Fooled by Randomness (17 page)

As an aside, Popper was not new to me. I had briefly heard of Karl Popper when I was in my teens and early twenties, as part of a motivated education in Europe and the United States. But I did not understand his ideas as presented then, nor did I think it would be important (like metaphysics) for anything in life. I was at the age when one felt like one needed to read everything, which prevented one from making contemplative stops. Such hurry made it hard to detect that there was something important in Popper. It was either my conditioning by the intellectual-chic culture at the time (too much Plato, too many Marxists, too much Hegel, too many pseudoscientific intellectuals), the educational system (too many conjectures propounded as truth), or the fact that I was too young and was reading too much then to make a bridge to reality.

Popper
^*
then slipped out of my mind without hanging on a single brain cell—there was nothing in the baggage of a boy without experience to let it stick. Besides, having started trading, I entered an anti-intellectual phase; I needed to make a nonrandom buck to secure my newly lost future and wealth that had just evaporated with the Lebanese war (until then I was living with the desire to become a comfortable man of leisure like almost everyone in my family over the past two centuries). I suddenly felt financially insecure and feared becoming an employee of some firm that would turn me into a corporate slave with “work ethics” (whenever I hear
work ethics
I interpret
inefficient mediocrity
). I needed the backing of my bank account so I could buy time to think and enjoy life. The last thing I needed was immediate philosophizing and work at the local McDonald’s. Philosophy, to me, became something rhetorical people did when they had plenty of time on their hands; it was an activity reserved for those who were not well versed in quantitative methods and other productive things. It was a pastime that should be limited to late hours, in bars around the campuses, when one had a few drinks and a light schedule—provided one forgot the garrulous episode as early as the next day. Too much of it can get a man in trouble, perhaps turn one into a Marxist ideologue. Popper was not to reemerge until I secured my career as a trader.

Location, Location

It is said that people generally remember the time and geographic condition where they were swept with a governing idea. The religious poet and diplomat Paul Claudel remembers the exact spot of his conversion (or reconversion) to Catholicism in the Cathedral Notre-Dame of Paris, near a precise column. Thus I remember exactly the spot at Barnes and Noble on Eighteenth Street and Fifth Avenue where in 1987, inspired by Soros, I read fifty pages of
The Open Society
and feverishly bought all the Popper titles I could get my hands on lest they run out of stock. It was in a sparsely lit side-room that had a distinctive smell of mildew. I remember vividly the thoughts that rushed through my head like a revelation.

Popper turned out to be exactly the opposite of what I initially thought about “philosophers”; he was the epitome of no nonsense. By then I had been an option trader for a couple of years and I felt angry that I was being taken for a total ride by the academic researchers in finance, particularly since I was deriving my income from the failure of their models. I had already started talking to finance academics as part of my involvement with derivatives and I had trouble getting through to them some basic points about financial markets (they believed in their models a little too much). There was all along lurking in my mind the idea that these researchers had missed a point, but I did not quite know what it was. It was not what they knew, it was how they knew it, that was the subject of my annoyance.

Popper’s Answer

Popper came up with a major answer to the problem of induction (to me he came up with
the
answer). No man has influenced the way scientists do science more than Sir Karl—in spite of the fact that many of his fellow professional philosophers find him quite naive (to his credit, in my opinion). Popper’s idea is that science is not to be taken as seriously as it sounds (Popper when meeting Einstein did not take him as the demigod he thought he was). There are only two types of theories:

Why is a theory never
right
? Because we will never know if all the swans are white (Popper borrowed the Kantian idea of the flaws in our mechanisms of perception). The testing mechanism may be faulty. However, the statement that there is a black swan is possible to make. A theory cannot be
verified.
To paraphrase baseball coach Yogi Berra again,
past data has a lot of good in it, but it is the bad side that is bad.
It can only be provisionally accepted. A theory that falls outside of these two categories is not a theory. A theory that does not present a set of conditions under which it would be considered wrong would be termed charlatanism—it-would be impossible to reject otherwise. Why? Because the astrologist can always find a reason to fit the past event, by saying that
Mars was probably in line but not too much so
(likewise to me a trader who does not have a point that would make him change his mind is not a trader). Indeed the difference between Newtonian physics, which was falsified by Einstein’s relativity, and astrology lies in the following irony. Newtonian physics is scientific because it allowed us to falsify it, as we know that it is wrong, while astrology is not because it does not offer conditions under which we could reject it. Astrology cannot be disproved, owing to the auxiliary hypotheses that come into play. Such point lies at the basis of the demarcation between science and nonsense (called “the problem of demarcation”).

More practically to me, Popper had many problems with statistics and statisticians. He refused to blindly accept the notion that knowledge can always increase with incremental information—which is the foundation of statistical inference. It may in some instances, but we do not know which ones. Many insightful people, such as John Maynard Keynes, independently reached the same conclusions. Sir Karl’s detractors believe that favorably repeating the same experiment again and again should lead to an increased comfort with the notion that “it works.” I came to understand Popper’s position better once I saw the first rare event ravaging a trading room. Sir Karl feared that some type of knowledge did not increase with information—but which type we could not ascertain. The reason I feel that he is important for us traders is because to him the matter of knowledge and discovery is not so much in dealing with what we know as in dealing with what we do not know. His famous quote:

“These” are scientists. But they could be anything.

