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Posts tagged ‘Nassim Taleb’

Is It Possible To Predict Black Swans?

In 1943, the chairman of IBM, Thomas Watson, declared that, “there is a world market for maybe five computers.” In 1962, Decca recording company said of the Beatles, “we don’t like their sound, and guitar music is on the way out.” And in 1974, Margaret Thatcher proclaimed that, “it will be years — not in my time — before a woman will become Prime Minister.”

Why are we so bad with the future?

Whenever we speculate about future events we are bound by two things, our rationality in the present and our memory of the past. The problem is that 1) cognitive biases and heuristics contort our rationality and 2) our memory is highly unreliable being subjected to its own set of prejudices (there are mountains of psychological studies that explore these two points. The specifics aren’t important here).

Philosophers knew about this all along even though they didn’t have the empirical data. They called our inability to have knowledge of the future the problem of induction. For example, if I asked you how you know the Sun will rise tomorrow you will likely tell me that you know from experience; you’ve seen it rise every single day of your life so you induce from the past that it will do so again. The worry is that relying on past events do not guarantee knowledge of future events (e.g., just because the sun has risen every day doesn’t mean it will tomorrow). Philosopher David Hume summarizes:

The supposition that the future resembles the past, is not founded on arguments of any kind, but is derived entirely from habit.

Here’s another more dramatic and realistic example. Pretend you’re a Turkey. Up until Thanksgiving time you would have no reason to believe that you and all your friends would be axed. Then, one day, out of no where, it’s Turkey genocide.

Past experience couldn’t have predicted what was about to happen, and this turned out to be hugely problematic for you, the Turkey. This problem, what some call the Black Swan Theory, is everywhere: the internet, World War One, Harry Potter, the rise of global religions. What binds these phenomena are their unpredictability and high impact on society – nobody saw them coming and they ended up changing the world.

There are three elements of the black swan events

  • They are very difficult to predict.
  • They have a high impact on society
  • After the event people have the tendency to rationalize them giving the illusion that they were expected

The fact of the matter is that we don’t know why black swans happened and we don’t know what and when the next one will be. That is the nature of black swans: before they occur they are extremely unpredictable but after they occur we explain them as if we saw them coming. They are prospectively unpredictable but retrospectively predictable, as Nassim Taleb says.

The frustrating aspect of Black Swan Theory is that it provokes people to ask when the next black swan will be. This completely misses the point. Asking when the next black swan is or whether or not it is possible to avoid black swans tells me that you don’t understand Black Swan Theory. By definition black swans can’t be predicted or avoided. Yet, people continue to believe that both are possible.

Why?

I think it goes back to the narrative fallacy, which is what the third bullet point highlighted. As Taleb explains, the narrative fallacy describes our “limited ability to look at sequences of facts without weaving an explanation into them, or, equivalently, forcing a logical link, and arrow of relationship, upon them.” I italicize “limited ability” to suggest that the narrative fallacy is unavoidable. We simply cannot assess the past without creating a narrative that fits with the present and projects the future. For better or for worse, this means we will continue believe that past experience guarantees knowledge of the future. It’s a strange paradox: we will always believe that we have a grip on the future even when we are repeatedly surprised by what it brings us.

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Genetics & Brokers: Why We Are Horrible at Predicting the Stock Market

There are few things more dramatic than brokers with hands on their faces – the pain, the agony, the defeat, it’s all there. Whenever I see pictures like the one above, I wonder what could have possibly gone so wrong. Turns out that a whole bunch of things could have gone wrong, and losing a lot of money in a small amount of time is at the top of the list.

The question is: Why are people so bad at predicting the stock market?

The answer could rest in evolutionary biology; we are poor predictors because natural selection did not favor individuals who thought about specific long-term events – it simply wasn’t advantageous for someone to understand something as abstract and elaborate as the future of stock market prices. Nassim Taleb makes this point nicely:

Our minds do not seem made to think and introspect; if they were, things would be easier for us today, but then we would not be here today and I would not have been here to talk about it – my counterfactual, introspective, and hard-thinking ancestor would have been eaten by a lion while his nonthinking but faster-reacting cousin would have run for cover… our predecessors spent more than a hundred million years as nonthinking mammals and that in the blip in our history during which we have used our brain we have used it on subjects too peripheral to matter.

Here’s the key. The genes of our primitive hunter-gathers ancestors “were, for all practical purposes, the same as ours.” This means that the size and make-up of our brains have remained largely unchanged since they evolved for the hunger-gather life style roughly 100,000 to 200,000 years ago. So when it comes to something like the stock market, our predictive power sucks because our genetics just aren’t up for the task. Our brains were built for existing in the moment and making quick useful decisions on the African savanna, not for simulating future stock prices in Manhattan, in other words.

How, then, do you explain the Warren Buffets of the world? Simple. If you take a million pennies and flip each of them ten times a handful will land on heads or tails ten times in a row; if you have a thousand pundits predicting the outcome of an event it is highly likely that at least a few will get it correct; and if you have 7 billion people participating in a global economy there will always be a handful that make a lot of money. In short, he benefitted from chance.

But not everyone agrees. In the 2009 book The 10,000 Year Explosion, Gregory Cochran and Henry Harpending argue that the development of agriculture nearly 10,000 years ago accelerated the rate of physical, biochemical, and cognitive evolution which caused our genetics to differ significantly from hunter-gathers. In addition, a wave of new books such as David Shenk’s The Genius in All of Us, Daniel Coyle’s The Talent Code, and Malcolm Gladwell’s Outliers, highlight our poor understanding of the role of genetics in physical and intellectual ability. Taken together, these two points challenge the notion that our genetics have not significantly changed since hunter-gatherer days. So maybe Warren Buffet was smart after all.

As for the stock brokers with hands on their faces, well, maybe they are just bad stock brokers.

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