things are a bit more random than we tend to think, rather than things are entirely random. To be honest, it’s actually pretty daunting to consider the massive role that luck plays in our lives. One common theme in the investment world is for people to turn to macro forecasters to hear their predictions and they seem to be quite confident in.

[00:02:41] Clay Finck: These experts are prone to not learn from their past failures of predicting market moves, and despite being wrong time and time again, they still seem to trick themselves into thinking that the next call is going to be correct. This also ties into hindsight bias and how past events almost always seem obvious and look less random.

[00:03:00] Clay Finck: With the benefit of hindsight, it’s easy to think that markets would skyrocket after Covid and the Fed printed all that money. But zoom back to April of 2020. Very few of us would’ve been so certain of such an outcome. Just think about your view of markets today and how uncertain things feel.

[00:03:18] Clay Finck: However, in the year ahead, however it plays out, it’s going to be obvious. However, it does play out with the benefit of hindsight. Consider also the fact that people tend to underplay the role of luck when they’re successful and overplay the role of luck when they fail. Taleb explains that this is largely emotions at play.

[00:03:37] Clay Finck: In the absence of deep critical thinking. A big lesson that Taleb shares in this book is to remain skeptical. He writes in the preface here, it certainly takes bravery to remain skeptical. It takes inordinate courage to introspect, to confront oneself, to accept one’s limitations. Scientists are seeing more and more evidence that we are specifically designed by mother nature to fool ourselves.

[00:04:02] Clay Finck: End quote. So the reason to remain skeptical is because we live in an uncertain world. There are an infinite number of different scenarios that can play out in the future, and we need to be humble enough to accept that the world is fundamentally uncertain. Taleb encourages us to think probabilistically instead of just thinking about how things turned out in reality, we must also consider the alternative outcomes that could have occurred, and as investors prevent the risk of getting blown up or taken totally out of the game.

[00:04:32] Clay Finck: Simple ways to have this happen is doing things like taking on leverage or even over-concentrating into one or two positions. He also has this great table in the prologue that shares the key themes of the book that he really wanted to address, and you have the words on the left column that are being mistaken by the words in the right column.

[00:04:51] Clay Finck: So the noise is being mistaken for a signal. Luck is being mistaken by skill. Randomness is being mistaken by determinism. Probability is being mistaken by certainty. A lucky idiot is being mistaken by a skilled investor. Survivorship bias is being mistaken by market outperformance among a host of other examples he lists here.

[00:05:12] Clay Finck: It’s a good reminder that the world is pretty messy and it isn’t as simple as we’d like it to be. Taleb writes, I quote, as much as you believe in the keep it simple, stupid. It is the simplification that is dangerous. End quote. Financial markets are one of the most prevalent places where people mistake luck for skill because it’s just so difficult to distinguish between the two.

[00:05:36] Clay Finck: Let’s take basketball for example, to try and compare that to how things work in the world or in investing. So Steph, Curry many of you might know him if you watch basketball. He might get lucky when he makes his first or second shot against these massive defenders that are all over him. But when you see Steph Curry just make shot after shot year after year, and he goes on and wins multiple championships, you can say with a pretty high level of certainty that he isn’t a fraud or he isn’t just lucky in making all these shots.

[00:06:07] Clay Finck: But in investing, someone who has a great five or 10 year track record might just be on a lucky streak, or they might be in the right sectors in the market at the right time. For example, they might be in value during the two thousands when value was hot, or writing tech stocks throughout much of the 2010s to today.

[00:06:26] Clay Finck: So before we get to the content here in chapter one, I wanted to share one point made in the prologue. He talks about how circumstances that are brought about primarily through luck could also be taken away by luck or randomness as well. So in the example of the investor that got lucky over a 10 year timeframe, he’s going to need more luck to keep that streak going.

[00:06:47] Clay Finck: However, had his performance been primarily driven by skill, then it’s much more resistant to the randomness of markets. It reminds me of the point that Morgan Housel made in his book, same as Ever in the chapter, titled, too Fast, too Soon. I’d much rather take consistently good results over a long period of time.

[00:07:07] Clay Finck: Then a tremendous burst of success over a very short period of time. The success gained over long periods is much more enduring and it’s resistant to outside forces in randomness. So in chapter one here, Taleb outlines a story of a character named Nero. Nero was a conservative trader that just wanted to consistently have good years and avoid the risk of ruin and avoid virtually any bad years.

[00:07:32] Clay Finck: Nero made a pretty good living in the markets trading. His trading style was really risk-averse, partly because of his previous career. It wasn’t nearly as lucrative or, and it really wasn’t nearly as fun either. Every time he thought about maximizing profits or increasing risk, he remembered what it was like in his previous career.

[00:07:55] Clay Finck: So he’s really optimizing for longevity and he’s also seen many traders get blown up or lose all their money, and he doesn’t want that to be him. So this story was based in the 1990s that Taleb shares here, and he inserts another character named John who actually lived across the street from Nero. So John had a larger house and he was a high yield trader.

[00:08:18] Clay Finck: So from an outsider’s perspective. John was much more successful than Nero. He had a bigger house. He had two top line German cars and many other fancy toys and things in his life. In no way did Nero want to be like John, trade like him, live a life that he lived, but he couldn’t help but feel the social pressure.

[00:08:40] Clay Finck: John would just keep adding onto his house and continually let Narrow know that he was doing quite well in life. John wasn’t as well educated, wasn’t as physically fit, and likely wasn’t as intelligent as narrow. Taleb points to the research that shows that most people would prefer to make $70,000 a year when others around them are making 60,000.