Putting the master in context, Popper was rebelling against the growth of science. Popper intellectually came to the world with the dramatic shifts in philosophy as attempts were made to shift it from the verbal and rhetorical to the scientific and rigorous, as we saw with the presentation of the Vienna Circle in
Chapter 4
. These people were sometimes called the logical positivists, after the movement called
positivism
pioneered in France in the nineteenth century by Auguste Comte, where positivism meant scientification of things (literally everything under the sun). It was the equivalent of bringing the industrial revolution into the soft sciences. Without dwelling on positivism, I have to note that Popper is the antidote to positivism. To him, verification is not possible. Verificationism is more dangerous than anything else. Taken to the extreme, Popper’s ideas appear naive and primitive—but they work. Note that his detractors call him a
naive falsificationist.

I am an exceedingly naive falsificationist. Why? Because I can survive being one. My extreme and obsessive Popperism is carried out as follows. I speculate in all of my activities on theories that represent some vision of the world, but with the following stipulation: No rare event should harm me. In fact, I would like all conceivable rare events to help me. My idea of science diverges with that of the people around me walking around calling themselves scientists. Science is mere speculation, mere formulation of conjecture.

Open Society

Popper’s falsificationism is intimately connected to the notion of an open society. An open society is one in which no permanent truth is held to exist; this would allow counter-ideas to emerge. Karl Popper shared ideas with his friend, the low-key economist von Hayek, who endorsed capitalism as a state in which prices can disseminate information that bureaucratic socialism would choke. Both notions of falsificationism and open society are, counterintuitively, connected to those of a rigorous method for handling randomness in my day job as a trader. Clearly, an open mind is a necessity when dealing with randomness. Popper believed that any idea of Utopia is necessarily closed owing to the fact that it chokes its own refutations. The simple notion of a good model for society that cannot be left open for falsification is totalitarian. I learned from Popper, in addition to the difference between an open and a closed society, that between an open and a closed mind.

Nobody Is Perfect

I have some sobering information about Popper the man. Witnesses of his private life find him rather un-Popperian. The philosopher and Oxford don Bryan Magee who befriended him for close to three decades depicts him as unworldly (except in his youth) and narrowly focused on his work. He spent the last fifty years of his long career (Popper lived ninety-two years) closed to the outside world, insulated from outside distractions and stimulation. Popper also engaged in giving people “firm sounding advice about their career or their private life, though he had little understanding of either. All this, of course, was in direct contravention of his professed (and indeed genuine) beliefs, and practices, in philosophy.”

He was not much better in his youth. Members of the Vienna Circle tried to avoid him, not because of his divergent ideas but because he was a social problem. “He was brilliant, but self-focused, both insecure and arrogant, irascible and self-righteous. He was a terrible listener and bent on winning arguments at all costs. He had no understanding of group dynamics and no ability to negotiate them.”

I will refrain from commonplace discourse about the divorce between those who have ideas and those who carry them in practice, except to bring out the interesting behavioral problem; we like to emit logical and rational ideas but we do not necessarily
enjoy
this execution. Strange as it sounds, this point has only been discovered very recently (we will see that we are not genetically fit to be rational and act rationally; we are merely fit for the maximum probability of transmitting our genes in some given unsophisticated environment). Also, strange as it sounds, George Soros, obsessively self-critical, seems to be more Popperian than Popper in his professional behavior.

Induction and Memory

Memory in humans is a large machine to make inductive inferences. Think of memories: What is easier to remember, a collection of random facts glued together, or a story, something that offers a series of logical links? Causality is easier to commit to memory. Our brain would have less work to do in order to retain the information. The
size
is smaller. What is induction exactly? Induction is going from plenty of particulars to the general. It is very handy, as the general takes much less room in one’s memory than a collection of particulars. The effect of such compression is the reduction in the degree of detected randomness.

Pascal’s Wager

I conclude with the exposition of my own method of dealing with the problem of induction. The philosopher Pascal proclaimed that the optimal strategy for humans is to believe in the existence of God. For if God exists, then the believer would be rewarded. If he does not exist, the believer would have nothing to lose. Accordingly, we need to accept the asymmetry in knowledge; there are situations in which using statistics and econometrics can be useful. But I do not want my life to depend on it.

Like Pascal, I will therefore state the following argument. If the science of statistics can benefit me in anything, I will use it. If it poses a threat, then I will not. I want to take the best of what the past can give me without its dangers. Accordingly, I will use statistics and inductive methods to make aggressive bets, but I will not use them to manage my risks and exposure. Surprisingly, all the surviving traders I know seem to have done the same. They trade on ideas based on some observation (that includes past history) but, like the Popperian scientists, they make sure that the costs of being wrong are limited (and their probability is not derived from past data). Unlike Carlos and John, they know before getting involved in the trading strategy which events would prove their conjecture wrong and allow for it (recall that Carlos and John used past history both to make their bets and to measure their risk). They would then terminate their trade. This is called a
stop loss,
a predetermined exit point, a protection from the black swan. I find it rarely practiced.

THANK YOU, SOLON

Finally, I have to confess that upon finishing my writing of Part I, that writing about the genius of Solon’s insight has carried an extreme effect on both my thinking and my private life. The composition of Part I made me even more confident in my withdrawal from the media and my distancing myself from other members of the business community, mostly other investors and traders for whom I am developing more and more contempt. I believe that I cannot have power over myself as I have an ingrained desire to integrate among people and cultures and would end up resembling them; by withdrawing myself entirely I can have a better control of my fate. I am currently enjoying a thrill of the classics I have not felt since childhood. I am now thinking of the next step: to recreate a low-information, more deterministic ancient time, say in the nineteenth century, all the while benefiting from some of the technical gains (such as the Monte Carlo engine), all of the medical breakthroughs, and all the gains of social justice of our age. I would then have the best of everything. This is called evolution.