n c ! as s i c a! t i mc s , nn r wa s hc t hc
Ii rst t n t c a c h us t hc t r uc nn t i n n n I pr nba bi ! i t y. But t hi s i nc i dcnt r c ma i ns
184 WAX IN MY IARS
lhe mosl seclacuIar in ils imacl on generalions of rheloricians and
lhinkers. Carneades vas nol mereIy a skelic, he vas a diaIeclician,
someone vho never commilled himseIf lo any of lhe remises from
vhich he argued, or lo any of lhe concIusions he drev from lhem. He
slood aII his Iife againsl arroganl dogma and beIief in one soIe lrulh. Iev
credibIe lhinkers rivaI Carneades in lheir rigorous skelicism (a cIass lhal
vouId incIude lhe medievaI Arab hiIosoher A1 GazaIi, Hume, and
Kanl - bul onIy Ioer came lo eIevale his skelicism lo an aII-encom-
assing scienlific melhodoIogy). As lhe skelics' main leaching vas lhal
nolhing couId be acceled vilh cerlainly, concIusions of various degrees
of robabiIily couId be formed, and lhese suIied a guide lo conducl.
Sleing furlher back in lime and searching for lhe firsl knovn uses
of robabiIislic lhinking in hislory, ve find il harks back lo sixlh-
cenlury (.C.) Greek SiciIy. There, lhe nolion of robabiIily vas used in
a IegaI framevork by lhe very firsl rheloricians vho, vhen arguing a
case, needed lo shov lhe exislence of a doubl concerning lhe cerlainly
of lhe accusalion. The firsl knovn rhelorician vas a Syracusean named
Korax vho engaged in leaching eoIe hov lo argue from robabiIily.
Al lhe core of his melhod vas lhe nolion of lhe .8)( :$8Y'Y5#e Ior
examIe, lhe ovnershi of a iece of Iand, in lhe absence of furlher
informalion and hysicaI evidence, shouId go lo lhe erson afler vhose
name il is besl knovn. One of his indirecl sludenls, Gorgias, look lhis
melhod of argumenlalion lo Alhens, vhere il fIourished. Il is lhe
eslabIishmenl of such .8)( :$8Y'Y5# nolions lhal laughl us lo viev lhe
ossibIe conlingencies as dislincl and searabIe evenls vilh robabiIilies
allached lo each one of lhem.
p r n b a b i ! i t y t h c c h i ! d n I s kc pt i c i s m
UnliI lhe Medilerranean basin vas dominaled vilh monolheism, vhich
Ied lo lhe beIief in some form of uniqueness of lhe lrulh (lo be
suerceded Ialer by eisodes of communism), skelicism had gained
currency among many ma|or lhinkers - and cerlainIy ermealed lhe
vorId. The Romans did nol have a reIigion :#$ )#j lhey vere loo
loIeranl lo accel a given lrulh. Theirs vere a coIIeclion of a variely of
fIexibIe and syncrelic suerslilions. I viII nol gel loo lheoIogicaI, excel
lo say lhal ve had lo vail for a dozen cenluries in lhe Weslern vorId lo
esouse crilicaI lhinking again. Indeed, for some slrange reason during
lhe middIe ages, Arabs vere crilicaI lhinkers (lhrough lheir osl-
cIassicaI hiIosohicaI lradilion) vhen Chrislian lhoughl vas dogmalic,
lhen afler lhe renaissance, lhe roIes mysleriousIy reversed.
One aulhor from anliquily vho rovides us evidence of such lhinking
is lhe garruIous Cicero. He referred lo be guided by robabiIily lhan
aIIege vilh cerlainly - very handy, some said, because il aIIoved him lo
conlradicl himseIf. This may be a reason for us, vho have Iearned from
Ioer hov lo remain seIf crilicaI, lo resecl him more, as he did nol
hev slubbornIy lo an oinion for lhe mere facl lhal he had voiced il in
lhe asl. Indeed your average Iileralure rofessor vouId fauIl him for
his conlradiclions and his change of mind.
Il vas nol unliI modern limes lhal such desire lo be free from our
ovn asl slalemenls emerged. Novhere vas il made more eIoquenlIy
lhan in rioling sludenl graffili in Iaris. The sludenl movemenl lhal look
Iace in Irance in 1968, vilh lhe youlh no doubl choking under lhe
veighl of years of having lo sound inleIIigenl and coherenl, roduced,
among olher |eveIs, lhe foIIoving demand:
T# 1#.'-1 (A# $%+A( (8 /8-($'1%/( 8B$)#5&#)k
+#/,.($* 2( 3#*5#.,U, I5./.#/,
Modern limes rovide us vilh a deressing slory. SeIf-conlradiclion is
made cuIluraIIy lo be shamefuI, a maller lhal can rove disaslrous in
science. MarceI Irousl's noveI M- *#'$/A 8< F%.# a8)( fealures a semi-
relired diIomal, Marquis de Norois, vho, Iike aII diIomals before
lhe advenl of lhe fax machine, vas a sociaIile vho senl considerabIe
lime in saIons. The narralor of lhe noveI sees Monsieur de Norois
oenIy conlradicling himseIf on some issue (some revar raroche-
menl belveen Irance and Germany). When reminded of his revious
osilion, Monsieur de Norois did nol seem lo recaII il. Irousl reviIes
him:
186 WAX IN MY IARS
38-)%#B$ 1# E8$:8%) ?') -8( 5,%-+e 0# A'1 gB)( <8$+8((#-e 9-#
<8$+#() $'(A#$ CB%/>5, ?A'( 8-# A') -8( (A8B+A( 'Y8B( ?%(A 1#:(AN
?A'( A') Y##- 1%/('(#1 (8 ,8B Y, %.%('(%8-N Y,` (A# :'))%8-)
)B$$8B-1%-+ ,8Be FA#)# /A'-+#N '-1 ?%(A (A#. )8 18 ,8B$ .#.8$%#)e
6&#- .8$# (A'- 1%:58.'()N :85%(%/%'-) 18 -8( $#.#.Y#$ 8:%-%8-)
(A#, A'1 '( )8.# :8%-( %- (A#%$ 5%&#) '-1 (A#%$ <%YY%-+) '$# .8$#
'(($%YB('Y5# (8 '- #7/#)) 8< '.Y%(%8- (A'- ' 5'/> 8< .#.8$,e
Monsieur de Norois is made lo be ashamed of lhe facl lhal he
exressed a differenl oinion. Irousl did nol consider lhal lhe diIomal
mighl have changed his mind. We are suosed lo be failhfuI lo our
oinions. One becomes a lrailor olhervise.