[00:09:02] Clay Finck: Rather than make $80,000 in a year when others around them are making 90,000. Most people naturally don’t care about how much they make. They care more about how much others make relative to them. So Nero had an idea of what was at play here For John, he didn’t agree with the methods that John used to trade.

[00:09:22] Clay Finck: And he said that it resembles taking a nap on a railway track. Taleb writes, you make money every month for a long time, then lose a multiple of your cumulative performance in a few hours. He has seen it with option Sellers in 19 87, 19 89, 19 92. In 1998, it was in September of 1998 that it was time for John’s Wake up call.

[00:09:47] Clay Finck: Nero felt vindicated as he got up for work and he saw John out in his front yard smoking a cigarette, a sight that he probably hasn’t seen before. When Nero saw that, he knew immediately that John had been fired from his job, and it turns out that he lost almost everything he had. And this is a great example of the emotions at play for great investors.

[00:10:09] Clay Finck: Nero was a great investor. He had found a way to consistently make money. A method that was rational and it really made sense to him. It might not have been too hard to keep doing what worked. The hard part is watching others become richer than you are by doing really stupid things to make this more applicable to times our audience might be aware of.

[00:10:30] Clay Finck: Think of those in your social group. Getting rich on tech stocks in 1999 in real estate in 2006 or in cryptocurrencies and profit list tech companies in 2021. Just because something is working really well doesn’t mean you need to jump on board. Narrow in the story is a prime example of keeping your emotions in check and sticking with a good strategy even when it’s out of favor.

[00:10:54] Clay Finck: Taleb would’ve referred to John as a lucky fool that got rich because he didn’t understand randomness in market cycles. There’s another lesson in the story, which is really to think probabilistically. Had Nero lived out his life a thousand times using the strategy he did. He likely would’ve become rich in the vast majority of Doza scenarios.

[00:11:16] Clay Finck: And as for John, he was putting himself in a vastly different situation, and he likely would’ve been blown up in a decent amount of the thousand cases. For the vast majority of people ending up with an above average result is enough. In the case of Nero, he lived a very comfortable life and it offered him pretty much everything he could have ever needed or wanted.

[00:11:38] Clay Finck: When you shoot for that top 1% type of life, you risk potentially exposing yourself to the rare event. And when you expose yourself to the rare black swans enough times, it’s really bound to catch up with you. And that’s really what happened with John here. Taleb encourages us to think about both the observed and the unobserved outcomes.

[00:11:59] Clay Finck: For example, say you were looking to get into a career as a trader, you might look at John and when he was doing well and say that trading is a really great profession. You don’t wanna get led astray though by the outliers, thinking that you’re also gonna be an outlier. You’ll also wanna consider how well the average trader does and how long people are able to last in the profession.

[00:12:23] Clay Finck: If your typical trader ends up exiting the field after two years, then you may have your work cut out for you. Related to the unobserved observations, consider the idea of looking at someone extremely successful. You look at Elon, Musk, LeBron, James, Tom Brady, Steph, Curry, you name it. We see the people at the very top, but we don’t see all the people that supposedly did all the right things and didn’t make it to the top.

[00:12:50] Clay Finck: For every Elon Musk, there are countless other people out there who didn’t see the fruits of their labor the way they’d like it to pan out. Taleb also uses the example of Bill Gates in the book, and he shares this idea of path dependency. So how one outcome leads to another outcome, which leads to another outcome.

[00:13:08] Clay Finck: So it’s very path dependent, so you have the one outcome because of what happened before it. Computer keyboards were designed, for example, in a very sub-optimal way, but we never ended up optimizing the layout of a keyboard because we started training people typing on the version that existed and people didn’t want to have to learn a new type.

[00:13:30] Clay Finck: So it’s very similar to languages in a way. Path dependency also plays out when it comes to network effects, and this is where Bill Gates was brought into the book. Taleb writes, I quote, while it is hard to deny that Gates is a man of high personal standards, work ethic, and above average intelligence, is he the best?

[00:13:50] Clay Finck: Does he deserve it? Clearly not most people are equipped with his software because other people are equipped with his software, a purely circular effect. Nobody ever claimed that it was the best software product. Most of Gates’ rivals have an obsessive jealousy of his success. They’re maddened by the fact that he managed to win so big while many of them are struggling to make their company survive.

[00:14:15] Clay Finck: End quote. So in the case of Bill Gates, his success is due to his own efforts, in addition to just being at the right place, at the right time, and all these other factors that are totally outside of his control in better understanding the unobserved outcomes. Teleb often refers to the example of a Monte Carlo simulation, which I essentially think of a computer program that runs through various scenarios for you.

[00:14:40] Clay Finck: After you do set up your model and put these specific inputs and assumptions in. Life is even more complex than a Monte Carlo simulation. He lists two reasons for why. This is in the example of John, life didn’t feel random to him. He saw that he can make a lot of money in the markets, but he couldn’t really see the risk.

[00:15:02] Clay Finck: It’s similar to playing with a revolver where five of the chambers are empty, but one chamber contains a bullet. When all you’ve seen in your life are the empty chambers being let go, it’s easy to forget that there’s a bullet in one of them. It can give people a false sense of security when they fall back on experiences and only looking at the things that they’ve encountered in their own lives to make matters even more complex.

[00:15:27] Clay Finck: We can envision the odds, but we can’t know for certain what the true odds are in markets or in many things in life. While in the revolver example, rational players can see there’s a bullet in one chamber, but in life we don’t observe the barrel of reality. We can only make educated guesses, which can really lead us to becoming delusional, ignoring the risk of ruin, ignoring the potential black swans on the horizon.

