FAUJI FINANCE

Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets is a book by Nassim Nicholas Taleb that deals with the fallibility of human reasoning.  He published the book in 2001. Taleb’s other seminal work is The Black Swan   which was described in a review by the Sunday Times as one of the twelve most influential books since World War II and was published in 2007 around the sub prime crisis.

Most Indian’s believe in something called “destiny”, to Taleb’s mathematical mind destiny  is “chance”.  He postulates that when seen through the prism of a sample data base all hardworking, disciplined and conscientious people do NOT become successful.  For every one million people who went into business, only one or two become Dhirubhai Ambanis. But we only remember the success stories and then weave tales around them. Nobody thinks that it was chance, fortune or sheer coincidence that led to some of his actions resulting in explosive growth for Reliance.

Taleb sets forth the idea that humans are often unaware of the existence of randomness. They tend to explain random outcomes as non-random. We overestimate causality, e.g., we see elephants(or something else) in the clouds, like Rorschach’s ink blots instead of understanding that they are in fact randomly shaped clouds that appear to our eyes as elephants;

He then extrapolates these observations to the stock markets and tells us that we tend to view the world as more explainable than it really is. So they look for explanations even when there are none.

Most of the Technical Experts who appear on the financial channels in the electronic media, try to find meaning in a garbage of data. Give a man a computer and piles of data and he shall find a pattern. Something like, the Chaos theory proponents say about “the butterfly effect”, wherein a  small change at one place in a deterministic nonlinear system can result in large differences to a later state. Taleb states that we get fooled by such random happenings because someone finds a pattern in them.

To take a military example, do all hard working, disciplined, equally qualified WestPoint graduates end up becoming Generals? No. It implies that apart from the requisite qualities, those who became Generals had something else going for them. Was it the death of a competitor? Was it the chance to be posted under a superior who was from his Regiment? Was it expungement of an adverse remark in his Confidential Report by a sympathetic friend of his father-in-law? Was it a sudden increase in the number of vacancies of Generals by the President? Was it participation in a battle which was thrust upon the nation due to a random terrorist event on 9/11? 

If one sits down and analyses, one will realise that random events occur around us all the time and a lot of our lives are products of those random events, and we get fooled by them by attributing the successes to our capabilities and our failure to the random happenings.

In financial markets, day traders often make daily or weekly profits like chicken food but their losses are like elephant dung. Therefore, never rule out the possibility of a random event leading to a huge downside in your investment decisions and never attribute a huge profit in your investments to just your intelligence. Don’t be fooled by randomness.

Go read this book  to understand how stock markets focus usually on data and noise and then they try to find a pattern in that noise. Build a foundation of KNOWLEDGE for your stock market investments. 

Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets 1st Edition 

This is the title of an old famous book.  Henceforth, I shall periodically put on my blog a list of recommended books and in case I have read them their book reviews, too. These books were read by me very late in my ‘investing life’.  But I feel they are the primers and foundation for investors seeking to generate “wealth” in the long term. These books are not for traders/addicts/pseudo-investors unless they want to be de-addicted, Why? Because the books will tell tales of all such people which constitute “the mob”. I shall sequentially make a small syllabus of “Must Read” books, articles and reports with links to sites from where these are available.

The first of the series is “EXTRAORDINARY POPULAR DELUSIONS AND THE MADNESS OF CROWDS  by Charles Mackay“.

Manias—especially macro manias—are associated with economic euphoria; business firms become increasingly up-beat and investment spending surges because credit is plentiful. For instance, in the second half of the 1980s , Japanese industrial firms could borrow as much as they wanted from their friendly bankers in Tokyo and in Osaka; money seemed ‘free’ (money always seems free in manias) and the Japanese went on a consumption spree and an investment spree. The Japanese purchased ten thousand items of French art. A racetrack entrepreneur from Osaka paid $90 million for Van Gogh’s Portrait of Dr Guichet, at that time the highest price ever paid for a painting. The Mitsui Real Estate Company paid $625 million for the Exxon Building in New York even though the initial asking price had been $310 million; Mitsui wanted to get in the GuinnessBook of World Records for paying the highest price ever for an office building.

 As the preface of the book says, “In reading The History of Nations, we find that, like individuals, they have their whims and their peculiarities, their seasons of excitement and recklessness, when they care not what they do. We find that whole communities suddenly fix their minds upon one object and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first.” How true !

The book was first published in 1841 by Richard Bentley, London and has been reprinted and edited since. The tag line says “the follies of mankind are not unique to the modern world”. The book thus, builds a historical case for manias, euphorias and bubbles. They are repetitive in nature, their forms may change. In the Preface, it is written, As George Santyana, the famous philosopher said, “Those who can’t remember the past are condemned to repeat it.” This book is the first book which any one investing in financial instruments, especially equity should read. It will give you a behavioural perspective on why people do what they do. The book is divided into 16 chapters and each chapter deals with a different scheme which a swindler brought or a social mania or craze which started and how the crowds lost reason and rationality and gave credence to the phrase, “Have you lost your mind?” When a wave, a bubble or a euphoria comes, reason is the first casualty. The book adequately deals about it. Even if you read just the first three chapters or 120 odd pages, it should be enough to make you understand that it is not your intelligence which will be needed to make money in the stock markets but your emotional behaviour and discipline.

If a person like Sir Issac Newton, the genius scientist who gave us laws of motion can be tempted to invest in a scheme of  “The South Sea Company” and then lose the entire money because all others were also investing in it, you can fully comprehend the meaning of my statement. The book covers this investment and many more such incidents.

This classic text serves as a salutary reminder that human follies and mistakes have been occurring periodically all over the world. The book draws historic parallels for almost every financial neurosis of modern times from the internet stocks craze in late 1990s to the subprime crisis of 2007. It has happened earlier and it will happen again. Money and GREED have more often than not been the cause of delusion of the masses. To quote Mackay from the book, “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.” 

The Misssisipi Scheme, The South Sea Bubble, the Tulipomania, the Alchemists, Witch Mania are some of the subjects Mackay dwells upon.

Imagine one bulb of tulip of the variety Semper Augustus being sold off in 1634, in Holland  and thereafter in Europe for 5500 florin each, when the price of 12 fat sheep, which could provide meat for a household for six months was only 120 florins. As Mackay writes, “…..there was such a rage among the Dutch to possess them that the ordinary industry of the country was neglected, and the population, even to its lowest dregs, embarked in the tulip trade…..”

The book is full of such manias and gives an important lesson for the investors. Beware of waves, manias and bubbles. If the price of a particular asset seems too good to be true, it usually is. In India I can quote a few such manias and waves, Plantation Schemes, Harshad Mehta Mania, Ketan Parekh list of K-10 stocks,  Master Gain and Master Plus mutual fund units being traded as shares (yes it is true), Morgan Stanley Close Ended Mutual Fund units being sold at a 100% premium to the NFO price of Rs 10 per unit and the Reliance Power IPO.

“Many persons grow insensibly attached to that which gives them a great deal of trouble, as a mother often loves her sick and ever-ailing child better than her more healthy offspring,”  says Mackay. Don’t we keep our losers in our portfolios more than our healthy shares ?

I advise all investors to read this book as the first book of your syllabus.

Book: Extraordinary Popular Delusions And The Madness Of Crowds New ed Edition by Charles Mackay