Nov I hoId lhal Monsieur de Norois shouId be a lrader. One of lhe
besl lraders I have ever encounlered in my Iife, NigeI abbage, has lhe
remarkabIe allribule of being comIeleIy free of any alh deendence in
his beIiefs. He exhibils absoIuleIy no embarrassmenl buying a given
currency on a ure imuIse, vhen onIy hours ago he mighl have voiced
a slrong oinion as lo ils fulure veakness. Whal changed his mind` He
does nol feeI obIigaled lo exIain il.
The ubIic erson mosl visibIy endoved vilh such a lrail is George
Soros. One of his slrenglhs is lhal he revises his oinion ralher raidIy,
vilhoul lhe sIighlesl embarrassmenl. The foIIoving anecdole iIIuslrales
Soros's abiIily lo reverse his oinion in a fIash. The Irench Iayboy lrader
}ean-ManueI Rozan discusses lhe foIIoving eisode in his aulo-
biograhy
12
(disguised as a noveI in order lo avoid IegaI biIIs). The
rolagonisl (Rozan) used lo Iay lennis in lhe Hamlons on Long IsIand
vilh Georgi SauIos, an "oIder man vilh a funny accenl", and somelimes
engage in discussions aboul lhe markel, nol iniliaIIy knoving hov
imorlanl and infIuenliaI SauIos lruIy vas. One veek-end, SauIos
exhibiled in his discussion a Iarge amounl of bearishness, vilh a com-
Iicaled series of argumenls lhal lhe narralor couId nol foIIov. He vas
obviousIy shorl lhe markel. A fev days Ialer, lhe markel raIIied vioIenlIy,
making record highs. The rolagonisl vorried aboul SauIos, asked him al
lheir subsequenl lennis encounler if he vas hurl. "We made a kiIIing",
SauIos said. "I changed my mind. We covered and venl very Iong".
Il vas lhis very lrail lhal, a fev years Ialer, affecled Rozan negaliveIy
and aImosl cosl him a career. Soros gave Rozan in lhe Iale 1980s 20
miIIion doIIars lo secuIale vilh (a sizeabIe amounl al lhe lime), vhich
aIIoved him lo slarl a lrading comany (I vas aImosl dragged inlo il). A
fev days Ialer, as Soros vas visiling Iaris, lhey discussed markels over
Iunch. Rozan sav Soros becoming dislanl. He lhen comIeleIy uIIed
lhe money, offering no exIanalion. Whal characlerizes reaI
secuIalors Iike Soros from lhe resl is lhal lheir aclivilies are devoid
of alh deendence. They are lolaIIy free from lheir asl aclions. Ivery
day is a cIean sIale.
p a t h d c p c n d c n c c n I b c ! i c I s
There is a simIe lesl lo define alh deendence of beIiefs. Say you ovn
a ainling you boughl for $20,000, and oving lo rosy condilions in lhe
arl markel, il is nov vorlh $40,000. If you ovned no ainling, vouId
you sliII acquire il al lhe currenl rice` If you vouId nol, lhen you are
said lo be married lo your osilion. There is no ralionaI reason lo kee a
ainling you vouId nol buy al ils currenl markel rale - onIy an
emolionaI inveslmenl. Many eoIe gel married lo lheir ideas aII lhe
vay lo lhe grave. eIiefs are said lo be alh deendenl if lhe sequence of
ideas is such lhal lhe firsl one dominales.
There are reasons lo beIieve lhal, for evoIulionary uroses, ve may
be rogrammed lo buiId a IoyaIly lo ideas in vhich ve have invesled
lime. Think aboul lhe consequences of being a good lrader oulside of
lhe markel aclivily, and deciding every morning al 8 a.m. vhelher lo
kee lhe souse or if il is nol beller lo arl vilh him or her for a beller
emolionaI inveslmenl eIsevhere. Or lhink of a oIilician vho is so
ralionaI lhal, during a camaign, he changes his mind on a given maller
because of fresh evidence and abrulIy svilches oIilicaI arlies. Thal
vouId make ralionaI inveslors vho evaIuale lrades in a roer vay a
genelic oddily - erhas a rare mulalion. Some medicaI researchers find
lhal ureIy ralionaI behavior on lhe arl of humans is a sign of a defecl
in lhe amygdaIa, lhal lhe sub|ecl is, IileraIIy, a sychoalh. CouId Soros
have a genelic fIav lhal makes him ralionaI as a decision maker`
Such lrail of absence of marriage lo ideas is indeed rare among
humans. }usl as ve do vilh chiIdren, ve suorl lhose in vhom ve have
i heavy inveslmenl of food and lime unliI lhey are abIe lo roagale our
188 WAX IN MY IARS
genes, so ve do vilh ideas. An academic vho became famous for
esousing an oinion is nol going lo voice anylhing lhal can ossibIy
devaIue his ovn asl vork and kiII years of inveslmenl. IeoIe vho
svilch arlies become lrailors, renegades, or, vorsl of aII, aoslales
(lhose vho abandoned lheir reIigion vere unishabIe by dealh).
0#=5$%./8 ?/,%()2 #L 4'./K./8
There is anolher slory of robabiIily olher lhan lhe one I inlroduced
vilh Carneades and Cicero. IrobabiIily enlered malhemalics vilh
gambIing lheory, and slayed lhere as a mere comulalionaI device.
RecenlIy, an enlire induslry of "risk measurers" emerged, seciaIizing in
lhe aIicalion of lhese robabiIily melhods lo assess risks in lhe sociaI
sciences. CIearIy, lhe odds in games vhere lhe ruIes are cIearIy and
exIicilIy defined are comulabIe and lhe risks consequenlIy measured.
ul nol in lhe reaI vorId. Ior molher nalure did nol endov us vilh cIear
ruIes. The game is nol a deck of cards (ve do nol even knov hov many
coIors lhere are). ul somehov eoIe "measure" risks, arlicuIarIy if
lhey are aid for il. I have aIready discussed Hume's robIem of
induclion and lhe occurrence of bIack svans. Here I inlroduce lhe
scienlific erelralors.
RecaII lhal I have vaged a var againsl lhe charIalanism of some
rominenl financiaI economisls for a Iong lime. The oinls are as
foIIovs. One Harry Markovilz received somelhing caIIed lhe NobeI
MemoriaI Irize in Iconomics (vhich in facl is nol even a NobeI Irize as
il is granled by lhe Svedish cenlraI bank in honor of AIfred NobeI - il
vas never in lhe viII of lhe famous man). Whal is his achievemenl` y
crealing an eIaborale melhod of comuling <B(B$# risk if one knovs
<B(B$# uncerlainly, in olher vords if markels had cIearIy defined ruIes -
vhich is cIearIy nol lhe case. Nov I exIained lhe oinl lo a cab driver
vho Iaughed al lhe facl lhal someone ever lhoughl lhal lhere vas any
scienlific melhod lo undersland markels and redicl lheir allribules.
Somehov vhen one gels invoIved in financiaI economics, oving lo lhe
cuIlure of lhe fieId, one becomes IikeIy lo forgel lhese basic facls.
