The Hidden Role of Chance in the Markets and in Life

[davelj]

I’ve seen several mentions of “The Millionaire Next Door” and “Rich Dad Poor Dad,” among others, in the forums. Anyone who takes these books seriously – and make no mistake, they shouldn’t be taken very seriously – should be sure to read Nassim Taleb’s “Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life.”

Taleb is an investor and mathematician who’s written several books and research papers on hedging, options and other financial topics. He tends to concentrate on the mental mistakes, both mathematical and behavioral, that investors tend to make when evaluating risks associated with investments.

I’d put “Fooled by Randomness” among only about a dozen or so books on finance that any serious student of investing must read. If nothing else, you’ll enjoy Taleb’s discussion of the various flaws in logic and methodology that are the basis of pop culture books like “The Millionaire Next Door” and “Rich Dad Poor Dad.”

[powayseller]

The Millionaire Next Door is based on statistical questionnaires and interviews. The premise is simple: live below your means, spend less than you earn. What is pop culture about that?

It makes sense that a plumber or A/C shop owner don’t try to live the lavish life. Being content in a lower-class working neighborhood, they keep their expenses low, reinvest their profits in the business, save, are frugal. This all makes sense. Not to you? You think these people got rich by chance?

[davelj]

Two primary issues: survivorship bias and (again) mistaking correlation for causation. (Btw, I’ve read both books – they’re not bad books, just not to be taken too seriously – some of the conclusions drawn are overly simplistic.)

Unfortunately, this is complicated and I don’t have the time or patience to type it all out.

Read Taleb’s book and then you’ll understand. Trust me. It’s a great book regardless of how you feel about his damning critique of the other two books, their methodologies and conclusions. Taleb’s forgotten more about investing and statistical research in the last 30 seconds than Kiyosaki, Stanley, etc. know cumulatively.

I guarantee you that there are quite a few things that “appear” to make sense to you when in fact they do not make any sense at all when put under the microscope of more rigorous logical analysis. That’s human nature.

[powayseller]

davelj, if you don’t feel it’s worthwhile to spend 4 minutes to make your point, then I don’t feel obliged to take your point seriously, since I have no basis on which to determine if what you say makes any sense.

Furthermore, why would you make a point, say you don’t have the time or patience to explain it, but then expect me to spend several hours and money to obtain and read the book? You expect me to spend more time on validating your point than you do?

So if you could backup the premise made in the thread you started, I would be grateful and very interested in what you have to say.

[davelj]

What luck. With one quick search I found a couple of interviews with Taleb online. Here’s a very abbreviated copied-and-pasted discussion of what he spends a great deal of time on in his book:

“There are two technical problems in randomness — what I call the soft problem and the hard problem. The soft problem in randomness is what practitioners hate me for, but academics have a no-brainer solution for it — it’s just hard to implement. It’s what we call in some circles the observation bias, or the related data mining and survivorship bias problems. When you look at anything — say the stock market — you see the survivors, the winners; you don’t see the losers because you don’t observe the cemetery and you will be likely to misattribute the causes that led to the winning.

There is a silly book called A Millionaire Next Door, and one of the authors wrote an even sillier book called The Millionaire’s Mind. They interviewed a bunch of millionaires to figure out how these people got rich. Visibly they came up with bunch of traits. You need a little bit of intelligence, a lot of hard work, and a fair amount of risk-taking. And they derived that, hey, taking risk is good for you if you want to become a millionaire. What these people forgot to do is to go take a look at the less visible cemetery — in other words, bankrupt people, failures, people who went out of business — and look at their traits. They would have discovered that many of the same traits are shared by many of these people, like intelligence, hard work, risk taking and even frugality. This tells me that the ‘unique’ trait that the millionaires had in common was mostly luck. But the author and most of his readers are not mathematicians or statistical researchers so this obvious and substantial methodological flaw is almost never discussed.