[00:15:52] Clay Finck: And this really leads to some people playing carelessly, being tricked into thinking that the game is terribly easy. Another key theme in the book is alternative histories. I. People tend to fixate on the outcomes and not the randomness that was associated with that outcome and also the alternative histories.

[00:16:11] Clay Finck: I was really trying to think of some sports examples here, and one that really came to mind was a game I watched when I was a kid. It was a game with Eli Manning in the New York Giants versus the New England Patriots. During the Super Bowl 42 in 2008. It’s funny, I think about in the interview with Morgan Housel, how we can be told things when we’re young.

[00:16:32] Clay Finck: We can be top math, we just totally forget it. But it’s stories that really stick with us for life. And it’s funny that this was one of the first examples that came to mind. So for those of you who might not remember that game, if you watched it. With about a minute left. It was third down and Eli Manning was in trouble.

[00:16:51] Clay Finck: I believe they were down three or four points. And Manning, he evades these giant defenders and he throws the ball deep Downfield. And David Tyree jumped and caught it and he almost lost it right after he caught it. But he ended up managing to pin it against his helmet. So he caught it, pinned it, and got the first down.

[00:17:12] Clay Finck: And that was really a key play, and it was the highlight of the game. And to me when I go back and watch that play the catch, it really felt quite lucky. It isn’t hard to imagine these alternative histories in just one play. Think about what if the defender reacted a split second quicker?

[00:17:33] Clay Finck: I. What if Eli Manning got taken down for a sack when these massive defenders were grabbing at his jersey? What if David Tyree happened to wear a different style of gloves that day? What if some totally random thing caused the Giants to run a different play? There are so many alternative histories just on that one play.

[00:17:53] Clay Finck: And randomness and luck just happened to play to the Giants Advantage and they went down and they ended up scoring the winning touchdown to take down Tom Brady and the Patriots. Now of course, I’m not saying there was no skill involved in that catch. He’s obviously a great wide receiver, great quarterback on that team, and there’s obviously skill in winning that game as well.

[00:18:14] Clay Finck: So my point is that in so many things, randomness in things we can’t control. Play a huge role in the ultimate outcome that ends up impacting us. Tremendously, when you look at the history books, it’s going to show the New York Giants as the winner of Super Bowl forty-two, and it’s not gonna really bring into consideration how random luck or alternative histories played into that game.

[00:18:41] Clay Finck: It’s just going to show the score and the Giants as the winner. And then those who bet money on the Giants, that game, they’re gonna be considered geniuses that hit it big. They’re gonna think they’re really smart for making that bet. And those who bet on the Patriots, they were considered fools, and they’re gonna be like, why did I pick the Patriots?

[00:18:59] Clay Finck: I should have picked the Giants. Taleb writes that the tendency to make and unmake profits based on the fate of the roulette wheel, is symptomatic in our ungrained inability to cope with the complex structure of randomness prevailing in the modern world. End quote. So it’s so important to understand that the human brain is not wired to think in terms of probabilities in these alternative histories.

[00:19:25] Clay Finck: And he helps drive home this point by giving an example of selling an insurance policy. If we were to go to an airport and ask Travelers en route to some remote destination, how much they would pay for an insurance policy that pays a million dollars if they died on the trip, and this is for any reason, then ask another collection of travelers how much they would pay for an insurance policy that pays the same amount in the event of death from a terrorist attack.

[00:19:50] Clay Finck: And only for a terrorist attack. Odds are that people would pay more for the second policy, even though a terrorist threat is included in the first policy. By definition, he writes As a derivatives trader, I notice that people do not like to insure against something abstract. The risk that merits their attention is always something vivid.

[00:20:11] Clay Finck: End quote. And Taleb is really pointing to the fact that human beings tend to be very emotional creatures. I quote it is also a scientific fact and a shocking one, that both risk detection and risk avoidance are not mediated in the thinking part of the brain. But largely in the emotional one, the consequences are not trivial.

[00:20:34] Clay Finck: It means that rational thinking has very little to do with risk avoidance. Much of what rational thinking seems to do is rationalize one action by fitting some logic to them, end quote. So this is why so much of the media and journalism space, they aren’t trying to deliver news or deliver information that’s truly helpful, but rather they’re really tapping into the oceans the best they can.

[00:20:59] Clay Finck: The media really can play into the psyche of the mindset of investors. We tend to naturally assume that down markets are more volatile than up markets. He gives an example in the book of market movements in the 18 months after nine 11. Were less volatile than the 18 months prior. But in the minds of investors, it was very volatile.

[00:21:21] Clay Finck: So the media really magnified the terrorist threats and their impact on financial markets. Unfortunately, in a world full of noise, people want the simple solution. That sounds good, but following such simple adages that you hear can sometimes get you into the most trouble. Taleb has certain parts of the book here that are just hilarious.

[00:21:43] Clay Finck: There were so many times when I was reading it where I just laughed out loud because he has quite an interesting and unique personality and writing style. There was one amusing remark where he mentioned that because of how he is a contrarian trader that bets on people’s underestimation of randomness, he needs most people in the markets to be fools of randomness.

[00:22:05] Clay Finck: But not everybody because he needs people to invest with him or hire his services because if everyone were fools, then no one would appreciate the work that he does and how he invests and such. In chapter three, Taleb gets into more detail on the Monte Carlo simulations that I mentioned. And I thought it was funny.

[00:22:24] Clay Finck: He mentioned that he became addicted to these the minute he became a trader and Monte Carlo simulations. They really shaped his thinking in matters related to randomness. He writes, mathematics is principally a tool to meditate rather than compute. So he’s partly obsessed with them because they can really be programmed to simulate just about anything.

