Sunday, August 05, 2007

Fooled by Randomness

I am taking some time whilst overseas to put some more substantial tomes into my literary diet that normally consists of The Economist, The New Yorker and occasional Newspapers. Whilst browsing at readings I came across the title 'Fooled by Randomness', by a Nassim Nicholas Taleb. Taleb develops a number of themes, all of which should be of interest to anyone engaged in public policy, economics, or any profession where randomness exists and rare events can sharply alter outcomes.

Taleb has been sharply critical of people who misunderstand the book and I hope I don't fall into the same traps in attempting to distill some of its wisdom. The overarching theme is that humans are easily fooled by randomness. Examples are brought forth from Taleb's 'day job' as on options trader, betting on rare events. People tend to, in his view, chronically underestimate the incidence of unforeseen catastrophic rare events when pricing securities and other financial instruments. Taleb also rejects the traditional distinction between risk and uncertainty (risk is where the probabilities are known not the outcomes, uncertainty where neither is known). The normal conception of risk may be applicable to casinos, but in the real world (markets, policy, etc) there is always a degree of epistemic doubt. The inductive method is not flawless yet people are prone to generalise from small samples and overestimate their ability to discern risk. Hence (almost) all real world situations should be thought of as involving action under uncertainty.

A further message is to be wary of the ubiquitous normal distribution. Whilst is has broad application and is instructive in certain areas, the assumption of normal distribution, in Taleb's view, led to several of the authors of the black-scholes options trading model (a Nobel prize winner) 'blowing up' when trading for their hedge fund. Taleb reminds us that power law distributions and others - 'fat tailed' distributions - dominate in many areas of life. Neglecting them leads to the danger of being caught off guard by the rare event.

Finally, Taleb guides us through the reasons for our failings in understanding risk. This discussion is multi-faceted. Taleb lambasts the arrogance of the academic, pseudo-mathematical elite in economics and finance with their over-certainty as to risk. Implicit is that part of the explanation for why we are so easily fooled is sociological - academic circles privilege those with a claim to know things. Consequently overconfident, arrogant type A's will rise to the top and reinforce the process. Taleb then incorporates insights and alternative theories from psycholody, neuro-biology, evolutionary neuro-science and behavioural economics. It is an enthralling read - for me it hit home for the first time how a deep understanding of the general pattern of human action is needed in order to understand the failings of economic theory. Market failures are not all interdependent oligopolies and natural monopoly...

The critique develops from anecdotes, philosophical musings and references to past writers and academics. It reads more as a personal essay than an academic work, and Taleb makes it clear that it is intended for broader application than a handbook of economics, statistics or finance (ironically, the book is sometimes criticised for failing to fulfill this purpose, when such purpose was never intended and would have limited the generality and applicability of the work). The recurring remarks on stoic philosophy and the noble life as a response to the risks and vagaries of life will not provide answers for everyone - Taleb is a unique character and his answers are his own. Still, the book is thought provoking and worthwhile and I recommend it to anyone with even a passing interest in the social sciences, risk management or just coming to terms with the vagaries of modern life.


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