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Overview

We all make mistakes by not recognizing the role of luck and random events in our lives. We use terms like “skills” when we should say “luck”. This is especially true for stock market investors, who are usually lucky idiots.

Some professions require skills in order to be successful. A plumber or a dentist needs to know what he’s doing in order to have a long career.

Unfortunately, the stock market is random and unskilled investors can easily produce great track records.

For example, if you have 10,000 investors who are relatively inexperienced (they only have a 45% chance of being profitable), then it’s basically better to invest based on the flip of a coin.

However, even if they are not good at it yet, after a few years of trading we can expect many of them to have been profitable. They would be praised for their exceptional skills and may claim that they have the perfect system for trading.

Of course, in the long run, people who are successful at random events will eventually lose their luck. For example, traders on Wall Street often have one bad quarter where they lose everything and go bankrupt.

Some people are successful at first, but their success is due to luck. It’s not because they’re great at what they do. We often mistake randomness and luck for skill and hard work.

Big Idea #1: We can never be sure any theory is right – things constantly change and the next observation may prove us wrong.

The basis of all science is induction, where we observe the world around us and infer things about it. We might see hundreds of white swans and assume that all swans are white, but this can be a mistake because seeing one black swan disproves our statement.

This is known as the problem of induction. A theory can never be proved right, only wrong (by a single “black swan”). Thus, theories are constantly being replaced by better ones.

The same mindset can be used to make good investments. Always consider the possibility that your assumptions may be wrong, and figure out how it would affect your portfolio. A person who ignores this advice saying “This has never happened before, so it won’t happen tomorrow either,” will likely see their portfolio affected one day.

We should not assume that the past will be a good sample of what the future holds. For example, swans might change colors in the future.

Yet, in the stock market, change is constant. If prices always rose on Mondays, rational investors would buy stocks on Sundays and eliminate that pattern. That shows that we can never be sure if a theory is right – things constantly change and the next observation may prove us wrong.

Big Idea #2: Life is unfair and non-linear: The best do not always win.

The general belief is that evolution usually leads to the survival of the fittest species. However, this applies only on average–a few unfit creatures survive as well. The same happens with certain things in life; for example, why does QWERTY exist as the standard keyboard layout?

Even though the QWERTY keyboard was not the optimal solution, it has prevailed. This is called a path dependent outcome: if we were to start from scratch again, we would not wind up with a QWERTY-keyboard. Similarly, even inadequate products may come to dominate the market if they pass a tipping point where enough people are using them and recommend them to others. For example Microsoft did this by creating positive feedback loops for their products when people started buying them because everyone else was already using them.

Non-linear events are hard to predict. We tend to think that if we add one grain of sand, the castle will not crumble. But in reality, a single addition can cause an entire castle to fall down.