Monitoring return on investment: survivorship bias and trader probabilities

Monitoring the Return on an Investment-Survivorship Bias-(market Traders- Probabilities)

On a broad perspective, Nassim Nicholas Tab's work of non-fiction, Fooled by Randomness, is about probability. The author discusses this field of study, however, in a number of disparate ways in which probability influences both financial and business investing as well as the general vicissitudes of life. His primary thesis is that, all things considered, what people generally attribute to perspicacity, skill, or to superstition is only the result of chance. He examines this theory in length by identifying several characteristics of investors within the trading market as well as business practices of companies. He also provides examples from varying fields of life such as nature and personal relationships. The commonality between all of this intellectual footwork is his reliance on probability as the general indicator of success or failure. Thus, he goes to great lengths to convince the reader that what people generally credit to their own man-made effort and endeavors is merely a smile or a frown from fortune itself.

Although the author references a multitude of varieties of life itself to propagate this theory, it is essential to grasp the financial ramifications of this work of literature. At the time of the writing the author was a professor of mathematics and a trader. Despite the apparent philosophical connotations of his findings, Taleb frames such theory in the pragmatic applications of the financial world. If there were a greatest lesson learned from his manuscript, it would revolve around his notion of "survivorship bias." Survivorship bias is the conception that historically, people are emotionally and psychologically programmed to revere those who survive or accomplish their goals to the point where they discount the countless others who failed. The ramifications of survivorship bias are that people will look at those who have succeeded and then find reasons for their success, which the author warns are generally not true and are merely side effects of luck.

The lesson for financial analysts and investors, however, is that such consecutive victories are bound to end, at some point. Those who realize this are prudent. The many who do not are merely victims of pride and overconfidence, which can certainly be detrimental when one is gambling and investing one's own money and interests. Yet such a human proclivity merely becomes exacerbated when one is heading up companies or entire interests in certain tradable stocks and bonds and conglomerates, so that when they fail, the general market or economy suffers at well. This point is one of the more insightful observations in Taleb's book. Simply by examining probability on a long-term basis, the author propounds the positions that adroitness or ability plays very little in any sort of success -- especially that related to finance and business -- and so it is best for individuals and organizations not to bank on what the author terms good fortune.

Largely based on this principle of survivorship basis, Taleb widely discourages the use of most forms of researching indicators for wise or poor investments. Such analysis can generally be stratified into both technical and fundamental modes of analyses. Technical analysis largely consists of looking at past events and previous data in the attempts of garnering insight into previous ones. Fundamental analysis is that which involves sifting through current or recently past information for the same purpose. Taleb explains that neither of these methods of analysis have a substantial bearing on future events, for the simple fact that they are all determined randomly. The reason why he disputes such conventional investment strategy, is because the probability of events aligning themselves so that they can occur again as favorably as they once did -- that lightening can strike twice or that a monkey randomly scribbling can craft not one but two seminal classic works of literature -- is exceedingly low, if not almost non-existent.

One of the boons of this particular manuscript is that Taleb defines and discusses many concepts that are intrinsically linked to probability itself. The timespan that people typically utilize to analyze probability, for example, is often far too insignificant. One of the ways in which Taleb supplements his claim that people tend to focus solely on those who have achieved their desired outcomes and not the countless others who failed along the way is by elucidating the fact that in order for true probability to be calculated, one must utilize as wide a timespan as possible which includes a copious amount of events. Those who are analyzing business prospects or particular tradable assets/commodities typically use too narrow a window in which to analyze probability. However, in chapter three of this manuscript the author indicates that true probability is calculated by analyzing the entire history of events. If people would do this, they would see how exceedingly rare some of the outcomes are that they are attempting to achieve, and be less inclined to create action to fulfill those ends. Such an inclination, of course, transcends mere fiscal analysis and extends itself to virtually all aspects of life, a topic Taleb takes on in the fourth chapter.

In the sixth chapter, Taleb details the statistical concepts of asymmetry and skewness as they relate to probability and its calculation. These are two very valid concepts to analyze since they can easily distort the proper evaluation of the likelihood of a certain event taking place. The author stresses the fact that recent events have the propensity to create skewness because people tend to disproportionately factor in events that happen recently into their inclinations for achieving a desired objective since they are affected by them psychologically. In proper statistics, the time frame in which an event occurs does not affect its probability. Yet for people who thrive on emotions that affect psychological and cognitive processes, contemporary events tend to be prioritized over distant ones, effectively skewing the true calculations for probability. Similarly, skewness relates to asymmetry in the sense that it is basic human nature to categorize and even polarize events and outcomes into those that are desirable and undesirable. Although there may be some level of polarization in the outcomes of events that can be calculated via probability, human nature's won't to view outcomes in only these two different ways creates an asymmetry that does not allow them to properly calculate the probability of an event.

Although there are many other chapters in this work in which the author discusses additional statistical concepts such as induction in chapter seven, one of the central precepts he constantly revisits is the human interpretation of these notions -- which is rarely without bias and is subject to a significant amount of sway from factors that in and of themselves should not affect probability or randomness. The reason that contemporary events affect one's judgment more than historical ones is because people tend to separate themselves from the past because of a perceived distance which little matters when one is simply determining events and outcomes for the sake of probability. Taleb revisits the concept of asymmetry while deconstructing the human proclivity to analyze in terms of absolutes in Chapter 11. By choosing to only consider outcomes via the traditional 'all or nothing' conundrum, in which one either succeeds wildly or fails miserably in an enterprise, individuals severely restrict the entire range of possibility and its effective use. Again, from an investment perspective this facet of human nature is integral to the author's argument that these basic tendencies of human nature run contrary to the full effectiveness of probability and randomness, which leads to a confusion of luck with skill and inappropriate action -- and occasional woeful results.

Another tenet Taleb cites that helps to corroborate his thesis that chance is the principle determinant in the outcome of events as opposed to man-made endeavor is his conception of rare events. This concept is closely linked with his idea about black swans. The author posits the viewpoint that despite a single sighting of a black swan can undo all of the empirical evidence in the world that swans are white. In more practical terms, then, this conception contends that events with a statistically low probability do in fact happen. When they do in conventional normative ways related to investments and business, they create havoc with outcomes of events and demonstrate the fact that past events and contemporary studies of them cannot effectively predict outcomes. Moreover, such rare events can significantly impact a particular industry and marketplace in such a way that the conventional means of analyzing investments and business opportunities no longer apply.

One of the most interesting facets about this concept of black swans and rare events is that as an investor himself, Taleb actually actively seeks such events and looks to invest in them. The logic is that because such events happen so rarely, that when they do occur the payoff is disproportionately high. So while those who invest and engage in business practices that are standard and do not account for rare events are adversely affected by their presence, counter-intuitive investment approaches in rare events can actually create a considerable amount of revenue for those who choose to "play" them.