Having a title with the word "Fooled" in it, Nassim Taleb's Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets practically begs to be reviewed here. So let me oblige.
Have you ever heard something like, "The market was up 15 points today, 0.14%, on lower oil prices"? Or have you ever watched the price of your favorite stock drop by 1.5% and wondered why, especially when there wasn't a single piece of news mentioning that company today?
If so, then you or someone have been fooled by randomness. Don't worry, though. It's perfectly natural. In his book, Taleb discusses why randomness occurs and what we can do about it.
The rare event
Reading this book, I picked out two main themes. One was that people tend to ignore the possibility of outlying events, things that happen only rarely. For instance, even though the Red River had flooded significantly five times in 30 years, many residents in North Dakota and Minnesota ignored the possibility of a severe flood. Then, in 1997, it happened again and $2 billion was lost (although, thankfully, no lives were). Or, we could ask: What are the odds of two major hurricanes hitting the gulf coast in a single year? Well it happened, as we all know, and residents are now having a difficult time getting insurance policies from companies like Allstate.
Outlying (rare) events can also impact the markets, and we ignore them at our peril. One example used in the book included the 1998 Russian bond market meltdown. One of Taleb's colleagues ignored the possibility that his investing decisions were incorrect, an assumption that ultimately cost him his job -- and cost his firm hundreds of millions of dollars.
The random event
The other main theme was that even though random events happen all the time, being human severely handicaps us in recognizing this and assigning probabilities to these events. One reason is that we try to seek order out of randomness. After all, if our remote ancestors hadn't been quite so good at picking the tiger out of the plants hiding it, we wouldn't be here. While that ability is important when it comes to not being eaten by lions or tigers or bears (oh my!), it doesn't do us a whole lot of good with investing in the stock market. Possibly, it is because our emotions are often tied into our investing decisions. Taleb argues that many decisions are made emotionally, with reason applying an after-the-fact rationale.
We also try to assign a reason for events, sometimes quite foolishly. For instance, Taleb recounts how he was mistakenly dropped off at his office at an entrance he normally didn't use. That day, the markets moved up and he did quite well. The next day, he deliberately used that entrance with the expectation that the markets would move up again. This phenomenon is also seen in the carrying of lucky charms, the wearing of particular articles of clothing, knocking on wood, and other harmless superstitions.
What to do
While this isn't a book with strategies on how to invest based on randomness, Taleb does bring out several points of investor psychology. We can either take advantage of that psychology, as he does in his daily trading, looking for the rare event, or try to prevent that psychology from wreaking havoc on our investing decisions. Just be aware of and plan for the certainty of the rare event. Johnson & Johnson (NYSE:JNJ) had the Tylenol scare of 1982. Nokia (NYSE:NOK) lost market share a couple of years ago and was severely punished. Will your company be next and what will you do if it happens?
Final thoughts
While reading this book, one thing troubled me: the author puts forth the axiom that randomness ruled the markets without ever really proving this point. While it is certainly true that randomness affects the short-term prices of securities, it is not necessarily true that it controls the long-term price movement. I can't help but remember Benjamin Graham's statement about voting and weighing machines. In the long term, a company's efforts have a real effect on its stock price. For instance, take a look at how the overall share price of Starbucks tracks with its earnings.
In conclusion, this was an excellent, sometimes humorous book and a fairly quick read. I would recommend it to anyone wishing to learn more about investor behavior and what we can do to overcome some of our biases.
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Fool contributor Jim Mueller owns shares of Johnson & Johnson and Starbucks, but no shares of any other company mentioned. The Fool has a disclosure policy.
