Would you leave your crypto profits to chance? Well, that’s what you are doing if you don’t have an understanding of probability and randomness.
📊 Today’s free letter covers some of the most important and least understood topics in trading and investing.
Read, enjoy and share with your network. Let’s all grow richer together.
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Fooled By Randomness
2021 has started with what seems like an infinite stream of crypto success stories.
Whether it is: a new institution joining the space, a new all time high or a new trader / investor reaching millionaire status, there seems to be an overriding impression whereby success seems guaranteed ✅
🚫 It is for this reason that in today’s newsletter, we would like to share the key takeaways from Nassim Taleb’s Fooled By Randomness. In a nutshell, Taleb explains how, in general: mild success can be explained by skills and hard work, but wild success is attributed to randomness and luck.
We have previously covered two of Taleb’s other books in his Incerto series: The Black Swan and Antifragile: Things That Gain From Disorder. Let’s tick off another today, so that we approach tomorrow as better informed traders and investors.
In trading and investing, the failure to identify randomness can lead us astray and result in big mistakes. Let’s use a case study.
Callum the Crypto Trader creates a dart board made of different assets. Each day, he puts on a blindfold and throws a dart at the board. The asset it hits is the next one he will trade. He threw the dart one day in 2017 and hit the coin on the board labelled ‘bitcoin’. By 2021, he had made some serious returns 💰
This is all well and good. Callum can do this everyday with the Market Meditations Podcast 🎧 streaming full volume in the background if that’s what makes him happy. The problem arises when Callum starts sharing his successes. He tweets:
I have a fantastic coin trading strategy involving dart throwing. I’ve made 100x returns on it. The key is to make sure that the blindfold is extra tight and that you say ‘All Hail Satoshi’ before you throw it.
The problem is that neither we, who read the tweet, nor Callum, who came up with this brilliant strategy, truly consider all other possible outcomes.
📣 Because of survivorship bias, we don’t hear about all of the people who failed at this because they hit assets that did not turn out to be so successful. The highest performing realisation will always be the most visible:
“…we tend to mistake one realization among all possible random histories as the most representative one, forgetting that there may be others. In a nutshell, the survivorship bias implies that the highest performing realization will be the most visible. Why? Because the losers do not show up”
The one success story becomes the viral one and the hundreds of losers are forgotten. Many traders and investors forget the probability play and trade off the survivorship bias. They put on their blindfolds and most likely will experience big losses from this strategy.
📌 Whilst the dart throwing strategy may seem extreme, there are many examples of people who have achieved extreme success in the crypto space through randomness.
And so, when reading headlines, strategies and success stories, it is crucial to consider randomness and probability. Before following a popular trading strategy, consider all other possible outcomes, remembering survivorship bias.
The Skewness Issue
The next step is to understand the difference between probability and expectation. If you are entirely new to the concept of probability, you might first want to read through a very simple example at the end of this letter 👇 Otherwise, let’s move straight to an example from Taleb.
Taleb was once called into a meeting room and asked for his opinion on the stock market. He said he thought there was an 70% chance that the market would be bullish next week.
Someone in the meeting interrupted him and asked: “if you think there is an 70% chance the market will be bullish next week then why did you just take a short position in S&P 500? Did you change your mind?”. All eyes were on Taleb as the meeting participants eagerly awaited his response 👀
Taleb explained that he hadn’t changed his mind about anything. He still thought there was an 70% chance the market would be bullish next week and he still wanted to short the market. The people in the meeting were utterly confused. Has Taleb forgotten the most basic principles of trading? Why on earth would you take a short position if you are bullish?
The answer lies in the difference between probability and expectation. Expectation is probability multiplied by payoff. Consider Taleb’s 2 scenarios:
1) Taleb said there was a 70% chance the market would rise. Suppose this is a 10% rise.
2) That leaves a 30% chance the market can go down. However, if it does go down, it will go down by 80%.
So how did Taleb reach his decision to short the market based on these probabilities and payoffs? The calculation is as follows:
(0.7 x 0.1) + (0.3 x -0.8) = -0.17, meaning that on average, the yield or return is -17%!
📉 In words: the market was more likely to go up but it was preferable to short it because, in the event of it going down, it could go down a lot.
Still not clear? check out our video guide 📺 on expectancy 👇
📚 When you start to consider expectation rather than just probability, the game is completely different. The lesson for traders and investors: as well as considering probabilities of something happening, try to also consider the payoffs associated with those probabilities and then taking an overall view based on the average return.
And there you have it. Just two concepts from a book full of knowledge, lessons and stories that are applicable to crypto markets. Beware of survivorship bias: before following a popular trading or investing strategy, consider all other possible outcomes. Begin to show an appreciation for the distinction between probability and expectation: it is not always as black and white as bullish or bearish. We begin to understand this when we factor in for payoff as well as probability.
📊 Have you been fooled by randomness too many times? Join our community and gain access to the full range of insights and analysis 👇
Probability and Expectation 101
Probability is the likeliness that one event will happen. Whereas expectation is the expected outcome or value of multiple events over a prolonged period of time.
For example, consider you are tossing a coin and every time you land on heads you are given £3, yet when you land on tails you have to pay £1.
The probability of you landing on either heads or tails is 0.5, which would mean after two coin flips you would have one head (+£3) and one tail (-£1). These are all the numbers we need to solve for expectation:
(£3x0.5) + (-£1x0.5)
£1.50 - £0.50 = £1
An average of £1 per flip is your expected value also known as expectation. After flipping a coin multiple times on average you will gain £1 per flip.
This concept may seem simple, but the vast majority of traders do not understand this. So now that you do, you're way ahead of the game.
DeFi Dad: How to Earn Passive Income with DeFi
DeFi Dad is a DeFI super-user who provides education on bankless money apps on the Ethereum blockchain and currently acts as the Chief DeFi Officer for Zapper.fi.
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Disclaimer: The content in this newsletter is for informational purposes only. Nothing in this email is intended to serve as financial advice. We are not financial advisors. Every investment and trading move involves risk. Do your own research when making a decision.