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Issue 208, 13 September 2006

Feature Article Don't be fooled by randomness Different activities are exposed to different degrees of luck and skill— and it can be hard to tell the difference. The unfortunate death last week of Crocodile Hunter Steve Irwin put Australian wildlife back in the limelight, and it’s not unfamiliar territory. Ever since Captain James Cook and the naturalist Joseph Banks set foot on Australian soil in 1770, the rest of the world has been enthralled by our unusual animals and plants. When the first (stuffed) platypuses were sent back to England, people there thought it was a practical joke. Our native wildlife is mostly known, however, for being dangerous and/or a little odd, but just to show that our animals can turn their hand to anything, the Australian black swan, Cygnus Atratus, holds a special place at the centre of philosophical debate. The black swan elegantly makes a crucial point about inductive reasoning, as set out by the English philosopher John Stuart Mill in the 19th century: ‘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.’ In the northern hemisphere all swans are white and people would have laid bets on all swans being that way. But there’s nothing like the discovery of a new continent to turn things on their head. Black swans and what they tell us about our readiness to jump to conclusions are particularly important in finance, and they lie at the heart of an excellent book titled Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets by Nassim Taleb. Russian roulette Taleb’s basic message is that life is made up of chance events, that we’re unable to assess the probability of these events with any accuracy, and that, even if we could, we’re not wired up to process probabilities effectively anyway. This, he says, makes trading and investing rather difficult. But because there are always people doing well and badly (if only because of the huge numbers having a go), we tend to assume that there is great skill involved. But the balance of luck and skill varies greatly depending on what exactly you’re doing and how you’re doing it. As Taleb explains: ‘$10m earned through Russian roulette does not have the same value as $10m earned through the diligent and artful practice of dentistry. They are the same, can buy the same goods, except that one’s dependence on randomness is greater than the other. ‘Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers, instead of six. After a few dozen tries, one forgets about the existence of a bullet, under a numbing false sense of security.’ Last pair of cufflinks Members (or ‘names’) of Lloyds of London, the famous insurance market, would know more about this than most. Names earned extra returns on their capital each year by putting it on the line to underwrite the world’s insurance losses. When becoming a name at Lloyds, people were told they were potentially liable for losses, ‘down to their last pair of cufflinks’. But of course this never happened and people became complacent. The author of this article remembers a friend’s father explaining in 1982 how becoming a name at Lloyds would make him around £15,000 a year and he’d only lose out ‘if London burnt down or something— and that ain’t going to happen’. Well London hasn’t burn down, but a different, unconsidered, catastrophe produced a similar result. Asbestos compensation has led to huge insurance losses around the world, and large numbers of Lloyds names lost their metaphorical last pair of cufflinks (fortunately for the friend’s dad’s couture, mum had a successful practice as a GP). The point is that you have to be very careful weighing up odds in the dynamic world that we live in, because they’re changing all the time and we may not be looking at the complete picture. And these rare events don’t just appear in finance. Steve Irwin was the first to admit that he took risks with animals. That’s how he lived his life and, though it’s deeply tragic for his young family, it’s not hugely surprising that that’s how it

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ended— but no-one would have imagined that he’d be killed by a stingray. Returning to finance, another black swan reared its head when the Russian Government defaulted on its national debt in 1998, sending shock waves through the financial markets and causing the collapse of hedge fund Long Term Capital Management. The Nobel-prize winning PhDs running LTCM proclaimed that their fund’s failure was the result of a ‘ten sigma event’, meaning that it had odds of one in several billion billion. But as Taleb explains, someone saying this ‘either: (a) knows what he is talking about with near perfection … and it is an event that happens once every several times the history of the universe; or (b) just doesn’t know what he is talking about when he talks about probability … and it is an event that has a probability higher than once every several times the history of the universe. I will let the reader pick from these two mutually exclusive interpretations which one is more plausible.’ All this has particular significance right now, because the stockmarket has rarely, if ever, seen a steadier rise than we’ve seen over the past few years. And with margin loans on the up and an increase of debt on company balance sheets, it looks as though people might be getting a bit complacent. What to do? So what can we do about it? Taleb suggests that most successful traders and investors over the long term are flexible, being prepared to admit mistakes and change their minds. They also don’t employ strategies that make them hostages to fortune— in other words, they do more dentistry and play less Russian roulette. In investing terms, this means maintaining a balanced portfolio, as we discussed in the cover story of issue 206/Aug 06, and steering clear of debt, both personally and in the companies in which you invest. Finally, as ever in value investing, it’s essential to allow a wide margin of safety in your investments. Taleb stresses that he doesn’t think everything is down to luck. He just thinks that more depends on luck than we imagine, and that it’s very hard to know what’s luck and what’s skill. To emphasise this point, Taleb is himself a trader by profession. He is, however, a trader with a difference. Instead of doing what most people do, which is to buy instruments that provide small but steady returns until they get hit by a black swan event, he buys instruments that ensure small but steady losses until a black swan arrives, at which point he cleans up. His theory is that bearing the drip, drip, drip of losses, waiting for the big win, is more than most people can manage, and that securities benefiting from this approach are therefore likely to be relatively out of demand and therefore underpriced. It’s a risky approach though— the thing about black swans is you never know when one’s going to turn up. For more on Nassim Taleb, visit James Carlisle

C o p y r i g h t © 2 0 0 6 The Intelligent Investor . Published by The Intelligent Investor Publishing Pty Ltd. ABN 12 108 915 233. Australian Financial Services Number 282288. PO Box 1158, Bondi Junction NSW 1355. Ph: 1800 620 414 Fax: (02) 9387 8674 WARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all subscribers.

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‘$10m earned through Russian roulette does not have the same value as $10m earned through the diligent and artful practice of dentistry. The...

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