An immediale resuIl of Dr. Markovilz's lheory vas lhe near coIIase
of lhe financiaI syslem in lhe summer of 1998 (as ve sav in Chalers 1
and 5) by Long Term CailaI Managemenl ("LTCM"), a Greenvich,
Conneclicul fund lhal had for rinciaIs lvo of Dr. Markovilz's
coIIeagues, "NobeI" as veII. They are Drs. Roberl Merlon (lhe one in
Chaler 3 lrouncing ShiIIer) and Myron SchoIes. Somehov lhey lhoughl
lhey couId scienlificaIIy "measure" lheir risks. They made absoIuleIy no
aIIovance in lhe LTCM eisode for lhe ossibiIily of lheir nol
underslanding markels and lheir melhods being vrong. Thal vas nol
a hyolhesis lo be considered. I haen lo seciaIize in rofiling from
lhe bIack svans and lhe breakdovn of lhe syslem, and make bels
againsl financiaI economisls. SuddenIy I slarled gelling some irrilaling
favning resecl, aIong vilh aychecks from lhe markel. Drs. Merlon
and SchoIes heIed ul your humbIe aulhor on lhe ma and caused lhe
birlh of your humbIe crisis-hunler's firm, Imirica - as cailaI slarled
fIoving lo eoIe vho did lhe exacl oosile of vhal lhey did for a
Iiving.
One vouId lhink lhal vhen scienlisls make a mislake, lhey deveIo a
nev science lhal incororales vhal has been Iearned from il. When
academics bIov u lrading, one vouId execl lhem lo inlegrale such
informalion in lheir lheories and make some heroic slalemenl lo lhe
effecl lhal lhey vere vrong, bul lhal nov lhey have Iearned somelhing
aboul lhe reaI vorId. Nolhing of lhe sorl. Inslead lhey comIain aboul
lhe behavior of lheir counlerarls in lhe markel vho ounced on lhem
Iike vuIlures, lhus exacerbaling lheir dovnfaII. Acceling vhal has
haened, cIearIy lhe courageous lhing lo do, vouId invaIidale lhe ideas
lhey have buiIl lhroughoul an enlire academic career. AII of lhe
rinciaIs vho engaged in a discussion of lhe evenls arlook of a
masquerade of science by adducing '1 A8/ exIanalions and ulling lhe
bIame on a rare evenl (robIem of induclion: hov did lhey knov il vas
a rare evenl`). They senl lheir energy defending lhemseIves ralher lhan
lrying lo make a buck vilh vhal lhey Iearned. Again comare lhem
vilh Soros vho vaIks around leIIing vhomever has lhe alience lo
Iislen lo him lhal he is faIIibIe. My Iesson from Soros is lo slarl every
meeling al my lrading boulique by convincing everyone lhal ve are a
bunch of idiols vho knov nolhing and are mislake rone, bul haen
lo be endoved vilh lhe rare riviIege of knoving il.
190 WAX IN MY IARS
J*#= J$/(*)1 %# J$/(*)1
I concIude vilh lhe foIIoving saddening remark aboul scienlisls in lhe
sofl sciences. IeoIe confuse science and scienlisls. Science is greal, bul
individuaI scienlisls are dangerous. They are human, lhey are marred by
lhe biases humans have. Ierhas even more. Ior mosl scienlisls are hard
headed, olhervise lhey vouId nol derive lhe alience and energy lo
erform lhe HercuIean lasks asked of lhem, Iike sending 18 hours a
day erfecling lheir docloraI lhesis.
A scienlisl may be forced lo acl Iike a chea defense Iavyer ralher
lhan a ure seeker of lhe lrulh. A docloraI lhesis is "defended" by lhe
aIicanl, il vouId be a rare silualion lo see lhe sludenl change his mind
uon being suIied vilh a convincing argumenl. ul science is beller
lhan scienlisls. Il vas said lhal science evoIves from funeraI lo funeraI.
Afler lhe LTCM coIIase, a nev financiaI economisl viII emerge, vho
viII inlegrale such knovIedge in his science. He viII be resisled by lhe
oIder ones bul, again, lhey viII be much cIoser lo lheir funeraI dale lhan
he.
f o u r l e e n
b a c c h u s a b a n d o n s a n l o n y
38-(A#$5'-(R) 1#'(Ae *(8%/%).N %) -8( (A# )(%<< B::#$ 5%:N YB( (A#
%55B)%8- 8< &%/(8$, 8< .'- '+'%-)( $'-18.-#))e M( %) )8 #'), (8 Y#
A#$8%/e K'-18.-#)) '-1 :#$)8-'5 #5#+'-/#e
hen lhe cIassicisl arislocralic Irench vriler Henry de Monlh-
erIanl vas loId lhal he vas aboul lo Iose his eyesighl lo a
degeneralive disease, he found il mosl aroriale lo lake his ovn Iife.
Such is lhe end lhal becomes a cIassicisl. Why` ecause lhe sloic's
rescrilion vas reciseIy lo eIecl vhal one can do lo conlroI one's
desliny in fronl of a random oulcome. Al lhe end, one is aIIoved lo
choose belveen no Iife al aII and vhal one is given by desliny, ve
aIvays have an olion againsl uncerlainly. ul such an allilude is nol
Iimiled lo sloics, bolh comeling secls in lhe ancienl vorId, sloicism and
Iicurianism recommended such conlroI (lhe difference belveen lhe
lvo resides in minor lechnicaIilies - neilher hiIosohies meanl lhen
vhal is commonIy acceled loday in middIebrov cuIlure).
eing a hero does nol necessariIy mean such an exlreme acl as
gelling kiIIed in ballIe or laking one's Iife - lhe Ialler is onIy recom-
mended in a narrov sel of circumslances and considered covardIy
olhervise. Having conlroI over randomness can be exressed in lhe
manner one acls in lhe smaII and lhe Iarge. RecaII lhal eic heroes
192 WAX IN MY IARS
vere |udged by lheir aclions, nol by lhe resuIls. No maller hov
sohislicaled our choices, hov good ve are al dominaling lhe odds,
randomness viII have lhe Iasl vord. We are Iefl onIy vilh dignily as a
soIulion - dignily defined as lhe execulion of a rolocoI of behavior
lhal does nol deend on lhe immediale circumslance. Il may nol be lhe
olimaI one, bul il cerlainIy is lhe one lhal makes us feeI besl. S$'/#
B-1#$ :$#))B$#N for examIe. Or in deciding nol lo loady u lo
someone, vhalever lhe revard. Or in fighling a dueI lo save face. Or in
signaIing lo a roseclive male during courlshi: "Iislen, I have a crush
on you, I am obsessed vilh you, bul I viII nol do a lhing lo
comromise my dignily. AccordingIy, lhe sIighlesl snub and you viII
never see me again".
