The Distribution Of Returns The Randomness Embedded In Them

As traders, one of the most important traits we can adopt is humility. We have to embrace our fallibility.

Markets are complex systems. We cannot know all the relevant variables and causal relationships. Therefore, when we make a market prediction or place a trade, we can’t truly know if the subsequent outcome occurred for the reasons we believed, for reasons we’re unaware of, or if it was all just random noise.

This presents us with a dilemma: We must act on incomplete information and then iterate off results where we can’t fully know the causes.

So we never really know if we were right for the right reasons, right for the wrong reasons (i.e., lucky), or a little bit of both. Hence the need to stay humble.

Where traders get into trouble is when they’re right a lot for the wrong reasons but they think they’re right for all the right reasons. They think they’re making money because they’re skilled but really they’re just lucky.

Nassim Taleb writes about this problem, saying:

At any point in time, the richest traders are often the worst traders. This, I will call the cross-sectional problem: At a given time in the market, the most successful traders are likely to be those that are best fit to the latest cycle.

Being aware of the randomness embedded in the distribution of markets returns keeps us from falling for the ego trap where we mistake skill for luck or information for noise. And since the two are difficult to distinguish over a short time frame, it forces us to focus on managing our risk in a way that tilts the odds for success in our favor over the longer term.

In his book Fooled by Randomness, Nassim Taleb offers a useful analogy of the “dentist investor” on the difference between noise and information. Here it is:

The wise man listens to meaning; the fool only gets the noise. The modern Greek poet C.P. Cavafy wrote a piece in 1915 after Philostratus’ adage “For the gods perceive things in the future, ordinary people things in the present, but the wise perceive things about to happen.” Cavafy wrote:

“In their intense meditation the hidden sound of things approaching reaches them and they listen reverently while in the street outside the people hear nothing at all.”