Luck By Chance

The author discuses a highly intelligent book that talks about the role of chance in investment success…

Nassim Nicholas Taleb has written a highly intelligent book about the role that chance plays in life and in the markets. It is not Taleb’s contention that success can be attributed entirely to luck. However, he says, one should accept that chance plays a greater part in events than most of us give it credit for. Often, with the benefit of hindsight, people attribute a positive outcome to their own actions, when in reality it may have been produced purely by chance.

A person who is successful may turn arrogant enough to think that his success was purely owing to his own merits and skills. But one has only to look around to find that many people who are equally meritorious have not enjoyed an equal measure of success. Clearly, chance does play some part.

The author cites the example of Croesus, King of Lydia and the wealthiest ruler of his time, to warn against hubris engendered by one’s good fortune. Croesus invites Solon, the Greek legislator famed for his knowledge and wisdom, to his court and tries to impress him with its grandeur and opulence. An indifferent Solon instead warns Croesus not to take his good fortune for granted, for it could at any time take a turn for the worse. Many years later, in a battle against Cyrus, the ruler of Persia, Croesus is defeated. When he is about to be put to death, Croesus recalls Solon’s warnings and shouts: “Solon, you were right”. This reference to Lady Luck’s inconstancy causes Cyrus to dwell on his own vulnerability and he grants Croesus a reprieve.

A dentist may be richer than a rock star
According to Taleb, in some professions, such as the stock markets, chance plays a greater part than in others, such as dentistry. If one puts a high premium on certainty and financial security rather than on absolute wealth, then in that sense a dentist may be richer than a rock star. If a dentist were to live his life over a thousand times, each time his life would follow a similar pattern and the amount of wealth he earns would vary only marginally. On the other hand, the scope for deviation would be much higher if a rock star were to live his life over and over again. Only in a few lifetimes would he end up fabulously rich. In most others he would spend his life struggling or being only marginally successful. Moderate success (that of the dentist), concludes Taleb, can be attributed to diligence; massive success requires a generous dose of luck.

The lucky fool
The author speaks of the ‘lucky fool’ —people who have become successful more due to luck but attribute their success entirely to their own skills. Such people also tend to be vulnerable, for success that owes more to luck also tends to be more susceptible to a sudden change of fortune.
Taleb drives this point home through the story of Nero and John. Nero is a proprietary trader (those who trade using their firm’s capital rather than that of clients, and are paid a percentage of the profits they generate). Nero has a highly conservative style of trading. This ensures that while his earnings are decent but not outsized, he will also not suffer a blowout — a sudden and massive loss that results in a trader being thrown out of his job. He is also conservative in investing his own money, preferring US treasuries over stocks. So while his investment returns may be low, reversals in the market also won’t take away his hard-won financial security.
Along comes John who is intellectually shallow but outwardly confident. He pursues a high-risk trading strategy. While the going is good his earnings are massive. What makes the situation worse for Nero is that John treats him condescendingly as an over-the-hill trader. John’s trading style pays off for some time: his house across the street grows bigger; his collection of sports cars swells; and his wife wears outsized diamond rings and boasts of holidays in exotic locales. But finally, in 1998, a black swan type risk (infrequent but high-magnitude event whose impact can be catastrophic) strikes and John suffers a blowout. Not only does he lose his job, his entire wealth gets wiped out.

Life: more vicious than Russian roulette
You may have heard of the game of Russian roulette: put a revolver to your head and pull the trigger. Either you win a huge payoff or your brains get blown out. Most sane people would be reluctant to play the game because the price of a negative outcome is intolerably high.
Life, says Taleb, can be more vicious than Russian roulette. It can at times resemble a game of Russian roulette played with a revolver that has a hundred, or even a thousand, chambers. Since in life the fatal bullet is delivered infrequently, people involved in a dangerous pursuit sometimes commit the fatal error of forgetting that the bullet even exists. Once they have played the game a few times and made outsized gains, they get cocooned by a false sense of security. (Could this be the phenomena at work in cases of corruption in high places in India? It’s a thought worth contemplating.)
Furthermore, when you play the game of Russian roulette, the risk is visible. Not so in real life. One may be engaged in a high-risk game without appreciating the true magnitude of the risk inherent in it. Sometimes, if you warn such people of the risks, they may not pay heed. They could even accuse you of envy or worse.
Taleb observes that people do not like to insure themselves against abstract risks, only against the most vivid ones. Take the instance of a financial planner who suggests to his client that he should buy an insurance product that will guard his client against a calamity that is admittedly rare but catastrophic. If for a few years the calamity does not strike, the client could well turn around and complain that the financial planner has wasted his money. Most people go by what happened, not taking into account what could well have happened (Taleb uses the term ‘alternative histories’ to describe the latter possibilities). Despite such ingratitude, financial planners and investment advisers should go the extra mile to think about, and guard against, those invisible risks that could blow up their clients’ portfolios.
Elaborating further on the concept of ‘alternative histories’, Taleb asserts that a performance or a decision should be judged not just by the results but also by the process. If you take a decision and it produces a negative outcome, it does not necessarily mean that the decision was wrong. Some external factor could have intervened to produce the negative outcome. If you are confident about your method and persist with it (in situations where life offers multiple opportunities), positive results will follow in due course.
The blurb on the book’s jacket quotes Fortune magazine as saying: “One of the smartest books of all time.” For once this is not hyperbole but well-deserved encomium. Taleb has elaborated upon many aspects of luck and chance that we may have thought of in passing, or which may be part of earthy wisdom. But most of us would not have dwelt upon such issues in as much depth, nor expressed them with as much clarity and sophistication. The book is not an easy read, but those who persevere will be rewarded every couple of pages with nuggets of unalloyed wisdom. What adds to the joy of reading it is the author’s irreverent tone. In particular, note his jibes against journalists and MBAs. The author himself belongs to only one of these categories; this reviewer belongs to both and yet finds it difficult to disagree with the author’s rather disparaging remarks about the two categories.

Key take-aways
• In any situation where there are conflicting viewpoints, those with their ears closest to the ground will be proved right eventually.
• People at the centre of events rarely see what’s going wrong. They have too much at stake to have any real perspective. Usually outsiders or people at the fringes who spot the problems first.
• Incentives matter. If a line of action benefits someone in the short run, he will pursue it, unmindful of the long-term consequences. By the time the day of reckoning arrives, he will have moved on and someone else will have to bear the brunt.
• What started off as a good thing will not always remain so; it could by degrees mutate into something draconian.
• Watchdogs can turn predators. Witness the part played by rating agencies in the subprime crisis.

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