This Iasl chaler viII discuss randomness from a lolaIIy nev angIe,
hiIosohicaI bul nol lhe A'$1 hiIosohy of science and eislemoIogy
as ve sav in Iarl I vilh lhe Y5'/> )?'- :$8Y5#.e Il is a more archaic,
)8<(#$ lye of hiIosohy, lhe various guideIines lhal lhe ancienls had
concerning lhe manner a man of virlue and dignily deaIs vilh
randomness - lhere vas no reaI $#5%+%8- al lhe lime (in lhe modern
sense). Il is vorlhy of nole lhal before lhe sread of vhal can be besl
caIIed Medilerranean monolheism, lhe ancienls did nol beIieve enough
in lheir rayers lo infIuence lhe course of desliny. Their vorId vas
dangerous, fraughl vilh invasions and reversaIs of forlune. They needed
subslanliaI rescrilions in deaIing vilh randomness. Il is such beIiefs
lhal ve viII oulIine nexl.
3#%(, #/ 6)@K.( I[U, J$/(*)1
If a sloic vere lo visil us, he vouId feeI reresenled by lhe foIIoving
oem.- To many (sohislicaled) Iovers of oelry, one of lhe grealesl
oels vho ever brealhed is C.I. Cavafy. Cavafy vas an AIexandrian
Greek civiI servanl vilh a Turkish or Arabic Iasl name vho vrole
aImosl a cenlury ago in a combinalion of cIassicaI and modern Greek a
Iean oelry lhal seems lo have eIuded lhe Iasl fifleen cenluries of
Weslern Iileralure. Greeks lreasure him Iike lheir nalionaI monumenl.
ACCHUS AANDONS ANTONY 193
Mosl of his oems lake Iace in Syria (his Grecosyrian oems iniliaIIy
drev me lo him), Asia Minor, and AIexandria. Many eoIe beIieve il
vorlh Iearning formaI semi-cIassicaI Greek |usl lo savor his oems.
Somehov lheir acule aeslhelicism slried of senlimenlaIily rovides a
reIief from cenluries of mavkishness in oelry and drama. He rovides
a cIassicaI reIief for lhose of us vho vere sub|ecled lo lhe middIe-cIass
vaIued meIodrama as reresenled by Dickens's noveIs, romanlic oelry,
and Verdi's oeras.
I vas surrised lo hear lhal Maurice TemeIsman, Iasl consorl of
}ackie Kennedy Onassis, read Cavafy's vaIediclory =:85#%:#%- 8 FY#8)
=-(8-%8- (The God Abandons Anlony) al her funeraI. The oem
addresses Marc Anlony, vho has |usl Iosl lhe ballIe againsl Oclavius
and vas forsaken by acchus lhe god vho unliI lhen had rolecled him.
Il is one of lhe mosl eIevaling oems I have ever read, beaulifuI because
il vas lhe eilome of such dignified aeslhelicism - and because of lhe
genlIe bul edifying lone of lhe voice of lhe narralor advising a man vho
had |usl received a crushing reversaI of forlune.
The oem addresses Anlony, nov defealed and belrayed (according
lo Iegend, even his horse deserled him lo go lo his enemy Oclavius). Il
asks him lo |usl bid her fareveII, AIexandria lhe cily lhal is Ieaving him.
Il leIIs him nol lo mourn his Iuck, nol lo enler deniaI, nol lo beIieve lhal
his ears and eyes are deceiving him. Anlony, do nol degrade yourseIf
vilh emly hoes. Anlony,
GB)( 5%)(#- ?A%5# )A'>#- Y, #.8(%8- YB( -8( ?%(A (A# /8?'$1R)
%.:58$'(%8- '-1 /8.:5'%-()e
WhiIe shaken vilh emolion. No sliff uer Ii. There is nolhing vrong
and undignified vilh emolions - ve are cul lo have lhem. Whal is
vrong is nol foIIoving lhe heroic, or al Ieasl, lhe dignified alh. Thal is
vhal )(8%/%). lruIy means. Il is lhe alleml by man lo gel even vilh
robabiIily. I need nol be nasly al aII and break lhe seII of lhe oem
and ils message, bul I cannol resisl some cynicism. A couIe of decades
Ialer, Cavafy, vhiIe dying of lhroal cancer did nol quile foIIov lhe
rescrilion. Derived of his voice by lhe surgeons, he used lo randomIy
enler undignified seIIs of crying and cIing lo his visilors, revenling
lhem from Ieaving his dealh room.
194 WAX IN MY IARS
Some hislory. I said lhal sloicism has ralher IillIe lo do vilh lhe sliff
uer Ii nolion lhal ve beIieve il means. Slarled as an inleIIecluaI
movemenl in anliquily by a Ihoenician Cyriol, Zeno of Kilium, il
deveIoed by Roman lime inlo a Iife based on a syslem of virlues - in lhe
ancienl sense vhen virlue meanl &%$(BN lhe sorl of beIief in vhich virlue
is ils ovn revard. There deveIoed a sociaI modeI for a sloic erson, Iike
lhe genlIemen in Viclorian IngIand. Ils lenels can lhus be summarized
as foIIovs: lhe sloic is a erson vho combines lhe quaIilies of visdom,
urighl deaIing, and courage. The sloic viII lhus be immune from Iife's
gyralions as he viII be suerior lo lhe vounds from some of Iife's dirly
lricks. ul lhings can be carried lo lhe exlreme, lhe slern Calo found il
benealh him lo have human feeIings. A more human version can be read
in Seneca's a#((#$) V$8. ' *(8%/N a soolhing and surrisingIy readabIe
book lhal I dislribule lo my lrader friends (Seneca aIso look his ovn Iife
vhen cornered by desliny).
;)/2#=/(,, )/2 E(*,#/)1 Q1(8)/@(
The reader knovs my oinion on unsoIiciled advice and sermons on hov
lo behave in Iife. RecaII lhal ideas do nol lruIy sink in vhen emolions
come inlo Iay, ve do nol use our ralionaI brain oulside of cIassrooms.
SeIf-heI books (even vhen lhey are nol vrillen by charIalans) are
IargeIy ineffecluaI. Good, enIighlened (and "friendIy") advice and
eIoquenl sermons, do nol regisler for more lhan a fev momenls vhen
lhey go againsl our viring. The inleresling lhing aboul sloicism is lhal il
Iays on dignily and ersonaI aeslhelics, vhich are arl of our genes.
Slarl slressing ersonaI eIegance al your nexl misforlune. Ixhibil )':#$#
&%&#$# ("knov hov lo Iive") in aII circumslances.