[00:22:48] Clay Finck: And while Taleb’s colleagues were immersed in news stories, central bank announcements and whatnot, Taleb was just obsessed with tinkering with simulations and doing these things like simulating the populations of fast mutating animals. And it’s also interesting, he mentions the connection between evolutionary biology in markets and it’s funny he mentions this because I’m currently reading what I learned about investing from Darwin by Pulak Prasad.

[00:23:15] Clay Finck: And this is just an absolutely phenomenal book. I’m really happy that Kyle covered it on the show. Pulak Prasad, he has been in the market for more than the past decade, and Kyle covered his book back on episode 5 97, and we also discussed his book in our TIP Mastermind community, as it’s been one of my very favorite books of 2024 and at the end of February.

[00:23:39] Clay Finck: Pulak Prasad is going to be joining us for Q&A, so if you’d like to join that Q&A and a and join our community, you can shoot me an email at Clayatheinvestorspodcast.com if you’d like to sit in on that discussion because pock, he actually doesn’t do public appearances. So with Taleb’s extensive experience with Monte Carlo’s, he could no longer visualize a realized outcome.

[00:24:03] Clay Finck: Without reference to the unrealized ones. So for everyone that is upset that they missed out investing in Tesla, remember that there are plenty of unrealized scenarios where Tesla wouldn’t exist in 2024, and they ended up going bankrupt. And for everyone who’s upset for not buying Amazon in 2001.

[00:24:22] Clay Finck: Remember that there are thousands of internet companies that ended up going to zero. We wanna position our portfolios in a way where if we ran forward the future 1000 times, we wanna achieve sufficient investment returns in nearly all of them. We don’t want luck to end up playing a major role in how our life ends up panning out.

[00:24:41] Clay Finck: Taleb also highlights the importance of studying history. And how it can be quite difficult for us to learn from history. Sometimes the best lessons are learned from painful experiences, but ideally, we’re able to learn from the mistakes of others in studying history. Investor Michael Batnik has this wonderful quote that I wanted to share here on learning from our mistakes.

[00:25:02] Clay Finck: Some lessons have to be experienced before they can be understood, and I can just. Totally resonate with that quote where some of my biggest lessons from investing have been from the mistakes I’ve made along the way. And I actually reviewed Michael Batnick’s book, it’s titled Big Mistakes, back on episode 5 79, where he really just walks through all these great investors in all the big mistakes they make, and it’s a great read, and I highly recommend tuning into that episode as well.

[00:25:30] Clay Finck: Taleb is definitely well aware of our natural inferior ability to assess risk, and he’s really watched other traders just ignore history and just get blown up spectacularly. It seems to be really common in the world he’s in. He writes. Blown-up traders think they knew enough about the world to reject the possibility of the adverse event taking place.

[00:25:56] Clay Finck: There was no courage, and they’re taking such risks, just ignorance. I have noticed plenty of analogies between those who blew up in the stock market in 1987, and those who blew up in the Japan meltdown in 1990. The bond market debacle in 19 ninety-four. Those who blew up in Russia in 19 ninety-eight, and those who blew up shorting NASDAQ stocks, they all made claims to the effect that their market was different and offered seemingly well-constructed intellectual arguments to justify their claims end quote.

[00:26:27] Clay Finck: So we either can be students of history and learn from the mistakes of others, or we probably end up learning the painful lesson ourselves and taking too much risk. Or getting caught up in a market bubble or whatnot with many of these traders, I’m sure that greed just blinds them to so many of the risks.

[00:26:47] Clay Finck: If you can make a killing year after year, it’s just so easy to believe that you’ve cracked the code that no one else has found, and that the game is now easy. When investing feels easy, that’s probably a good time to check in and ensure you aren’t taking excess risk and you aren’t letting your emotions take over.

[00:27:05] Clay Finck: We can look back at the past with hindsight bias, knowing that tech stocks were far overvalued in 1999, for example, but once we’re in a bubble ourselves. It’s very difficult not to get carried away, especially if it’s your first time experiencing such an emotional train ride. The same people who get caught up in a bubble are the same ones who say after the fact they knew it all along.

[00:27:29] Clay Finck: Remember that the easiest person to fool is ironically ourselves. Although Taleb is a trader, I think there are so many great points in this book related to investing more broadly. He gives the example of a portfolio that returns 15% per year with 10% levels of volatility. So you can generally think most outcomes end up between 5% and 25% of returns.

[00:27:53] Clay Finck: So over one year, the probability of a positive return is 93%. Over any given month, the probability of a positive return is sixty-seven percent. But when you zoom in to just one day, it’s fifty-four percent, and one hour, it’s fifty-one percent. So the more you compress the timeframe, the more random your returns are, or the higher chance of a negative outcome.

[00:28:17] Clay Finck: And for those of you who are aware of the loss aversion bias, naturally losses hurt more than the gains feel good from a psychological perspective. So the more you check your portfolio in this situation, the more pain you’re going to feel. I. So for many of you in the audience who check your stocks or portfolios daily, I am guilty as charged.

[00:28:38] Clay Finck: Just remember that you’re not only looking at the returns on a day-to-day basis, but you’re really looking at the volatility and the randomness of your returns. So many days. You can simply attribute stock price movements simply to randomness and not anything. We should really apply sound logic to.

[00:28:55] Clay Finck: Taleb makes the funny joke that when he sees an investor monitoring his portfolio really closely, looking at the live prices on their phone or their tablet, he smiles because he knows that there are still investors out there getting caught up in the randomness and letting their emotions flow, watching you know, that randomness with a close eye.

[00:29:13] Clay Finck: Taleb also recommends tuning out of the news as the news tends to be full of noise and information that offers you no predictive power or ability. So if the news is important enough, it’s really just going to find a way to get to you without you having to check on it constantly. Taleb writes, I quote, my problem is that I am not rational.

