Nassim Taleb, well known as the author of The Black Swan, laid out the foundation for that book in Fooled by Randomness, penned several years earlier. The earlier book contains a number of thought provoking ideas on probability, some old some new, but most of which have potential application in the investment process.
One is simply the broad concept he calls probabilistic thinking as opposed to deterministic thinking. Past events always look less random than they were. This is called the hindsight bias or, in sports, Monday morning quarterbacking. In other words, our natural inclination is to look at events that have occurred as flowing inevitably from preceding events or causes. In this way, we tend to jump to the conclusion that whatever occurred was, if not certain to occur, at least, the most probable outcome. In contrast, a probabilistic approach would look at an event that occurred as just one possibility out of a range of outcomes with each possible outcome having a probability attached to it. Taleb calls these outcomes, which could have occurred but didn’t, “alternative histories”. Taleb would argue that what occurred may in fact have been unlikely, in other words just a random occurrence. This distinction becomes hugely important when we try to learn from the history of events lest we learn the wrong lessons. It also has significant implications when looking into the future. In evaluating a strategy, one must consider the risks of all possible future outcomes, not just examine the pattern of past occurrences. Probabilistic simulations of the future are exactly what Monte Carlo simulations accomplish, and that is why we use them as an important financial planning tool in assessing the probable success of a given client retirement plan.
Another interesting concept Taleb examines is that of asymmetry and skewness. It’s true that in many cases data falls into “normal” distributions with data clustered around the average and declining smoothly to skinny “tails” on both ends (the familiar bell curve). However, market based data and economic data has an uncomfortable tendency to be asymmetric or skewed such that the data isn’t nicely balanced on both sides of the average. It’s this observation which led to Taleb’s “black swan” concept --- the rare unexpected event. The name arises from an historical conviction that all swans were white because no one had ever seen any other kind; that is, until a species of black swans was discovered in Australia. Taleb makes the point that very rare events are often treated as though they will never occur. However this is extremely dangerous, particularly if these rare events also have very large consequences. For example, while it may be true that housing prices rarely go down, if such an occurrence can bankrupt your business as a mortgage lender or underwriter, you better not ignore it (see Countrywide Mortgage and Lehman Brothers)!
We have used the lessons of this type of analysis in reviewing our holdings in alternative assets. We have been replacing the Gateway fund with the Prudent Bear fund based on a review of the distribution of their historic and expected returns. Both funds have skewed returns. Gateway is likely to have rare times with large negative returns and frequent times with moderate positive returns while the Prudent Bear fund is likely to have rare times with large positive returns and frequent times with modest negative returns. Tellingly however, the large negative returns for Gateway will tend to occur when most assets are doing poorly, such as the 4th quarter of 2008. In contrast, this is precisely when the Prudent Bear fund will tend to have its large positive returns --- when it’s needed most. So in this case, the particular way this fund’s returns are skewed makes it a much better diversifier for client portfolios.
Randomness is inevitable in life and in investing. The better we can understand it, the more appropriately we can plan for contingencies, and effectively manage risk so we and our clients aren’t fooled by randomness.