Sunday, October 12, 2014

Fooled by Randomness, Russian Roulette, and CFD’s.

Having recently finished reading “Markets Never Forget, But People Do” by Ken Fisher, I just started “Fooled By Randomness” by Nassim Taleb.

I was intrigued by the discussion on Russian Roulette: 
(and wrote this to mainly attempt to clarify my thoughts).

“Imagine an eccentric tycoon (we’ll call him Brad) offered you $10million to play Russian Roulette….Five-out-of-Six of these histories would lead to enrichment; One would lead to a (catastrophic) statistic.”

“If the roulette-betting fool continues to play the game, the bad histories will tend to catch up with him – but if there are enough players, say thousands, we can expect to see (a handful) of extremely rich survivors (and a very large cemetery).”

Finally, …. “Consider the possibility that the roulette winner would be used as a role model…,”  and “the winner of the $10million (multiples) would elicit the admiration and praise of some fatuous journalist.”
Fooled by Randomness, Taleb.

Statistically (if I have calculated this right)…. using a 6-shooter:

83.33% chance of a Reprieve (Win)
16.66% chance of a Boom

But what if you played more than once? (0.833 X 0.833 etc)

2. 69.44% chance of Reprieve / 30.56% Boom
3  57.87% chance of Reprieve / 56.87% Boom
4  48.22% chance of Reprieve / 52.78% Boom
5  40.19% chance of Reprieve / 59.81% Boom
6  33.48% chance of Reprieve / 66.52% Boom
7  27.91% chance of Reprieve / 72.09% Boom
10 16.15% chance of Reprieve / 83.85% Boom
13 9.34%   chance of Reprieve / 90.66% Boom

Despite the book’s argument about the mathematics not being necessary, I was compelled to calculate the numbers.  What Blew-Me-Away (ha-ha), was that after 4 plays - you had effectively just flipped a coin, … at still existing.

Someone that had played Brad’s game successfully 4 times, might be starting to think that they are really good at Russian Roulette (perhaps they say that they spin the chamber differently to everyone else, or it could be, they say that they handle pressure better – whatever), but where is the skill in a 50-50 chance?  

This is where the CNBC journalist and public attention comes in, which only reinforces the winner’s belief in their (mistaken) view of skill over randomness.  Or, at least in the winners underestimation of their exposure to the hidden risk of randomness.

Here’s my point – finally:

I feel like I have played this game. I used CFD’s. I’m still alive, in that I have not blown up completely but I certainly haven’t made millions.  However, I think I started to hear the coming BOOM more and more, each time I heard my CLICK.

Perhaps if I had hit that massive winner first up on Tesla like I almost did, I’d be a victim of my own success by now, but Damn, I was getting more and more gun-shy each time I pressed the trigger.

For a time I thought I was actually smart enough to out-wit the market, and read the charts well enough!!  But sure, you can be right once or twice (skill/luck/randomness –whatever), but after 4 tries, if the randomness becomes a 50-50 bet, and the loss result is blowing up your account – I realize I REALLY don’t want to play anymore.

Taleb goes on to discuss the real world differences to Russian Roulette, which manifests as the “black swan” event, the infrequency of the fatal bullet and increased difficulty in anyone even assessing risk in the market.  All interesting stuff.

There’s a another flipside to this discussion I think, that involves Pavlov’s Dog, and Classical Conditioning of the Salivation Reflex.

A Bell rung, will occasionally also deliver food to the dog, but not always.  The dog learns to salivate each time in anticipation of this random event.  (The promise of a financial reward with each buy CLICK – even when infrequent - leads to the gambling trader).  

A dog can’t count to 5 or 6.  Can the trader?  Maybe I need a 7-shooter.

But that’s a whole new issue I need to work on.

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