This bias makes us miscompute the odds and wrongly ascribe skills. If you funded 1,000,000 unemployed people endowed with no more than the ability to say “buy” or “sell”, odds are that you will break-even in the aggregate, minus transaction costs, but a few will hit the jackpot, simply because the base cohort is very large. It will be almost impossible not to have small Warren Buffets by luck alone. After the fact they will be very visible and will derive precise and well-sounding explanations about why they made it. It is difficult to argue with them; ‘nothing succeeds like success.’ All these retrospective explanations are pervasive, but there are scientific methods to correct for the bias. This has not filtered through to the business world or the news media; researchers have evidence that professional fund managers are just no better than random and cost money to society (the total revenues from these transaction costs is in the hundreds of billion of dollars) but the public will remain convinced that “some” of these investors have skills…”

Again, I’d read the book – this is a sub-cliff notes version. But to answer your question, “You expect me to spend more time on validating your point than you do?” My answer is no. I don’t expect you to spend any time validating my point. If you want to live your life in ignorance, that’s your problem, not mine. I was giving you some free worthwhile advice. Whether you decide to benefit from taking it is up to you.

[powayseller]

Interesting…if the Millionaire authors wanted to prove their point, they should take 1000 20-somethings with and without the Millionaire traits (B or C college students, high SAT scores, frugal, no need to show-off with money, save, budget regularly, live below their means). Follow these people over 30 years, and keep track of their net worth. Then they would know if the traits truly are predictors.

For immediate data, they should have looked at non-millionaires and determined if there are overlapping factors. Do both groups have high SAT scores and mediocre college grades? Then they can do that probability stuff, like r-squared, and calculate how much of the wealth is coincidence, vs. linked to those traits.

One premise of the book does make sense: the more you live below your means, the more you can save and the greater your net worth.

I found it interesting that they didn’t ask the millionaires about personal satisfaction. What is the point of being a millionaire if you’re so frugal, you won’t even take your wife out to dinner? Some of those people are just nut jobs. What is the link between net worth and happiness? Well, there isn’t one. Ever see the photos of those beaming poverty-stricken people in 3rd world countries? So the whole millionaire thing doesn’t impress me.

Personally, I want enough money that my husband can stop working if and when he chooses. Just some financial security, so we can support ourselves while still on this earth.

What good is all that millionaire money? I find that I worry about money more, now that I have more. I should be more peaceful about it, but am more worried. What if I lose it? That’s always on my mind.

[LookoutBelow]

Aha Grasshopper !!! Powayseller has figured out the key to prosperity ! Its a conundrum, If a person “saves” their way to prosperity, they always become afflicted with the disease I call the “Cheap Disease”…they only have their seemingly larger amounts of capital by “DENYING” themselves the benefits of wealth and abundance. Not a lifestyle worth living in my book, trading your life experiences and possibly life changing moments for an obscure number printed on a sheet of paper mailed to you from your bank every month does not define your worth. It doesnt define anybodies worth really, it merely gives you a sense of false security.

I never thought anything was tougher in my life than making money, I wanted larger than average amounts that could give me some peace of mind and financial stability, but I was WRONG!! I found out later, that “KEEPING” wealth is much harder to do than make it. It takes on its own entity, living, breathing, feeding, lifeform.

Now you have something bigger to worry about, even more so than when you were a “Have Not”. Being categorized in the column of “Haves” is much more stressful than being in the column of being a “Have not”
Why ?
I’ll try to explain:

Trying and fighting to save something like a bank account, property, wealth..etc..is mentally restricting because its a “defensive” mindset IE. You now have “something to lose”…whereas, to get that same wealth, you had to take chances, be shrewd, logical, committed and ballsy….that is a “Offensive” oriented mindset. Not very many people are good at both sides of the equation of wealth.

Cheap millionaires (savers) cant spend it or use it, and Gunslinger, damned the torpedoes millionaires types lose it…the better life is somewhere in between. Im trying for that. But, when your on your death bed, which of the two types “photo albums” of their lives would you like to be looking at ?

Surfer logic…my apologies if its too simplistic and or simple, but its the way I see it.