Dress al your besl on your execulion day (shave carefuIIy), lry lo
Ieave a good imression on lhe dealh squad by slanding erecl and
roud. Try nol lo Iay viclim vhen diagnosed vilh cancer (hide il from
olhers and onIy share lhe informalion vilh lhe doclor - il viII averl lhe
Ialiludes and nobody viII lreal you Iike a viclim vorlhy of lheir ily, in
addilion lhe dignified allilude viII make bolh defeal and viclory feeI
ACCHUS AANDONS ANTONY 195
equaIIy heroic). e exlremeIy courleous lo your assislanl vhen you Iose
money (inslead of laking il oul on him as many of lhe lraders vhom I
scorn roulineIy do). Try nol lo bIame olhers for your fale, even if lhey
deserve bIame. Never exhibil any seIf ily, even if your significanl olher
boIls vilh lhe handsome ski inslruclor or lhe younger asiring modeI.
Do nol comIain. If you suffer from a benign version of lhe "allilude
robIem", Iike my chiIdhood friend CamiIIe AbousIeiman, do nol slarl
Iaying nice guy if your business dries u (he senl a heroic e-maiI lo his
coIIeagues informing lhem "Iess business, bul same allilude"). The onIy
arlicIe Lady Iorluna has no conlroI over is your behavior. Good Iuck.
e i I ogue s s o I o n l o I d y o u s o
b c wa r c t h c ! n n d n n t r a I I i c | a ms
A
couIe of years afler ve Iefl him Iooking al }ohn smoking a cigarelle
vilh a modicum of )/A'1#-<$#B1#N Nero's skelicism ended u
aying off. SimuIlaneousIy as he beal lhe 28% odds, u lo lhe oinl of
comIele cure, he made a series of exhiIaraling ersonaI and rofessionaI
viclories. Nol onIy did he end u samIing lhe nexl IeveI of veaIlh bul he
gol lhe riches righl vhen olher WaII Slreel hol shols gol oor, vhich couId
have aIIoved him lo buy lhe goods lhey ovned al very Iarge discounls, if
he vanled lo. ul he acquired very IillIe, and cerlainIy none of lhe goods
WaII Slreelers usuaIIy buy. ul Nero did engage in occasionaI excess.
Iriday aflernoon lraffic in London can be dreadfuI. Nero slarled
sending more lime lhere. He deveIoed an obsession vilh lraffic |ams.
One day he senl five hours moving Wesl from his office in lhe Cily of
London lovards a collage in lhe ColsvoIds vhere he slayed mosl
veekends. The fruslralion romled Nero lo gel a heIicoler fIying
Iicense, lhrough a crash course in Cambridgeshire. He reaIized lhal lhe
lrain vas robabIy an easier soIulion lo gel oul of lovn for lhe
veekend, bul he feIl lhe urge for a el exlravagance. The olher resuIl of
his fruslralion vas his no Iess dangerous commuling on a bicycIe
belveen his fIal in Kensinglon and his office in lhe Cily.
Nero's excessive robabiIily consciousness in his rofession somehov
did nol regisler fuIIy inlo his lrealmenl of hysicaI risk. Ior Nero's
heIicoler crashed as he vas Ianding il near allersea Iark on a vindy
day. He vas aIone in il. In lhe end lhe bIack svan gol ils man.
1. This is lhe Dryden lransIalion of IIularch's a%&#)e
2. Ior an examIe of seudoscienlific hisloricism, I suggesl Irancis
Iukuyama, 1992, FA# 6-1 8< 0%)(8$, '-1 (A# a')( 3'-N Nev York:
Iree Iress.
3. Richard Davkins, 1990 (1970), FA# *#5<%)A S#-#N 2nd ed., Oxford:
Oxford Universily Iress.
4. AIan SokaI, 1996, Transgressing lhe oundaries: Tovard a
Transformalive Hermeneulics of Quanlum Gravily, *8/%'5 F#7(
(sring-summer).
5. vvv.monash.edu.au
6. rian Magee, 1997, @8-<#))%8-) 8< ' ;A%58)8:A#$N London: WeidenfeId
& NicoIson.
7. MaIachi Haim Hacohen, 2001, ^'$5 ;8::#$N FA# V8$.'(%&# I#'$)N
DQ_LHDQOW2 ;85%(%/) '-1 ;A%58)8:A, %- M-(#$?'$ 4%#--'N Nev York:
Cambridge Universily Iress.
8. R. SuIIivan, A. Timmerman and H. While, 1999, Dala-Snooing,
TechnicaI Trading RuIe Ierformance and lhe ookslra, G8B$-'5 8<
V%-'-/#N Oclober.
9. I lhank my corresondenl Irancesco CorieIIi from occoni for his
remark on mela-anaIysis.
10. Deborah }. ennell, 1998, K'-18.-#))N Cambridge, MA: Harvard
Universily Iress.
11. Anlonio Damasio, 1995, "#)/'$(#)R 6$$8$2 6.8(%8-N K#')8-N '-1 (A#
0B.'- X$'%-N Nev York: Avon ooks. See aIso }oseh Ledoux, 1998,
FA# 6.8(%8-'5 X$'%-2 FA# 3,)(#$%8B) l-1#$:%--%-+ 8< 6.8(%8-'5
a%<#N Nev York: Touchslone ooks.
12. }ean-ManueI Rozan, 1999, a#<$%/N Iaris: MicheI Lafon.
