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By Amey Stone Here's an experiment -- safe to try yourself at home -- that illustrates the thinking of Nassim Nicholas Taleb, a trader, professor, philosopher, and author of Fooled by Randomness (Random House, 2005), a newly updated book that became a cult favorite on Wall Street after it was first published in 2001.
Flip a coin 50 times and write down an "A" when it comes up heads and a "B" when it comes up tails. But before you do so, jot down a list of As and Bs comparable to the one you'd expect to generate. When you're finished flipping, compare the lists.
MORE REWARDING. What you'll likely see is that the actual coin-toss results look far less "random" than the list of As and Bs you wrote yourself. Taleb says he can always tell a human-generated random list since it never includes long stretches of the same result, which is what actually happens when you toss a coin 50 times.
The lesson? Random events may not look random at all. And unusual events -- such as a coin coming up heads 20 times in a row -- happen far more often than you'd expect.
That observation is the essence of Taleb's investing strategies -- from which he continues to make millions, even though he only trades part-time. His main vocation now is to write and lecture about his theories. He admits the latter is a far less remunerative occupation -- but more personally rewarding and intellectually stimulating than his highly quantitative option-based trading strategies. Fooled By Randomness, which sold more than 100,000 copies in hardback, become available in paperback for the first time this fall. The latest edition is about 100 pages longer than the first and includes a new preface, updated examples, 40 pages of notes and references, and writing that's a bit smoother.
PROJECTING CAUSALITY. But fans of the book will be happy to see that it has lost none of Taleb's personality. It has an anecdotal style, loose structure, and sometimes combative tone, all while grappling with complex mathematical and philosophical concepts. Taleb's writing, like his conversation, is highly animated and moves swiftly from topic to topic in a way that is common among very bright people who have a lot to say.
"I'm not saying that everything is random," he explained in a wide-ranging two-hour interview in a Manhattan coffee shop in mid-October, when he was still smarting from a critical review of his ideas in The New York Times. "But that we often see causality where there may be none."
Taleb is chairman of a private investment firm, Empirica -- which is open to new investors by invitation only -- and now mainly invests in the funds of traders that Taleb considers "like-minded." Taleb's long-term investment returns aren't public, but he says trades placed during the market crash of 1987 and the Nasdaq dive of 2000 were profitable enough to keep his strategy in the black for several decades.
TRADING ON RANDOMNESS. For Taleb, trading is only a part-time job at this point. "I'm never happy presenting myself as a trader," he says. He considers himself more of a philosopher and writer. He is a professor in the "Sciences of Uncertainty" at the Isenberg School of Management at the University of Massachusetts, Amherst, and also teaches at New York University. Greek-Orthodox Lebanese by birth and educated in France, Taleb has a PhD in applied mathematics from the University of Paris (his dissertation was in probability) and an MBA from the University of Pennsylvania's Wharton School.
So how does an appreciation of randomness lead to successful trading? Take the coin-flipping example one step further. It might be tempting after a string of 20 heads-up coin tosses to think that you have a knack for turning up heads. You might be willing to wager that the 21st coin toss would also come up heads. Truth is, odds are still 50-50 the next coin toss will come up tails.
In the same way, argues Taleb, just because an investor has beaten the market for 10 years doesn't mean he will continue to do so. The same goes for the track records of companies, economic cycles, and almost any financial market. "The past is not predictive of the future," he says. His mantra is that if something really terrible could happen to financial markets, it probably will at some point, and investors need to be prepared or risk getting wiped out.
FAR-OUT BETS. Taleb calls such unanticipated events "black swans," in reference to philosopher Karl Popper's observation that just because you've seen 100 white swans doesn't mean that a black swan doesn't exist. "My basic message is, don't cross the river if it's an average of four feet deep."
The intricacies of Taleb's complex and mathematically driven trades -- which are based on large numbers of options purchases -- are secret. But he offered a few glimpses into his current thinking.
For instance, Taleb is betting that the price of oil, now at $61 a barrel, will be at either $10 or $400 in three years. He admits that he does not know which one it will be, but he believes it's possible that it will reach either extreme. Since most traders don't think such extremes are possible, he can buy options -- which are simply contracts that give investors the right, but not the obligation, to buy a security at a certain price at a set point in the future -- that would profit from either scenario for a cheap price (see BW, 5/30/05, "Options Trading Grows Up").
AGAINST WALL STREET ORTHODOXY. Taleb has another position built around the idea that "there will be a burst of severe volatility" in financial markets that will "lead to a big chain of interlocking credit events," which will wreak havoc on stock and bond returns. "If it happened, we would be protected," he says. "And there's minimal cost if it doesn't happen."
Using options, he can keep betting for years on unlikely events, losing a small amount of money on his many bets that turn out wrong. But in the rare instances when he's right, he makes a fortune. It sounds impossible, but he is proof it works. "People see me lose money all the time," says Taleb, who shared his tax returns to show that he still makes a seven-figure income from trading even while only doing it part-time. "I reduced my trading out of love for philosophy," he says. "Not out of a desire to make money out of books."
Taleb's approach is in sharp contrast to Wall Street orthodoxy. Most pros invest based on what they think is most likely to happen, historical patterns, or their own fundamental analysis. But in doing so, they ignore the possibility that something quite unexpected could occur. "The role of the rare event is underestimated," he says.
GOOD BLACK SWANS. These ideas have inspired both fans and detractors. He says his fans are often unsuccessful investors who take solace in seeing how much luck is involved in the success of others. His detractors are those who have a stake in forecasting things -- economists, analysts, journalists -- and those who like to think that their success came from their smarts alone.
Critics have lambasted Taleb as a nihilist (he prefers the term skeptic) who, by attributing so much success to luck, leaves his readers with no way to at least try to get ahead in life and investing. But Taleb, who seems to have a personal mission of winning others over to his way of thinking, says understanding the limits of predictive powers (one of his latest essays is titled, "The Scandal of Prediction"), will help people in their daily lives.
He believes that people are hurt by believing that events like the economy's strength or the returns on a stock investment can be forecast. And he thinks people would be happier if they had a realistic idea of the chances that something wildly unlikely could happen: Some black-swan events they overestimate -- like the chances of being a victim of terrorism. And some they underestimate -- like the potential for global financial meltdown.
Black swans don't have to be bad. Taleb is also positioned to profit if medical science comes up with a cure for cancer. "There will be at some point a big breakthrough in medical research," he says. "I want to be part of it."
POETRY'S APPEAL. To many professional traders and investors, Taleb's theories on randomness in markets don't seem so radical at all. Books like Burton Malkiel's A Random Walk Down Wall Street (see BW, 8/11/2003, "Summer Reading Worth Investing In") and many articles, such as, "Why Index Funds Can't Be Beat," have long argued that much of investing success is random and it's fruitless to try to beat the market by picking stocks.
These days Taleb is far less interested in the investment implications of his ideas than he is in studying their impact on artistic endeavors. "I'm not against being fooled by randomness," he says, citing a love for poetry -- an art form he says is driven by writers' ability to see patterns and connections where they don't always exist. "I'm only against it where it can hurt us."
Taleb's book explains how to avoid being fooled by randomness. But those who take his ideas to heart can see that with a proper understanding of probability, they may even be able to profit from randomness.
Stone is a senior writer for BusinessWeek Online in New York