I have just been re-reading this book by Nassim Nicholas Taleb.
It’s a fascinating read about how we find it so difficult to assess whether what we’re seeing in the market place is the result of skill or chance. If we are looking at something that requires a large number of small transactions that require demonstrable skill – such as playing the piano or dentistry then it’s unlikely that someone who has performed well on several occasions will be able to bluff their way in the future if they are incompetent.
By contrast individuals whose work involves a small number of large operations and who are measured by results rather than process plus results – such as CEOs or investment traders may well – if there a larger number of people engaged in the profession be successful entirely by chance. Probability tells us that if there are enough monkeys in the market then some will be successful every year for years on end. This is because we lose sight of the unsuccessful ones. This is a particular problem in a random environment such as the market. Not only do we perceive random success as deliberate – the successful do too and it affects the way they behave.
Taleb explains that while looking at the past delivers a pattern – almost ANYTHING can deliver an apparent pattern – that’s what chaos theory tells us. It can’t be used to predict the future. While you can use statistical probability to help you make aggressive bets, you can’t use it to manage risk. To do that you have to make sure that you protect yourself from unexpected events – Black Swans Taleb calls them – which can wipe you out.
So the rules of thumb as to whether a track record is valid or not is
1) Are there so many players that a significant number would statistically look good for 6 or 7 years – given that we only see the winners?
2) Is the environment for the activity non-random? Engineering is non-random – if it goes wrong people die while government activities are random as in if they go wrong nothing very much happens really.
If we reviewed offers made to us in this light and applied some elementary statistics then we would get on better.
But why do we find it so difficult to manage rationality? – Because we need emotion to make decisions and rationality is only wheeled out after the event to make it look good – something that every salesman knows.
We don’t use logic – we use heuristics – quick and dirty rules of thumb which save us time. Scientific method takes too long. Taleb argues that our brains are wired up to ensure the spread of progeny and get us out of trouble quickly. If we processed things to explain the world as it is – the time lag would kill us – particularly with a woolly mammoth and a couple of sabre tooths on our case.
Our brains use modules to kick in and solve problems on automatic pilot. Really there’s no central processing unit which is very much in line with modern brain research, There’s a really interesting description of how this works in Bob Cialdini’s book on influence but basically it’s about the search for pattern and the use of certain short cuts like social proof, authority, and reciprocity to make quick decisions rather than logical decisions. We’re much better at spotting cheats than using logic for instance.
Taleb argues that our decision making is biased against perceiving abstractions as risks. Being non critical of how much are own or others success is random rather than achieved leads into all sorts of difficulties, particularly where the “noise” is great compared with the “signal”.
It’s a timely reminder that the survivors are the ones who haven’t bet the company.