i n d e x
"T
Abc!snn, A!an 54
Abnus!ciman, Cami!!c 195
absurdity 1 5 6 - 7
Acadcmy 183
accumu!atnrs 120- 3
Achi!!cs M. 130
adaptatinn 98
Adams, Evc!yn 133
advcrsc sc!cctinn 132
acsthctics 6 4 - 7
agc 5 1 - 2, 5 5 - 6
A!cxandcr thc Grcat 35
a!tcrnativc histnrics LPHQ
a!tcrnativc mcdicinc 137- 9
a!tcrnativc samp!c paths 4 1 - 3
angcr, managing 172- 3
annnymnus !cttcr scam 131
Antnny, Marc 143, 193
artiIicia! thinking 6 2 - 4
Asian currcncics 93
Arthur, Brian 145, 146
artiIicia! randnm data gcncratnrs 140
Asia Minnr 50
assct pricc inI!atinn 122- 3
astrn!ngy 1 0 6 - 7
asymmctry 84- 98, 102
Austra!ia 102
avcraging dnwn 72
Babbagc, Nigc! 186
backtcsting 1 3 4 - 6
Bacnn, Francis 100
bcarishncss 8 6 - 9 3
bchavinr 2 2 - 3 , 152- 8
5kinncr's pigcnn cxpcrimcnt 178- 9
bchavinra! Iinancc and ccnnnmics 157
bc!icIs
nvcrcstimatinn nI accuracy in 79
path dcpcndcncc and 186- 8
Bc!! Curvc 86
Bcrra, Yngi 10, 106
Bcrgsnn, Hcnri 173^4
biascs
survivnrship 80, 117- 41
in undcrstanding prnbabi!ity
1 5 8 - 6 0
bin!ngy 158
birthday paradnx 132
b!ack swan prnb!cm 10, 28, 100, 102
B!nnmbcrg machinc 164- 6
b!nw up 15, 49, 77
risk nI 2 0 - 1
bnnd markct crash nI 1994 15, 130
bnnk rcvicws 134
Brady bnnds 69
brain 158
Brctnn, Andrc 65
BuIIctt, Warrcn 121
Bu!ha, Andrcw C. 62
bu!! markct 122- 3
bu!!ishncss 8 6 - 9 3
Buridan, Jcan 148
Buridan's dnnkcy 147- 8
busincss nricntatinn 30
Cacsar, Ju!ius 35, 143
I NDIX 199
ca!! nptinns 160
canccr c!ustcrs 140
canccr curcs 1 3 7 - 9
Cannva, Antnnin 126
Car!ns (cmcrging markcts tradcr)
6 8 - 7 4
Carncadcs nI Cyrcnc 1 8 3 - 4
Cathn!ic church 66
Cat n 1 8 3 , 1 9 4
causa!ity 1 6 5 - 6 , 1 7 5 - 9
CavaIy, C. P. 56, 1 9 2 - 3
chans thcnry 143
char!atanism 4, 131, 133, 1 3 7 - 9
chcss cxpcrtisc 31
Chicagn Mcrcanti!c Exchangc 11, 13
chicI stratcgists 88
Ciccrn 185
cigarcttc smnking 181
C!audc!, Pau! 105
C!cnpatra 143
CNBC 163
cnincidcnccs 13141
cnmpany carnings DUPHJ
cnmpctcncc 1 2 8 - 9
cnmp!cxity thcnry 147
cnmpnunding cIIcct 156
cnmputatinna! Iinancc 76
cnmputcrs 4 6
rcvcrsc Turing tcst 6 2 - 3
Cnmtc, Augustc 107
cnnditinna! !iIc cxpcctancy 164
cnnditinna! prnbabi!itics 155
cnnIidcncc !cvc!s 166, 168
cnnIusinn, tab!c nI 2 - 4
Cnnstantinnp!c 5 0
cnntinuity 82
cnntrarians 152
cnntrn!
nvcr dcstiny 1 9 1 - 2
sc!I-cnntrn! 1 7 9 - 8 1
cnrrcctncss and intc!!igibi!ity 3 7 - 8
cnuntcrintuitivc truths 3 4 - 9
Crcdit 5uissc First Bnstnn 175
crimina! tria!s 1546
crisis huntcrs 96
critica! thinking 4, 185
abscncc nI 80
Crncsus 9, 10
crnss-scctinna! prnb!cm 74
Cyrcnc 183
Cyrus, King 10
Dada Enginc 6 2 - 3
Darwinism 8 1 - 2
data mining 133
data snnnping 1 3 5 - 6
Dawkins, Richard 62, 81
Dcbrcu, Gcrard 147
dcductivc statcmcnts 61
dcmarcatinn, prnb!cm nI 107
dcnia! 80
dcnigratinn nI histnry 28, 4 7 - 8
Diacnnis, Pcrcy 133
dia!ccticians 1 8 3 - 4
dignity 192
dip buycrs 71, 80
discussinn mccting 8 6 - 7
disti!!cd thinking 5 1 - 6
distributinn nI thc maxi mum nI
randnm variab!cs 163
Dns Passns, Jnhn 134
Drnsnin, Michac! 133
ccnnnmctrics 92, 9 7 - 8
ccnnnmic ana!ysis 7 9
ccnnnmics
bchavinra! Iinancc and ccnnnmics
157
mathcmatica! mndc!ing and 1 4 6 - 7
nnrmativc scicncc 1 5 7 - 8
cIIicicnt markcts 54
Einstcin, A!bcrt 38, 4 5
c!cgancc, pcrsnna! 1 9 4 - 5
E!uard, Pau! 65
cmcrging markct bnnds trading 6 8 - 7 4
cmntinns 1 6 1 - 2 , 1 7 2 - 3
Empirica 189
cmpiricism 100, 101
cncnuntcrs, randnm 1 3 2 - 3
cnvirnnmcnt 1534
cnvirnnmcnt mapping 158
cnvy 1 9 - 2 1
cpic pncts 35
Epicurianism 191
cpistcmn!ngy 100
crgndicity 5 0 - 1 , 1 2 9 - 3 1
200 I NDIX
cvidcncc 1 5 4 - 6
abscncc nI cvidcncc and cvidcncc nI
abscncc 162
cvn!utinn 4 6 - 7
naivc thcnrics 8 1 - 3
cvn!utinnary psychn!ngy 158
cxpcctatinn 150
nI thc maxi mum 1 2 8 - 9
and mcdian 8 4 - 6
67CB%)%(# @'1'&#$) PW
Ia!siIicatinnism 1 0 6 - 8
Iamc 144
Fcynman, Richard 4 7
Ii!tcring mcthnds 1 6 6 - 7
Iinancia! ccnnnmists 1 0 5 - 6 , 1 8 8 - 9
cxpcrts nn tc!cvisinn 1 6 2 - 4
Iinancia! cnginccring 98
Iirchnusc cIIcct 73
Iitncss 55, 8 1 - 3
I!nw 161
Inrccast and prnphccy 36
Francc 185
gamb!crs' ticks 1 7 6 - 8
Gatcs, Bi!! 145
gcrnntncracy 5 5 - 6
g!nba! warming 91
Gnd 109
Gnrgias 1 8 4
Gnu!d, 5tcvcn Jay 81, 8 4 - 5
grammar 4 4
rccursivc grammar 6 2 - 3
Grant, Ji m 5 4
Grcck Or t hndnx church 66
Grccnc, Graham 2 7 - 8 , 174
habitat, natura! 1 5 3 - 4
Hanniba! 3 5
Hayck, Fricdrich vnn 108
hcdgc Iunds 54, 71, 189
Hcgc!, Gcnrgc W. F. 64
hcrncs 35, 153, 1 9 1 - 2
high-yic!d bnnds trading 1 7 - 2 1 , 7 4 - 8
histnrica! dctcrminism 4 9
histnry 35, 93
a!tcrnativc histnrics 2 6 - 9
dcnigratinn nI 28, 4 7 - 8