[00:29:36] Clay Finck: And I am extremely prone to drown in randomness and to incur emotional torture. I am aware of my need to ruminate on park benches and in cafes away from information, but I can only do so if I am somewhat deprived of it. My sole advantage in life is that I know some of my weaknesses, mostly that I am incapable of taming my emotions, facing the news, and incapable of seeing a performance with a clear head.

[00:30:04] Clay Finck: Silence is a far better end quote. So to see him stay again and again in this book, how even though he’s aware of the randomness at play in the world, he’s just as susceptible as anyone to falling prey to it. Jumping ahead to chapter five here, Taleb tells an interesting story about a trader that got caught on the wrong side of a trade.

[00:30:25] Clay Finck: So he describes this trader as named Carlos. Carlos was an emerging markets trader, and he traded bonds from all these emerging markets. And throughout the 1990s, these bonds were really in a bull market, and he had a big tailwind at his back. And this greatly benefited traders like Carlos. So Taleb was skeptical of traders of Carlos’s type.

[00:30:50] Clay Finck: He was very well dressed, well spoken. And he was really smart. Probably had gone to the nice school, had an MBA, had all the credentials he needed, and Taleb, he jokes that he believed that true traitors, they dress sloppily and they’re really the mere opposite of the Carlos’s of the world.

[00:31:10] Clay Finck: I. So Carlos did exceptionally well during his career, not only because he was in the right sector riding the right trend, but also because he was buying dips along the way. So whenever there was a momentary panic, Carlos would step in with confidence during that bull market. And the trend would resume being right about the reversals time and time again really made Carlos feel invincible.

[00:31:35] Clay Finck: So this strategy worked really well until the summer of 1990. And this is when the dip that happened didn’t end up translating into a rally. That summer in 1998 would be his first bad summer. It was actually so bad that it should be considered catastrophic. Up until that point, he had earned $80 million cumulatively in those previous years, and in that one summer, he lost his firm.

[00:32:01] Clay Finck: $300 million. So he talks about how this happened. So the market dropped and Carlos had started to average down as he’d habitually done. It’s what’s always worked in his experience. And he was plenty confident that the market was going to bounce as it always did before. And Carlos knew that some other firms were going through some liquidity issues and they were.

[00:32:26] Clay Finck: There was really forced selling at play, so this was really a common sign that bargains were available. He bought in at $52 and he stated that the bonds would never trade below 48. So he was actually, at this time, betting big on Russian bonds, saying that Russia was just too big to fail or too big to default on their debt obligations.

[00:32:48] Clay Finck: So he continued to double down as the bonds traded down to $43 in July, and he ended up wagering half of his own net worth or around $5 million in the Russia principle bond, thinking that the profits from it are gonna have ’em set for life. The market had other plans for him by the middle of August.

[00:33:08] Clay Finck: They were trading down in the twenties. Carlos understood that there was a difference between price and value. So he continued to hold on as he believed that the true value was substantially higher than the price that was shown on the screen. Everyone in Carlos’ circle agreed that the sell-off was far overdone, but by the end of August, the bonds kept falling and they dropped below $10.

[00:33:31] Clay Finck: Now, the board members at Carlos firm wanted to understand why in the world the company had so much exposure to a government. That wasn’t paying their own employees or their soldiers. Veteran Trader Marty O’Connell refers to what was happening around here as the firehouse effect. And the firehouse effect is when you have a bunch of firemen with a lot of downtime, they’re talking to each other, you know they’re doing so for far too long, and it ends up being an echochamber where they all agree on many of the same things, and an outside observer would just deem them to be ludicrous.

[00:34:06] Clay Finck: We can also refer to this really as an echochamber, where the same talking points are repeated again and again by the same people that think the same way. This trader hadn’t considered the possibility. Of the low probability event happening because he’d never seen such a thing happen in his own experience before, and it ended up costing Carlos a lot of money in his job.

[00:34:27] Clay Finck: I. He also ended up switching careers because of the damage that it ended up doing to him. What’s also interesting is that before this collapse of Russian Bonds, a trader like Carlos would’ve been considered the top of his field because his returns were probably really good relative to other traders.

[00:34:46] Clay Finck: But Taleb wisely points out that the best traders, or the way I think of it, are the best investors at any given point in time. May actually be the worst traders or worst investors. Teleb writes here, at a given time in the market, the most successful traders are likely to be those that are best fit to the latest cycle.

[00:35:07] Clay Finck: This does not happen too often with dentists or pianists because these professions are more immune to randomness. End quote. If a trader has a really hot streak, odds are it may solely be due to randomness being at the right place at the right time. Or maybe taking too much risk. People tend to assume that traders that had a hot streak are successful because they’re skilled or they’re good at what they do.

[00:35:33] Clay Finck: But we must remember survivorship bias. For every successful trader, there are a host of unsuccessful ones who may be just as skilled. Over short time periods, a successful trader does not make a good trader or a successful investor does not necessarily make for a good investor. It’s also important to not get married to your positions when something goes against you.

[00:35:58] Clay Finck: Putting the majority of your net worth into it probably isn’t a sound practice of risk management. Taleb writes, there’s 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. End quote. I just love that there’s a saying that bad traders divorce their spouse sooner than they abandon their positions.

[00:36:26] Clay Finck: This bias is also known as the Endowment effect. The Endowment effect is the tendency to hold onto something we own simply because we already own it. Taleb argues that if you buy a painting for $20,000 and the price goes up to $40,000, you should keep it only if you would acquire it at that current price.

