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Are markets just a roll of the dice?

DAVE EBNER takes a look at a recent business bestselling book that considers the role of chance in financial markets

There are few certainties in life or capital markets and it is this observation that guides Nassim Nicholas Taleb, a trader and writer whose recent work explores the underestimated role of chance and unlikely outcomes in the volatile world of investing.

"History teaches us that things that never happened before do happen," Mr. Taleb writes in Fooled By Randomness,published last fall by New York-based Texere LLC. The book recently ascended toward the top of the business bestseller list in Canada.

The problem, as Mr. Taleb sees it, is few investors actually ascribe adequate probabilities to rare events -- and at the same time overstate the likelihood of more common occurrences.

"We are probability blind," Mr. Taleb writes, suggesting our ability to weigh outcomes is hindered by our survival instinct. If one is faced with immediate danger, for instance, instinct tells us to run each time, even if the odds of death are 90 per cent.

"Our brain has been wired with biases that may hamper us in a more complex environment, one that requires a more accurate assessment of probabilities," Mr. Taleb writes.

These biases are often seen in the supposed wisdom of strategists, analysts and economists on Bay and Wall streets. Recall January, 2001: North American stock markets had tumbled from the bubble peaks of 2000 and the economy was stumbling. The U.S. Federal Reserve Board announced a surprise interest rate cut Jan. 3, delighting investors who drove stocks markedly higher that day. The old maxim, Don't Fight The Fed, was on most lips and the vast majority of market watchers happily predicted further gains ahead.

Stocks faltered badly, of course, surprising the many observers who had effectively overstated the odds of stocks rising. Numerous analyses looked at the history of U.S. stock markets and their behaviour during easing cycles, finding that stocks pretty much always rose when interest rates fell.

But to Mr. Taleb, this is the key mistake. He considers the history of U.S. stock markets as merely one statistical sample, explaining that if the course of time were to be run again, the variety of outcomes would be far larger than those found in the actual history. Essentially, drawing definitive conclusions from a single sample exaggerates one's true knowledge.

Mr. Taleb likens this situation to an urn filled with many black balls but only a couple of red ones. Picking balls out of the urn, our knowledge of red balls -- effectively the unlikely event -- will probably grow far slower than our knowledge of black balls. As more and more balls are drawn out, conclusions are made about the composition of the urn. Say a million balls are drawn and only 50,000 -- 5 per cent -- are red. It is then often presumed the established pattern will hold. However, Mr. Taleb wonders what happens if the urn actually contains 100,000 red balls per million. "A single random run is bound to exhibit some pattern," he writes, warning investors that "the more data we have, the more likely we are to drown in it."

Bay and Wall streets -- believing stocks rose when interest rates fell based on their piles of data -- discovered last year there are more red balls in the metaphoric urn than previously believed.

"At no time in modern history did the stock market go down point-to-point in an easing cycle," Merrill Lynch Canada Inc. told clients in a strategy report this week. "Until now."

Mr. Taleb's business is based on the "until now." He runs Empirica Capital LLC, a "crisis hunting" hedge fund based near New York. The firm makes bets the unexpected will occur. It loses a small amount of money consistently, hoping for big gains when their bets occasionally hit the mark.

While this strategy may not be better or worse than any other, what underlies it is the idea that nothing is certain. This concept emerged from the work of David Hume, an 18th century Scottish philosopher and popularized by 19th century philosopher John Stuart Mill, who called it the "black swan" problem.

"No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion." More simply, a million white swans cannot prove all swans are white but one black swan definitely proves not all swans are white.

At Empirica Capital, Mr. Taleb's primary goal is to avoid "blowing up," business slang for losing all one's money when things are going seriously wrong.

This is among the useful lesson that readers can take from the book, says Douglas Pollitt, an analyst at Pollitt & Co. Inc., a boutique investment house based in Toronto.

"Keep in mind things can change quickly and unexpectedly," Mr. Pollitt says. "And that's not usually in the minds of most investors."

Research suggests unusual events happen far more often in stock markets than statistics would lead one to believe. In a normal bell curve, strange events -- signified by standard deviations from the mean -- are infrequent. For instance, a normal bell curve says an event five standard deviations from the mean should occur about every 7,000 years. But in the markets such events happen every three or four years.

Early in Fooled by Randomness, Mr. Taleb recounts the stories of two successful peers from his days as a senior trader in London and New York. The two traders had impressive multiyear runs before blowing up in 1998 when Russia defaulted on its debt. One based his trading on his knowledge of economics -- "he believed that the economic intuition he was endowed with allowed him to make good trading decisions," Mr. Taleb writes. The other relied on quantitative strategies, tactics designed to find and exploit reliable patterns in the markets -- and also to gauge, manage and minimize risk.

By 1998, both traders had amassed major profits. But alongside their gains, both became increasingly convinced of their own acumen -- not really considering the possibility their success came from luck, like happening to employ the right strategy at the right time. Both made big bets on Russia, understating the chances of disaster, overstating the chances of success -- and both blew up.

Realizing the role luck may play in life and markets can keep investors humble -- and hopefully keep their money safer, Mr. Taleb believes. Consider how luck can produce winners. Say there are 10,000 money managers in the world and by random luck half make money in a given year. The pool is reduced to 5,000 the second year and say half, by luck, make money again. Repeat the series over 10 years and one is left with 20 managers who made money each year -- simply by luck.

North American society -- from CNBC to The Globe and Mail -- will laud and praise money managers who post decade-long winning streaks, applauding their skill, never ascribing the outcome to luck. And it may well be skill -- but one cannot be sure.

Such conclusions are found in academic work on probabilities and capital markets, says Moshe Milevsky, an author and finance professor at York University.

"We all think we're a lot smarter than we actually are," Mr. Milevsky says. "When you're picking mutual funds, most of the success should probably be attributed to randomness and not to skill -- something I've found in my work."

The message for investors is resist perceived certainties. Resist the urge to chase fads and "hot" sectors, funds or stocks. Cover one's ears when the conventional wisdom is spouted. By doing so, one hopefully avoids risk by always assuming losses are a distinct -- though perhaps rare -- possibility.

Mr. Taleb recalls a conversation with a cab driver near the end of Fooled by Randomness. Mr. Taleb explained a theory that attempted to measure future risk but the driver "laughed at the fact that someone ever thought there was any scientific method to understand markets and predict their attributes. Somehow when one gets involved in financial economics, owing to the culture of the field, one becomes likely to forget these basic facts."

© The Globe and Mail

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