FOOLED BY RANDOMNESS: The Hidden Role of Chance in the Markets and in Life.

FOOLED BY RANDOMNESS: The Hidden Role of Chance in the Markets and in Life.

By Nassim Nicholas Taleb. Texere. 203 pp. $27.95

You are considering an investment adviser with an admirable track record: For 10 years, through good times and bad, he has consistently made profits for his clients, even as other advisers have crashed and burned. If you are convinced his methods are lawful but know nothing else about how he picks winners, should you hire him?

Most of us would say you can’t argue with success. If he has managed to make profits over a sustained period, he must have a knack for anticipating the market, and it’s a pretty good bet he’ll keep it up. This, hedge fund operator Taleb tells us, is an example of being fooled by randomness. The investment adviser’s long string of successes may be only a streak of good luck that will end once you hand him your money.

Counterintuitively, even a long series of wins can be the result of chance; it all depends on how many attempts you make. If one person starts flipping a coin, it is highly unlikely that his first 20 flips will be heads. But let’s say you gather a million coin flippers in a stadium and, after every flip, you ask those who got tails to leave. After 10 flips, there will be about 1,000 left; after 15 flips, about 30. Each survivor can justifiably claim to have an enviable record in coin flipping, yet we can confidently say that about half of them will get tails on the next flip. Some will get 17 or 18 consecutive heads, and one may even get 20, yet—extraordinary as that record may be—no rational person would give more than 50/50 odds that the 21st flip will also be heads.

This is easy enough to recognize in theory but devilishly hard to apply in practice. The successful investment adviser’s track record— taken in isolation—looks impressive. Our minds are geared to extract order from chaos, and we resist the possibility that his success might be due to dumb luck.

Using a variety of imaginative examples, Taleb reminds us that we view the world through the lens of survivorship bias—we tend to consider only the few winners and not the many losers in a particular endeavor. The hotshot investment adviser enjoys an aura of competence because we find it hard to imagine that someone could do so well based on luck alone. But viewing him in isolation is a mistake; many people entered the business at the same time, and it was statistically quite probable that a few would wind up having unusually long winning streaks. Yet good luck in the past, no matter how sustained, is no guarantee of good luck in the future. Taleb gives many examples of investors who lost huge sums by entrusting them to traders with excellent track records.

Is there no such thing as competence, then? Taleb does not go quite so far: "I never said that every rich man is an idiot and every unsuccessful person unlucky, only that in absence of much additional information I prefer to reserve my judgment. It is safer."

In reality, there is no safe harbor. Reliable information costs money and time; opportunities may be lost. Even though success may be the fruit of good fortune, it may also be the result of competence, or a combination of the two. We live in a world of probability and must make judgments on the evidence available within a finite amount of time. While it is important to remember, as Taleb shows in his charming and colorful book, that randomness can fool us, ignoring the most obvious inference from the available evidence can lead to errors as well. In the end, we cannot escape making judgments—and hoping for a little luck to help us along.

—Alex Kozinski