[00:36:45] Clay Finck: If you wouldn’t acquire the painting at $40,000, then it’s said that you’re married to your position and it’s now become an emotional investment. This, of course ignores the consequences of taxes, but I struggle with this point by Taleb and I disagree a bit because we talk a lot about letting your winners run on the show and not tinkering with your portfolio too much.

[00:37:07] Clay Finck: And part of the game of achieving multi-baggers is hanging onto your winners when they approach intrinsic value or maybe even exceed intrinsic value to some degree. But the bias at play here can be a really useful mental model. Once we buy a stock, something in our brain changes about how we view it, we likely now have a positive skew towards that stock, and we’re now prone to confirmation bias.

[00:37:32] Clay Finck: And confirmation bias is essentially when we start looking for information that tells us we made a good decision when buying the stock. And it somewhat blinds us to anything that conflicts with our decision to buy. With that said, it’s just so important to be open to the idea of changing your mind when the facts change.

[00:37:50] Clay Finck: You shouldn’t update your investment thesis just because the price goes against you, and in my opinion, you shouldn’t just sell just because the price goes up. If your original investment thesis upon entering the trade doesn’t pan out, then odds are that it’s best to exit the position no matter how much it hurts psychologically to do so in the case of Carlos, he was a trader that entered a position and he morphed into a long-term investor when the environment changed. So from what I understand in the story, he had updated his thesis once things changed, and that’s just a big red flag and a sign that you’ve entered a really bad trade.

[00:38:29] Clay Finck: So when we enter a position, we should really have a plan for what we would do in the event of losses. Carlos really wasn’t aware of the possibility of losing money here, and all he had done up to that point was really make money. I also loved that Taleb had a chapter on skewness and asymmetry. One of my favorite lessons on asymmetry was from my previous conversation with Gotham Base on episode 5 83.

[00:38:55] Clay Finck: He explained that if you have two stocks and one is compounding at twenty-six per year to the upside, and the other is declining at twenty-six per year to the downside, and then you equal weight those positions from the beginning, at the end of 10 years, your average annual return would still be 17.6%.

[00:39:14] Clay Finck: This shows how your winners can really carry your portfolio. Even when you have big losers that fall by the wayside. So Gottem’s point during that episode was really that compounding is convex to the upside, but concave to the downside. So also remember that humans are wired to think linearly, so we really have to pound these ideas into our heads that really aren’t that intuitive.

[00:39:39] Clay Finck: Asymmetry is also why Taleb is able to make money by betting on black swans. Even though the market statistically is likely to go up year after year, it’s during the downtimes when the market gets hammered that Taleb makes out like a bandit. He generally loses money. When the market is going up. But during a month, like March, 2020 or black Monday in 1987, he makes all these losses back plus some additional gains on top of it.

[00:40:08] Clay Finck: So although the frequency of profits is low for Taleb, when they do occur, the magnitude of the gains is enormous. So while others perish during chaos, Taleb thrives in it. I think he referred to himself as a chaos hunter. In the book, as Taleb puts it, I try to make money as infrequently as possible, simply because I believe that rare events are not fairly valued and that the rarer the event, the more undervalued it will be in price end quote.

[00:40:40] Clay Finck: So simply put, Taleb is capitalizing on the asymmetry of downed markets. Typically, markets tend to slowly march upward, but when those surprises happen, it just sends the market down much faster than many market participants expect. Another interesting point I picked up from this piece on asymmetry is not to take stable market prices as a sign of a stable investment.

[00:41:05] Clay Finck: Taleb is really a big skeptic of using past data to predict future performance. He explains that he needs a lot more than just data. The rare Black swan or the rare event has the potential to make all past data irrelevant, and history teaches us that things that have never happened before do happen. I think many people, myself included, can become duped to thinking that we can look at past data and believe that we’ve somehow increased our knowledge on what the future will look like.

[00:41:36] Clay Finck: But. Things are just changing all the time. There’s some brilliant second level thinking here from Tale that sort of makes my head spin. He writes, rare events exist precisely because they’re unexpected. If the fund manager or trader expected it, he and his like-minded peers would not have invested in it.

[00:41:56] Clay Finck: In the rare event, it would not have taken place. End quote. So had everyone been prepared for something like the great financial crisis, then there would be more people who would’ve been in a better position financially and not have their homes foreclosed on, for example. And since there would be less foreclosures, this would’ve helped prevent so much of that for selling that happened by many people and not made the crisis as bad as it was.

[00:42:20] Clay Finck: So that’s the way I interpret that quote there. It’s a good reminder that. Whatever bad outcome is the worst case scenario in your life, in your portfolio just in your head, what is the worst case scenario? The reality is that the rare event that could happen in that worst case scenario is likely much worse than you can even imagine or even fathom.

[00:42:45] Clay Finck: In dealing with randomness, we have to keep an open mind and be open to the idea of things happening that we can’t even fathom in that moment. So I wanna transition here to talk about one of the most important takeaways from the book, and that’s understanding survivorship bias. I’ve touched on this a little bit during this episode.

[00:43:04] Clay Finck: Tullet makes the case that if you have an infinite number of monkeys in front of typewriters and you just let ’em type away. There’s certainty that one of them is going to come out with an exact version of the Iliad, and the probability of this is ridiculously low for each particular monkey. It’s extremely low, but if you did this enough times, he assumes that it would eventually happen.

[00:43:28] Clay Finck: Now for that monkey, he asked the question of, would you be willing to bet your life savings that the monkey would be able to write the Odyssey next? This is really getting to the question of how relevant is past performance in forecasting future performance? And this is a trap that many people fall into where they derive conclusions based on a past time series.

