Tuesday, December 9, 2014

Taleb’s “Alternative Histories” and Investing.

“Clearly my way of judging matters is probalistic in nature; it relies on the notion of what could have probably happened….
            If we have heard of {histories greatest generals and inventors}, it is simply because they took considerable risks, along with thousands of others, and happened to win.  They were intelligent, courageous, noble (at times), had the highest possible obtainable culture of their day – but so did thousands of others who live in the musty footnotes of history.”  (Taleb, Fooled by Randomness).

Julius Caesar was a fantastic general, yet was amazingly lucky (until he was not), whereas Erwin Rommel, also a fantastic general was plagued by bad luck on multiple occasions, (with a random and erratic Commander in Chief not helping).
What other outcomes for these generals could have happened?  And, would they be judged by history differently for their decisions, despite no change in their skills?

“Every once in a while, someone makes a risky bet on an improbable or uncertain outcome and ends up looking like a genius,” (Marks, The Most Important Thing),  … or a fool.

But how do I picture these alternative histories that could have occurred but did not? 
(I saw this graph somewhere but couldn’t re-find it, so recreated it below).

At point X now, current conditions are known (as best as available information can be utilized).  The correct decision (always) to take is the one that is logical, intelligent, and informed “at that time” (Marks).

At point X now, all red outcomes are “possible” and unknown, but some are more “probable” than others.

At point Y later, only a single red outcome has eventuated.   At which point it often becomes hard to imagine that any of the others were “possible” to begin with.

(Note: The distribution in reality may be skewed towards one side of possible outcomes.  This is more to highlight the concept of possible and probable only, not the mathematics).

When things go as predicted (luck playing a role), people tend to look like geniuses for their correct actions.  “Coincidences look like causality.  A lucky idiot looks like a skilled investor.” (Marks).   However, the correctness or quality of a decision cannot be judged by its outcome, especially if randomness is involved.  For this reason correct decisions based on a sound process are often wrong, and the macro events that may have caused it, beyond anticipating.  Incorrect decisions and processes can also be seen as correct, with an unanticipated event causing the outcome you wanted.

Whilst the mean is the most “probable” outcome (reversion to the mean?), it is not at all certain, as for any individual situation, all outcomes are “possible”.  In fact the collective likelihood of all the other outcomes is higher than the one we think is most probable!

The most extreme outliers at +3s and - 3s can be the black swans (good and bad). (Maybe there should be black swans AND white knights?).

At least by having a good process at X, we can limit the pain of black swan events and not necessarily experience account destruction when they do occur.  We must trade based on what we think are probable outcomes, while not doing too much damage or loss in the rest that occur.   We need to cut off the bad tails effect on us, or limit it.  Fortunately options do that, yet expose us to the full range of favorable possibilities.

This does not mean to imply not trading a contrarian strategy, or positioning to get lucky etc.  Its what we think are probable and possible, based on our analysis, not probable as in the herd thinks it likely.

I think understanding that we can’t know the outcome of all that is possible, but can try to understand what is probable and position accordingly, whilst protecting the risk of severe damage to my account, is the best thing I have learnt in 2014.  (Possibly! Probably!)

Clearly some “alternative histories” would have been far worse than the one we know.  But in 1940, our now known outcome was nowhere near certain, and one could argue improbable.  The things that HAVE happened in the world are just a “small subset of the things that COULD have happened.”  And finally, “ensure survival” (Marks).

(If you want to think more about alternative histories, watch the Back to the Future movies!)

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