Sunday Musings: Fooled By Randomness

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My preference is to read business books that offer a fresh perspective or a different view of looking at things. The same applies to books that deal with investments. Most aren’t worth the paper they are printed on because they rehash MPT, Modern Portfolio Theory (which by now is some 60 years old and in dire need of revamping), or focus on why ETFs are better than mutual funds along with the same old Buy & Hold scenario.

All of these are approaches that are based on a bullish environment and, when the bear suddenly appears, those portfolios get slaughtered big time. Of course, heavy bear market losses get swept under the rug in a hurry by the media and by many of the most well-known B & H proponents.

Bear markets can be considered Black Swans, or rare events, as I wrote about last year. In my advisor practice, I like to be prepared as best as I can to deal with those events by being disciplined and always have an exit strategy to fall back on. To me, if a bear market has the power to slice portfolios in half over a fairly short period of time, then one should pay attention and be prepared at all times.

I was reminded of that again when I read Nassim Taleb’s book “Fooled by Randomness,” which further elaborates on the Black Swan concept. Nassim explores how randomness not only affects the markets but also makes inroads into your daily life. It’s a fascinating read and gives some insight in how the author himself, a mathematical trader, is trying to resist being fooled by randomness and how he tricks his emotions in regards to probabilistic outcomes.

He cites examples of high profile traders making hundreds of millions of dollars for their employers only to lose more than that in just one week, because they did not consider the possibility of career ending rare events. I was shocked to learn that only very few of the top traders working for investment banks base their decisions on certain observations (that includes past history) and then make sure that the costs of being wrong are limited. Here’s what Nassim said (page 131):

They know (the traders) before getting involved in the trading strategy which event would prove their conjecture wrong and allow for it. They would then terminate their trade. This is called a stop loss, a predetermined exit point, a protection from the black swan. I find it rarely practiced.

Read that last sentence again! This is only way I know of to protect your portfolio from receiving a serious haircut, yet most investment approaches, especially those based on Buy and Hold, do not allow for it. Whether you call it randomness, a rare event, a black swan or any other name, the outcome will be the same.

I believe that especially in a bubble bursting economic environment with worldwide effects, such as we have been experiencing, not paying attention or simply ignoring the possibility of a bear market, will have dire consequences for those in denial.

If with all my blog posts, I can get only one idea across to you, which is to never ever work without a sell stop, then my efforts will have been successful.

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