Fooled By Randomness Part 2 – Nassim Taleb

Market Meditations | February 18, 2021

In Tuesday’s education letter, we discussed Taleb’s Fooled By Randomness. We explored how probability impacts our successes in trading and investing.

In today’s letter, we discover another concept from this book. We explore the 5 traits of the Market Fool. Recognise why they are foolish and be sure to avoid them.


1️⃣Overestimating Accuracy 

Taleb believes it is foolish to be overconfident about the accuracy of historical data in predicting future events. This is due to:

  • The existence of Black Swan events. For more about Black Swan events, check out our ? letter ?
  • The questionable reliability of the data source
  • The fact that the market could have changed since then

✅ The key takeaway here is to not rely solely on historical trends or data to make investment decisions. Just because an asset has never deviated more than -10% from it’s 1 month average, does not mean this will always be the case. 

Just consider traders before the Global Financial Crisis in 2008, who thought mortgaged backed securities could never show extreme volatility due to their historical price behaviour. How wrong they were.

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2️⃣Getting Married To Positions 

There is a saying that bad traders divorce their spouse sooner than abandon their positions.

? Loyalty to ideas is not a good thing for traders, scientists or anyone. 

The entire progress of mankind in the realm of science has been due to the process of falsification: proposing a theory which is then challenged, rejected and replaced by a better one. And then that new theory is rejected and so on and so forth. It is through being wrong and the ability to admit that we are wrong, that we increase our knowledge and make progress.

? We should have a similar approach to our trading strategies. Try a strategy, have stop-loss levels in mind, if they are breached, abandon the idea and move on to a better one.

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3️⃣Changing Their Story

It is unfortunate to see that investors who originally entered a short term position, can end up becoming ‘long term’ traders when they are losing money. 

For instance, they went long an asset expecting a 10% price rise in the next week. When the asset crashes in price, they decide that actually, the 10% price will be in the next month. Which then becomes the next 2 months, 2 years and so on.

? They postpone their decision to sell as part of their denial. 

Even worse, some people double up on their position. They decide to go long even more at these ‘improved’ lower levels.

These traders never accept that their method of determining value was wrong.

? Don’t change your story to fit your trade. You will bleed loses in the process. What’s more, time is money. There is an opportunity cost to your actions. The longer you try to force this trade, the more opportunities you are forfeiting in other potential profit making trades.

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4️⃣No Game Plan

A market fool has no game plan ahead of time as to what to do in the event of losses.

Either out of laziness or worse yet, they are not aware of such a possibility. 

To continue on the example of the 2008 Global Financial Crisis, consider those who bought more mortgage backed securities when the bonds were declining.

They had no plan. When you have no plan in the markets, hysteria takes overHow much money will hysteria make you? Not as much as we would like you to make. That’s for sure.

? As confident as you are in your strategy, you must consider a game plan for an unfavourable outcome. Always predefine your risk. Know how much you are willing to lose and when you will call it a day.

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5️⃣Denial 

Even if you do stick to your stop-loss, there is another important step that many traders and investors skip. Asking the question: Why did you end up taking a loss? 

? When losses occur, there must be a clear acceptance of what has happened. A bad trader refuses to believe that the loss was his own fault. Instead, he deems the failure to have been a case of being ‘unlucky’.

And of course, naturally, when he makes money he attributes it all to skills. 

From the perspective of the market fool, losses always happen due to bad luck, while profits always come due to skills.

? If we do not take the time to understand our mistakes, we are destined to repeat them.

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Conclusion 

So now you know what a market fool looks like. Pick up a mirror: is there a market fool looking back at you? If the answer is no, great, carry on. Alternatively, you might have noticed while reading this letter that you exhibit one or two of the mentioned traits. First of all, congratulations for having enough self awareness to recognise this. Next, focus on changing these behaviours. This will bring you more success in trading and investing. Market Meditations regularly shares education and self improvement pieces to help you make sure you are on the right path. Good luck and you can always DM us on ? Market Meditations Twitter ? to let us know how you are getting along.

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