Cheers,

[PD]

I would rather worry about keeping my money than worry about where I’m going find the cash to pay my mortgage or feed my children.
My parents “live for today” and always have. Nothing like a bankruptcy when you are in your late 40s…
I do think that some people are better able to aquire wealth than others, just by keeping your lifestyle within certain boundries. I don’t like going to expensive restaurants, I never buy a new car and I almost always buy used high tickets items.
Out of our close circle of friends, two of them are quite rich and made it on their own. One of them is smart and managed to get into the right industry at the right time but I am not convinced he would have done so well in another job. The other is the shrewdest person I have ever met. He was going to be rich, regardless. It won’t be long before his net worth is over 100 million.
Another friend’s husband has tried at least 5 businesses. He has failed miserably at them all. If he succeeds, it will be from luck and nothing else because he is one of the most incompetent people I have ever met.
There are two kinds of luck – blind luck and luck you make for yourself. There are actually studies that show that very lucky people make their own luck.
Napoleon listened while another recommended a third person. He finally said, “Fine he is brilliant, but is he lucky?”

[lindismith]

Love this thread!

[Anonymous]

Chris Johnston

It is interesting to me that anyone could be critical of living one’s life within their means. In general, I would think that to become very wealthy chances(risks) have to be taken at some point. I feel that you can put yourself into position to “get lucky.”

I think the premise of the millionaire next door is good for the average person. The thought of being a inprudent, and hoping for blind mathematical luck to bring you good fortune, is not a plan I could ever follow. That would essentially support, straight adjustable, 125% financing as the best way to buy a house.

Maybe I misunderstood the basic premise of this thread, as it makes no sense to me. Sorry Dave if I did.

[ucodegen]

There is a critical difference between relying on luck and putting yourself in a position to exploit luck when it occurs.

relying on luck would be the 125% finance, no backup plan, hope things get lucky approach.

being prepared would be to live under your means and to have the resources (and the cajones to use them) when the opportunity arises. RE: cajones, it is too easy to get to a situation where one is risk averse when being careful with expenditures.. one has to look at risk-loss / payoff ratios.

The real trick is to know the difference between relying on luck and being prepared and willing to exploit luck.

Luck can be attributed to the randomness. It can either be good or bad. ie stock, large price drop is good if you want to buy in, bad if you are holding (on margin?)..

[davelj]

One of the problems with discussing things over the internet is the need for brevity. Who, after all, has the time and inclination to thoroughly explain complicated issues in a forum setting? The problem with brevity is that it unitentionally leads to misunderstanding.

Obviously, where accumulating wealth is concerned, it is better to be relatively frugal vs. relativey extravagant. After all, common sense dictates that the more capital you have, the easier it is to compound capital (in absolute terms, that is – once you have too much capital, it can get progressively difficult to compound that capital in relative terms – ask Warren Buffett about this problem). I agree with that particular point made in The Millionaire Next Door (how can one not?). It is logically incorrect to say, however – as The Millionaire Next Door implies – that, “You’re likely to become a millionaire if you’re really frugal and take some risk on the investing (or business) side.” You may be MORE likely to become a millionaire, but as Taleb correctly points out, the bankruptcy world is littered with smart, frugal people who took some risk. The problem is that the winners’ risks worked out and the losers’ didn’t. Some of that, of course, can be controlled through risk management. But, much of it cannot and can only be attributed to… “luck” or “fate.”

One of the reasons that our particular generation of humans has survived and thrived on this planet is that we are poor estimators of risk. We are overconfident and often take on more risk than we are aware of. This evolutionary trait encourages risk-taking and has advanced mankind in the aggregate although clearly lots of individuals fail. As an investor, it’s important to be aware of the fact that you, me and almost everyone routinely underestimate risk because of lots of internal evolutionary behavioral factors that I’m not going to go into (read up on Behavioral Finance). This will never change, but at least your decision making will improve at the margin by being aware of your inherent biases as a human.

There’s plenty in The Millionaire Next Door that’s good information, but that doesn’t mean you should accept the author’s conclusions (as Taleb points out).

I agree with most of the posters that you have a lot of opportunities to make your own luck or exploit luck when it presents itself. I always liked Ronald Reagan’s quip, “You know I’ve been lucky all my life, but I always found that the harder I worked, the luckier I got.” There’s a lot of wisdom there. Having said all that, I’ve also found that bad luck trumps all: intelligence, hard work, etc. But obviously there are certain things you can do to minimize your odds of getting sunk by bad luck.