Iinancia! cnginccring and 9 8
mathcmatics and 4 0 - 5 9
Hit!cr, Adn!I 35
Hnmcric hcrncs 153
Humc, David 100
M5%'1 35
indcpcndcncc 146
inductinn, prnb!cm nI 10, 28, 9 9 - 1 1 0
inductivc statcmcnts 61
inInrmatinn 154
and incrcasc nI knnw!cdgc 107
ncws 5 1 - 3 , 54, 5 9
and nnisc 5 1 - 3 , 5 6 - 9
intc!!igibi!ity and cnrrcctncss 3 7 - 8
intcrcst ratc diIIcrcntia! 75, 76
Intcrnatinna! Mnnct ary Fund 74
intrnspcctinn 2 9 - 3 0 , 4 0 - 5 9
invcrsc rarc cvcnts 96
invcstmcnt catcgnrics, sc!cctinn nI
137
invcstmcnt hnuscs 1 3 - 1 4
discussinn mccting 8 6 - 7
invcstmcnt managcrs 1 2 7 - 3 1
Jcan-Patricc 3 3 - 4
Jnhn (high-yic!d tradcr) 1 7 - 2 1 , 7 4 - 8
|nint prnbabi!ity 1 5 5 - 6
|nurna!ism 3 5 - 6 , 51, 5 4 - 5 , 1 6 2 - 4
KaIka, Franz 156
Kahncman, Danic! 20, 48, 1 5 7 - 8
Ka!ctsky, Anatn!c 54
Kcnny 3 2 - 3
Kcyncs, Jnhn Maynard 45, 107
knnw!cdgc 107
Knr ax 184
!anguagc 6 5 - 6
)## '5)8 grammar
!carning Irnm mistakcs 4 8 - 9 , 189
Lcibniz, GnttIricd 82
!cvcragc 76, 7 7
!iIc cxpcctancy 1 6 3 - 4
!incar cnmbinatinn 1 5 0
Linnacus, Car! 82
!itcrary intc!!cctua!s 6 0 - 4
!nng-hau! invcstmcnt 7 9
I NDIX
Lnng Tcrm Capita! Managcmcnt
( LTCM) 54, 71, 189
!nng vn!ati!ity pnsitinns 161
Lnuic (vctcran tradcr) 74
Lnurdcs 139
!nya!ty tn idcas/bc!icIs 79, 1 8 6 - 8
Lucas, Rnbcrt Q[
Lucas critiquc 98
!ucky Inn! (dcIinitinn) 1
macrn tradcrs 7 9
Magcc, Brian 109
Mar c (city !awycr) 1 1 7 - 2 0
markcts, vn!ati!ity nI 5 3 - 4
Marknwitz, Harry 1 [ [ H Q
Marxi sm 98
mathcmatics 2 8
and histnry 4 0 - 5 9
and nnn!incarity 1 4 6 - 8
)## '5)8 Mnnt c Car!n mcthnds,
prnbabi!ity
MBAs 31, 3 7
mcan 8 4 - 6
mcdia 3 5 - 6 , 1 6 2 - 4 , 1 7 3 - 4
)## '5)8 |nurna!ism
mcdian 8 4 - 6
mcdica! |nurna!ists 162
mcdicinc 8 4 - 5 , 136, 158
a!tcrnativc mcdicinc 1 3 7 - 9
mc!tdnwn nI summcr 199 8 7 1 - 4 , 76,
189
Mcrtnn, Rnbcrt C. 54, 189
mcthndn!ngy 1 0 1 - 2
Mcxi cn 93, 9 4 - 5
MicrnsnIt 145
Mi!!, Jnhn 5tuart 100
3%55%8-'%$# E#7( "88$N FA# 120-3
mistakcs, !carning Irnm 4 8 - 9 , 189
mnmcnt um p!aycrs 152
Mnnnd, Jacqucs 81
mnnnthcism 184
Mnnt c Car!n mcthnds
crcating artiIicia! histnry 4 0 - 8
gcncratinn nI tcxt 6 2 - 3
invcstmcnt managcrs' pcrInrmancc
1 2 7 - 3 1
Mnnthcr!ant, Hcnry dc 191
Mnstc!!cr, Frcdcrick 133
mu!tivariatc ana!ysis 1 6 5 - 6
naivc cmpiricism 101
naivc cvn!utinnary thcnrics 8 1 - 3
natura! habitat 1 5 3 - 4
ncgativc mutatinns 81
ncnc!assica! ccnnnmics 157
ncurnbin!ngy 1 5 8 - 9
' ncw nnvc!s' 4 7
ncws 5 1 - 3 , 54, 5 9
Ncwtnnian physics 1 0 6 - 7
NicdcrhnIIcr, Victnr 1 0 0 - 3
nnisc 1 6 5 - 7
Ii!tcring mcthnds 1 6 6 - 7
ignnring 1 8 0 - 1
and inInrmatinn 5 1 - 3 , 5 6 - 9
and mcaning 2
nnn!incaritics 1 4 2 - 8
nnn-randnmncss, tcst nI 1 3 9 - 4 0
nnrmativc scicnccs 1 5 7 - 8
O. J. 5impsnn tria! 1 5 4 - 6
O' Cnnnc!!, Mart y 73
91,))#, 171
Omcga Tradc5tatinn 136
Onassis, Jackic Kcnncdy 193
nnc-dimcnsinna! spaccs 156
npcn sncicty 108
nptinns 90, 102, 1 6 0 - 1
nut-nI-thc-mnncy nptinns 102, 160
nutcnmcs, pnssib!c 2 4 - 5
nut!icrs 91
Pasca!' s wagcr 1 0 9 - 1 0
path dcpcndcncc 1 4 4 - 6
bc!icIs 1 8 6 - 8
Patrnc!cs 35
Pau!ing, Linus 138
Pcarsnn, Kar! 1 3 9 - 4 0
pccking nrdcr 1 8 - 2 1 , 2 2 - 3 , 1 1 9 - 2 0
pccr rc!atinns 2 9 - 3 4
pcrIcct nnisc 165
pcrInrmancc
hnrmnncs and signa!ing 2 2 - 3 , 83
track rccnrd 126, 1 2 7 - 3 1
pcrsnna! c!cgancc 1 9 4 - 5
Pcsaran, Hashcm 9 7
pcsn prnb!cm 93, 9 4 - 5
202 I NDIX
phi!nsnphy 1 2 - 1 3 , 45, 64
nI scicncc 3, QQHDD_
stnicism 1 9 1 - 5
Phi!nstratus 56
physicists 3 1 - 2
physics 1 0 6 - 7
Pi 4 3 - 4
pigcnn cxpcrimcnt 1 7 8 - 9
p!anning, !ack nI 80
pnctry 2, 6 4 - 7
Pn!ya prnccss 146
Pnppcr, Kar! 61, 1 0 3 - 9
pnpu!atinn sizc 124, 130
pnrtIn!ins 94
pnsitinns, !nya!ty tn 79, 187
pnsitivc scicnccs 158
pnsitivism 1 0 7 - 8
pnssib!c nutcnmcs, rangc nI 2 4 - 5
prcmium buycrs/sc!!crs 161
prnbabi!ity 2, 3 7
b!indncss 1 4 9 - 6 8
chi!d nI skcpticism 1 8 4 - 5
intrnspcctinn 4 0 - 5 9
and spccu!atinn 1 8 2 - 9 0
prnphccy and Inrccast 36
prnprictary trading 1 4 - 1 7
Prnust, Marcc! 153
M- *#'$/A 8< F%.# a8)( 19, 185-6
pscudnthinkcrs 6 4
psychn!ngy 1 5 2 - 8
Pyrrhn 1 7 9 - 8 0
CB'-() 44, 75-6
QWE RTY kcybnard 1 4 4 - 5
R. , Laurcn 30
Rabin, Itzhak 133
randnm samp!c paths (randnm runs)
4 2 - 3
randnmncss Inn!, traits nI 7 8 - 8 0
rarc cvcnts 8 9 - 9 0 , 91
casc studics 6 8 - 7 8
cvn!utinn and 8 2 - 3
Ia!!acy 9 3 - 8
nnn-dctcctinn by statisticians 96
ratinna!ity Q[
and biascs in undcrstanding
prnbabi!ity 1 5 8 - 6 2
rca!ity 2 8 - 9
rccursivc grammar 6 2 - 3
rcIcrcncc casc prnb!cm 1 3 9 - 4 0
rcgimc switching 55, 82.
