Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets

For anyone that is familiar with the commonly used finance phrase “Black Swan”, you can thank Nassim Taleb, who popularized the term in 2001 with his book "Fooled By Randomness". The main theme of the book is that the scientific methods utilized in financial theory tend to lean towards empirical observation, while deductive reasoning is eschewed. Financial markets are inherently random due to the nature of human behaviour; just because an event has not occurred in historical observation, doesn’t mean that it can’t occur in the future.

A conundrum many market participants face is that, “no amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is significant to refute that conclusion.” This problem is compounded by human behaviour and how the brain responds asymmetrically to gains and losses (gains are valued relatively less than losses of equal magnitude), which causes financial market participants to misprice low probability or “fat-tail” events.

Throughout the book, Taleb relies heavily on philosophy to support his argument; he uses Karl Popper’s idea that scientific theories are never right, they are just not yet known to be wrong and are exposed to be proven wrong in the future. The bottom line is that an investor is unable to identify ex-ante how these unknown black swan events will materialize, and because of the inherent randomness in markets, one would be wise to construct portfolios that can withstand adverse shocks that are not able to be modeled through empirical observation. In Taleb’s opinion, a healthy dose of skepticism and the freedom to contradict one’s previously held beliefs is the way to combat the path dependency of ideas that can lead to being overexposed to fat-tail events. Unsurprisingly, this book will appeal to those readers who are interested in how philosophy intersects with probability in financial markets.