Addressing one of the other topics in this thread, if you worry about money all the time, something’s wrong in your life. In my view, the primary value of money is freedom and security – it gives you freedom to do things you want to do and security to sleep at night and not worry about finances so much, both of which hopefully lead to “inner peace” (or “contentment”) which I think is the primary measure of the quality of your life. If you’re rich and not content, what’s the point? If you’re dirt poor but truly want for nothing, then you’re probably content. Everyone’s wired differently and has to find out what makes them tick on these fronts. And I can tell you that a lot of people simply lack the introspection necessary to figure out what is going to make them content. Instead they defer to “society” to answer the question for them… this rarely turns out well as you might have noticed.

[sdduuuude]

“Luck is the residue of good planning”

-Branch Rickey

Being rich is not about having things.
It is about not needing things.
Some think rich people have money.
I think rich people have time.

– sdduuuude

[Anonymous]

Chris Johnston

Thanks Dave, I would have to say that I agree completely with your whole post except bad luck trumping all. Maybe I am a fool, but I do not believe in blaming or crediting luck for things that happen. If you take prudent risks, rarely will one bad event blow everything up.

Most people that get blown out in business ventures can be found to have been taking too much risk after the fact. I think “luck” is just part of the random chaos type of pattern that occurs in studying distributions of outcomes over time. Essentially, those events are the fringes on the bell curve. Although low in probability, they are not zero in probability. Therefore, it cannot be planned in our risk-reward plan to associate a zero probability to that outcome. If one does that, and the “unlucky” or 1% likely scenario occurs, and one is blown out of his business because of that, it is poor planning, not bad luck.

As a trader I have this in mind with every single trade that I make. It is why my trading business will never be “carried out” over bad luck. It could fail, but bad luck would not be the reason, because that is planned for via stops, etc..

However, that is knit picking a great post!

[docteur]

I have to agree with sdduuuude and Chris J.

This belief that wealth is created through luck really makes me bristle because I have intentionally created great wealth in my life – twice.

I am a multimillionaire and I wrote out a plan almost 20 years ago, precisely how I was going to achieve that wealth and keep it after I got it. I confidently moved forward with my plan because I looked at every contingency I could at the time.

I did not miss anything in my life; to the contrary I enjoyed every minute of it (and still am) because I believed the outcome of my planning was a given and I had all the time in the world to enjoy life.

So, I plan 99% of the time and implement/act 1% of the time. Creating wealth has taught me the most important characteristic of the wealthy – Patience.

There was no luck involved. Period.

I was wealthy once before from scratch and also had a plan that worked. Where I failed the first time was I had no plan on how to keep that wealth and lost it making stupid investments. This time I have both sides of the “wealth plan” and it’s progressing just fine.

So I call BS on the randomness of wealth. Sure luck is out there but (and this concept may be hard for some to grasp) you create your own “luck” by careful planning so that you are prepared when you create it. (I would use the word “opportunity” in place of luck).

I read an article a while back which I referenced in an earlier post which stated that people who survive disasters (plane crashes, car wrecks, hurricanes, etc.) have a plan in place BEFORE the disastter strikes. They “rehearse” several scenarios so if/when it happens, they are prepared. Those folks survive disasters, time and time again and when asked if it was luck, they say No, I was prepared.

Prosperity works the same way. You rehearse and plan until the perfect scenario comes your way (or by being ready for it, you recognize it/create it to show up). Then you are ready, confidently prepared and you jump on it with both feet.

That’s why a guy like Warren Buffett consistently, year after year, makes money. He waits for the right opportunity PATIENTLY and when it comes along, he grabs it.

That’s why wealthy people can make money in several different, unrelated ventures. The core beliefs and actions taken to create wealth are basically the same.

Like Chris J says, he only takes the trade/puts on a position when all the varilables line up perfectly. Creating wealth is no different.

Luck my ass. Saying luck creates the wealth is just an excuse for someone who doesn’t plan. My favorite saying is “Those who fail to plan, plan to fail.”

By the way, is the author of that book a millionaire? If he isn’t, he’s probably planning on becoming one after all the folks who believe luck plays a part in becoming wealthy buy his book. Heck, if it’s luck. Just play the lotto everyday…

My advice, don’t waste your money and buy into a belief that doesn’t serve you. Plan a lot, implement a little, enjoy your life, living in the belief that you will prevail and wealth will come your way. Success leaves clues.

Luck is a cop out.

[Author]

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