[00:43:53] Clay Finck: As Tailed puts it, the more data we have, the more likely we are to drown in it. So instead of betting on a one-hit wonder, we like to see a long track record. A company that does well in its first year of going public. It might be a great investment, but we’re much more likely to have confidence in the company’s ability to execute.

[00:44:13] Clay Finck: If it has a ten-year track record of solid performance, or maybe even 20, 30, 40 years, it’s very hard to simply be lucky for 40 years in a row. The predictive ability of past data depends on two factors, the randomness of the data and the number of data points there are. The world of business is full of randomness and it’s just full of a ton of data points as well.

[00:44:38] Clay Finck: If you have millions of people that are trying to start businesses and trying to make it big, it’s no wonder that we have the Elon Musk’s and the Jeff Bezos’s of the world. Those are the people we constantly see in the headlines, even here on the podcast here, but the people we don’t see are the countless data points that didn’t get to where they are.

[00:44:58] Clay Finck: This is why Warren Buffett might make it look like it’s so easy to beat the market, but the vast majority of fund managers don’t beat the market. This really gets to the heart of survivorship bias. We can try and replicate all the tactics that Buffett uses, but for one, we simply aren’t. Warren Buffett.

[00:45:16] Clay Finck: And two, there are countless people who have tried to use his approach in investing and ended up with a different result. In Buffett’s early days, he was buying Cigars-type businesses, and part of his investment thesis was that the market price would eventually converge with the intrinsic value.

[00:45:33] Clay Finck: Sometimes that might happen, and sometimes it might take a really long time for it to happen and lead to subpar returns. Or think about when he purchased Coca-Cola in 19 eighty-nine. He needed the company to continue to execute in all these different markets they were in globally, and he was ultimately right in his assessment of the business.

[00:45:51] Clay Finck: But there’s almost certainly an alternative scenario where the bet would’ve looked terrible in hindsight. Nobody would go out and say that Buffett’s success was due to luck, but it certainly played some part of it. Taleb uses another example of a couple that lives in one of the richest areas of Manhattan.

[00:46:09] Clay Finck: I really liked this story and wanted to share it. So there was a husband and a wife in Manhattan, and the husband worked very demanding hours and he wanted to live close to work. So they stretched their living expenses and they lived in a really expensive area. That way they had close proximity to get to and from work, and then he could maximize his time at work and not spend hours commuting.

[00:46:31] Clay Finck: So by any measure, these people were extremely successful and extremely wealthy. But when you look at the neighborhood they were in. They were actually near the bottom in terms of the size of where they lived, how much money they made, and the things they have. And when the man’s wife would look around, she felt like she had next to nothing when she compared herself to her peers.

[00:46:56] Clay Finck: So she was surrounded by larger diamonds, larger living spaces, and she didn’t get the respect that she felt she deserved. And because of this. The wife feels that her husband is a failure by comparison to those around them, but the reality is that they are wildly successful and they’re actually better off than 99.5% of Americans.

[00:47:19] Clay Finck: So when you compare the husband to his high school friends and how they turned out, he was certainly near the top. But when you compared it to his neighbors, he was certainly at the bottom. And this is a perfect example of Survivorship bias at play. This couple chose to live in an area full of successful people, which is an area that by definition, Excludes failure.

[00:47:41] Clay Finck: So those who failed don’t show up in the sample set or show up in that neighborhood. And this really gets to the heart of why many people never feel satisfied with their life. They get money, they move to a nice neighborhood by their standards, and then they feel poor again. Or they just get used to the nice things that they’re now surrounded by.

[00:48:02] Clay Finck: And Taleb also calls out the book, The Millionaire Next Door. And this book explains how a bunch of people became millionaires by saving, consistently investing among other things. And Taleb points out two flaws in the book. First is that the study only looked at the millionaires, which he equates to the lucky monkeys on typewriters.

[00:48:22] Clay Finck: And the book makes no mention of the people who also invested, just like these people in the study, but they happen to invest in the wrong things at the wrong time. Or maybe they’re in a country where their currency hyperinflated, or they’re just in a situation where their assets were seized.

[00:48:38] Clay Finck: Those are excluded from the study, is the point he’s making. And then the second flaw he points out is that. There was a massive bull market in the asset values in the people they were studying. If you invested from 1980 to 2020. And the book essentially assumes that these asset returns are permanent.

[00:48:57] Clay Finck: So the US, like I mentioned, had that exceptional run from the 1980s, and we shouldn’t assume that these levels of returns are going to continue forever. And these are the sort of assumptions that led to the Great crash and the Great Depression after 1929. Another example he gives here in the book is that, it’s commonly said that successful people are optimistic people. So optimistic people tend to take more risks and they’re more confident about their odds. And then those who are successful end up showing these characteristics of being optimistic. And we give them all this praise, but we don’t see the optimistic people that ended up making a bad bet.

[00:49:39] Clay Finck: So it’s a good reminder to just be careful of the assumptions we make. When we’re looking at a particular data set, and particularly looking at winning stocks, for example, I also liked a couple of the concepts here. In chapter 10, he mentions chaos theory, which points to how the smallest inputs can lead to a disproportionate response.

[00:49:59] Clay Finck: Morgan Haussle wrote in his book How the U.S, they actually would’ve lost the Revolutionary war had the wind been blowing in a certain direction, preventing the opposing army from sailing downstream to just finish the war. And wipe out the U.S. And had the wind been blowing in the other direction, the outcome of the war would’ve been entirely different and there would be no United States of America.

