The Art of Streetplay

Thursday, July 14, 2005

Intellectual food for thought, major notions proposed in Fooled By Randomness, a good book.

--We are subject to hindsight bias--the "I knew it all along" bias--so that past events will always look less random than they were. While discussing our past, for example, we tend to backfit explanations concocted ex post. We create reasons for why certain events occurred ('this happened for so and so reason, b/c I was this and that, which led to...), choosing (subconsciously?) not to accept the fact that chance may had at least some part in spurring on the event. Were we successful because of skill, or b/c we were lucky?
My solution: before making a decision, write down what decision you are making, and most importantly write down why. Write down what you would do under the various possible future states of nature, and if the future surprises you in some unexpected way, sell, get out, write down what surprised you and why. See what effect that surprise has on the stock, and attempt to incorporate that new possibility into your next decision. It is hoped that the reasons why you made that decision, if correct, will cause you to reach your expected conservative estimate of what will happen in the future. If they don't, then perhaps you will need to readjust your expectations on a more fundamental level.
--It is difficult to apply probability to real life-- unlike a gambler at a roulette table, mother nature doesn't tell you how many holes there are on the roulette table, nor does she deliver problems in a textbook way. In the real world one has to guess the problem more than the solution.
My solution is to make an active effort to conjure up the various possible states of nature, and then to assign probabilities to each. Erring on the side of caution is probably the best course of action. This notion is analogous to Graham's margin of safety.
--Risks are not good in and of themselves-- An example of naive empiricism-- the author of "the Millionaire Next Door" looked for traits that many millionaires had in common and figured out that they shared a taste for risk taking. Clearly risk taking is necessary for large success-- but it also necessary for failure. Had the author done the same study on bankrupt citizens, he would certainly have found a predilection for risk taking.
At the lower level, it is clear that risk in and of itself is not good. The effectiveness of risk is a function of the downside risk, the upside potential, and the underlying probability distribution for the various states of nature. So for every decision we make, there will obviously be only one final outcome (ie. I have made a profit of $1,000 off of that trade). However that final outcome means very little-- it is the product of only one state of nature. The "real" outcome of that decision is the sum of the outcomes under all possible states of nature, weighted by their respective probabilities discounted for volatility. An interesting point, though, is that it is easier to think of possible states of nature ex ante-- after the event has taken place, it is very very difficult for us to look at the past and examine all the other things that could have happened.
At the higher level, 1) we need to look not only at the characteristics of winners-- we also need to look at the characteristics of losers. 2) 'Necessary' qualities of winners does not imply causality, that certain qualities will necessarily cause winners to come about. 3) Finally, it's probably a good idea to get "the whole picture" before coming to a conclusion regarding the effects of certain qualities. Before I make the assumption that risk-taking is a good thing, I would like to examine its correlation to everything which has an impact on me. I would examine its correlation to financial success and failure, as well as emotional side effects. Finally, I would seriously consider whether risk-taking is right for a person like me--given that I am who I am, given that I have certain personality traits, how do the odds of financial and emotional success and failure change?
--Our assessment of risk is flawed even on a fundamental biological basis-- it is a fact that our brains tend to go for superficial clues when it comes to risk and probability, and these clues are largely determined by what emotions they elicit. Both risk detection and risk avoidance are not mediated in teh "thinking" part of the brain but largely in the emotional one (the "risk as feelings" theory).
This is a bit harder to control for, but to know of this fact's existence alone is a good thing. All we can do is strive for objectivity in our decision making and risk assessment processes.


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