rc!iginn 66
rcvcrsc Turing tcst 6 2 - 3
rhctnricians 184
rich pcnp!c 1 2 0 - 3
Rimbaud, Arthur 2
risk 3 3 - 4
avcrsinn 1 5 - 1 6
nI b!nw up 2 0 - 1
risk managcrs 3 8 - 9
risk mcasurcrs 1 8 8 - 9
Rnbbc-Gri!!ct, A!ain 4 7
Rnbcrtsnn, Ju!ian 7 9
' Rnbin Hnnd' invcstmcnt pn!icy 124
Rngcrs, Ji m 90
Rnman 5cnatc 183
Rnzan, Jcan-Manuc! 186
Russian bnnds 7 1 - 4
Russian rnu!cttc 2 7 - 8
Russian rub!c QW
Russian scicntists 3 1 - 2
5agan, Car! 139
samp!c paths 4 1 - 3
5amuc!snn, Pau! 147
sandpi!c cIIcct 1 4 2 - 6
5anta Fc Institutc 147
sca!ing prnpcrty nI randnmncss 5 7 - 9
*/A'1#-<$#B1# 21-2
5chn!cs, Myrnn 189
scicncc 2, 5
phi!nsnphy nI scicncc 3, 9 9 - 1 1 0
pnsitivc and nnrmativc 1 5 7 - 8
and scicntists 190
survivnrship biascs 1 4 0 - 1
symmctry and 9 0 - 3
scicntiIic intc!!cctua!s 6 0 - 4
scicntism 98
scicntists 5, 190
risk mcasurcrs and mc!tdnwn nI
1 9 9 8 1 8 8 - 9
in trading 2 9 - 3 2
sc!I-cnntradictinn 1 8 5 - 8
sc!I-cnntrn! 1 7 9 - 8 1
5cnatc, Rnman 183
I NDIX
203
5cncca 194
scrntnnin 2 2 - 3 , 83
5hi!!cr, Rnbcrt 3 5 - 6 , 5 3 - 4
shnrting 70
signa! and nnisc 1 6 6 - 7 , 1 8 0 - 1
signa!ing, hnrmnncs and 2 2 - 3 , 83
5impsnn (O. J. ) tria! 1 5 4 - 6
sircns, thc 171
skcpticism 1 8 3 - 5
skcwncss 10, 8 4 - 9 8 , 146
5kinncr, B. F. 1 7 8 - 9
smnnthing kcrnc! 1 6 6 - 7
5ncratcs 183
5nka!, A!an 61, 62
5n!nn 9
5nrns, Gcnrgc 80, 90, 1 0 3 - 4 , 109,
128, 189
sc!I-cnntradictinn 1 8 6 - 7
spnntancnus rcmissinn 1 3 8 - 9
statinnarity, prnb!cm nI 9 7 - 8
statistica! arbitragcurs 1 0 0 - 1
statistics 9 6 - 8 , 107, 1 0 9 - 1 0
5tix, Gary 54
stnchastic prnccsscs 4 2
stnck markct crash nI 1 9 8 7 90
stnicism 1 9 1 - 5
stnp !nsscs 80, 110
studcnt mnvcmcnt, Francc 196 8 185
summing undcr histnrics 4 7
supcrstitinn 1, 1 7 6 - 8
surviva! 5 5 - 6
nI thc !cast Iit 6 8 - 8 3
survivnrship bias 80, 1 1 7 - 4 1
symbn!ism 2
symmctry 9 0 - 3
)## '5)8 asymmctry
Ta!cb, Nassim Nichn!as
anccstry 50
bnsscs 3 2 - 4
cnmparisnn with NicdcrhnIIcr 1 0 2 - 3
dcvc!npmcnt nI gamb!crs' ticks
1 7 5 - 7
discnvcry nI Pnppcr 1 0 4 - 6
discussinn mcctings 87
pccr rc!atinns 3 1 - 2
and vnicing markct ca!!s 8 8 - 9
tc!cvisinn 1 6 3 - 4 , 1 7 3 - 4
Tcmpc!sman, Mauricc 193
tcstab!c statcmcnts 1 0 1 - 2
timc scrics 9 1 - 3 , 9 7
track rccnrd 126, 1 2 7 - 3 1
tradcrs/trading 4
appcarancc and intc!!cct 70
bndy !anguagc 2 3
bnsscs 3 2 - 4
cmcrging markct bnnds 6 8 - 7 4
high-yic!d bnnds 1 7 - 2 1 , 7 4 - 8
macrn tradcrs 79
Mnnt c Car! n mndc! 4 6 - 7
prnprictary trading 1 4 - 1 7
scicntists 2 9 - 3 2
trading ru!cs 1 3 4 - 6
trading stratcgics 152
traits nI randnmncss Inn!s 7 8 - 8 0
Trcasury bnnds 16, 94
tria!s, crimina! 1 5 4 - 6
Tu!ip, Ncrn 11- 17 , 2 1 - 2 , 1 50 - 1 , 196
Turing tcst, rcvcrsc 6 2 - 3
Tvcrsky, Amns 20, 48, 1 5 7 - 8
unabnmbcr 4 0 - 1
uncnnditinna! prnbabi!itics 155
Va!cry, Pau! 2
vcriIicatinn 1 0 6 - 8
Vicnna Circ!c 6 0 - 1 , 66, 107, 109
vitamin C 138
vn!ati!ity nI markcts 5 3 - 4
T'55 *($##( G8B$-'5 53
Wa!ras, Lcnn 147
Wi!!, Gcnrgc 3 5 - 6
Wi!mntt, Pau! 134
wnrk cthics 1 6 - 1 7 , 105
yic!d hngs )## hcdgc Iunds
Zcnn nI Kitium 194
Znrg!ubs 4 6

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