[00:50:23] Clay Finck: I. And Taleb also takes a stab at Bill Gates here saying that he clearly doesn’t deserve the level of success he’s had today. And I talked about path dependence earlier, and it’s really interesting how in the information, age, path dependence and network effects are extremely important. So in the case of Bill Gates and Microsoft, many people were on board with Microsoft and it created that feedback loop of, since others were on Microsoft, you now had an incentive to use that program.

[00:50:54] Clay Finck: Sometimes it’s just better to be lucky than to be good. There’s that saying. Another interesting part about network effects and these networks is the tipping point at which the network takes off and it offers this sort of asymmetric upside. In Malcolm Gladwell’s book, the Tipping Point, he shows some of the behaviors of variables such as epidemics that spread extremely fast beyond some unspecified critical level.

[00:51:18] Clay Finck: And it’s really the same with book sales. Book sales tend to explode once they reach some sort of tipping point, and the word of mouth just takes it everywhere. And these non-linearities are practically impossible to model or predict, and it’s just really due to the randomness that’s involved. This again links to one of the beauties of investing for my own portfolio.

[00:51:40] Clay Finck: I wanna spread myself out across bets that I think have limited downside, but I have a lot of potential upside, far down the line. And I don’t know which bets exactly are going to be the big winners, but I wanna expose myself to companies with a lot of room to grow. They’re bought at a fair price that I deem to be sensible, and I size it enough to be a large enough part of my portfolio where it really makes a difference, and then I just wanna leave it alone for many years.

[00:52:05] Clay Finck: Since we can’t predict the significance of these non-linearities, they really aren’t going to be obvious beforehand, but it’s going to look obvious. What the benefit of hindsight, like I’ve talked about today. Just think about most big winners in the markets. I’m sure absolutely nobody. 10 years ago envisioned them being as big as they are today in terms of their size.

[00:52:29] Clay Finck: Our brains really can’t fully comprehend the power of these non-linearities. And if we find ourselves with a winner, we generally want to let it run. At least that’s my personal approach. And then we’ll have the Nassim Talebs of the world call us Lucky after the fact. It’s so interesting. He also mentions the idea of when it rains, it pours.

[00:52:51] Clay Finck: Some people just really seem to be inherently lucky, and other people just seem to be inherently unlucky. An author either has a wildly successful book, or the author can hardly make a sale at all, especially with the information age, successful people or books or. Whatever else. It spreads like wildfire and then a lot of the others are just left in the dust and can hardly attract a single eyeball because there can be so much variability in our world.

[00:53:19] Clay Finck: It can make it quite difficult to forecast anything. For example, people might wanna know where the S&P is going to be trading one year from now. And since people want that, many firms are happy to try and forecast it. What’s maybe more important that I wanted to mention here, more important than the forecast at least, is the variability in the forecast.

[00:53:40] Clay Finck: Or the degree of confidence in that forecast. So it’s one thing if you estimate a 10% increase with a, say a 5% variability in either direction, and it’s a whole different story. If you estimate a 10% increase where returns might be as high as 40 or 50%, or as low as negative 40%. So you know if you have a high degree of certainty within a narrow band, that’s totally different from the second scenario I mentioned.

[00:54:06] Clay Finck: So the variation in the returns. Matters a lot, but no one really asks about the variation or the degree of confidence. When someone makes a forecast, they usually just share their forecast. One other important takeaway I wanted to mention here is differentiating process versus outcome. So much in the stock market and in price movements is just noise and we need to be mindful of the degree of randomness in markets.

[00:54:34] Clay Finck: So underperforming the market in one year doesn’t necessarily make one a bad investor and outperforming the market in one year doesn’t necessarily make one a good investor. Sometimes terrible stocks skyrocket in price, and sometimes great stocks decline in price, and that’s just the way markets work.

[00:54:51] Clay Finck: What is more important is honing in on a process that meshes well with your skill set and your temperament. The best investors focus on a process that is repeatable, and they aren’t quite as focused as much on the outcome, at least in the short term, because they recognize the role of luck and randomness at play in that short-term outcome.

[00:55:11] Clay Finck: And it’s often just simply full of noise. Investors who are focused on the outcome tend to chase things as well. XYZ investment went up a lot recently, so they’re going to chase that fad or chase that trend. And this is really an outcome based approach without considering the underlying process and the probability of success with that approach when your process isn’t based on luck.

[00:55:33] Clay Finck: And it’s based on an approach that is sound logical and rational. Hopefully this will lead to results that you are satisfied with over the long run. Alright, so we’re getting close to wrapping up this discussion and in light of all this talk on luck and randomness, Taleb says that he has no conclusion on figuring out.

[00:55:53] Clay Finck: When something doesn’t have an element of luck in it, which honestly isn’t all that helpful. There are of course investors who are very skillful and their performance is largely driven by skill and not primarily by luck. And the sort of Catch twenty-two here is that many of the best investors are going to fly under the radar, in my opinion at least, because they’re going to be implementing high levels of risk management.

[00:56:19] Clay Finck: So an investor who’s far outpacing the market. Either has luck going their way or they’re taking too much risk. They’re going out and marketing themselves, trying to get more investors to invest with them. But eventually the bad investors, their luck is going to turn, and I’m not going to name any names here, but I’m sure many in the audience can come up with somebody that’s been in the headlines.

[00:56:42] Clay Finck: Taleb writes, I am unable to answer the question of who’s lucky or unlucky. I can tell that person A seems less lucky than person B. But the confidence in such knowledge can be so weak as to be meaningless. I prefer to remain a skeptic. I never said that every rich man is an idiot and that every unsuccessful person is unlucky only that in the absence of much additional information, it is preferable to reserve judgment once as it is safer.

[00:57:12] Clay Finck: End quote. Alright, that’s all I have for today’s episode. Thanks for tuning in, and I hope to see you again next time.

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