There is an interesting book out by Nassim Nicholas Taleb called Fooled by Randomness, 2005, Random House (!!?), 2005, ISBN 0-8129-7521-9. To get right to the point, Taleb has combined cognitive science and statistics with finance.
There is nothing new about cognitive scientists using statistics. But there is something distinctly recent, at least, about finance people thinking about how cognitive science and statistics might be applied to how we approach investment thinking. I don’t mean the cookbook use of cognitive science in investments, rather, I mean how we think about investment risk. The theme of Taleb’s book is concerned with how we think about randomness.
The reader can form her/his own opinion about Taleb’s ideas. Speaking for myself, I am intrigued with his thesis that many “experts” in economics and investments are largely deluded when it comes to perceiving risk. Taleb suggests that validation of forecasting methods and the use of error estimation is generally lacking in investment trading. The cognitive connection applies to how investment traders think. Taleb suggests that there is a general lack of probabilisitic thinking.
Coming to grips with infrequent and unexpected outcomes (black swans) is one of the most befuddling and confusing challenges we all face. Our primate brains form elementary strategies for dealing with certain risks. We catch a glimse of a big carnivore in the brush and we run.
But what to do if we have a bundle of money in the market and some social or economic perturbation comes along? What will the market do if the Molybdenum prices skyrocket or if China invades Taiwan? Individuals and industries are concerned with the value of their investments over the course of positive and negative events. Stock traders need to act on clues so as to protect the value of their accounts.
Taleb laments the lack of probabilistic thinking in the investment community. He suggests that individuals and firms who are deemed as highly successful in investments are in reality just very lucky more frequently than we realize.
Even for hacks such as myself who gasped and sputtered through a few semesters of exposure to probabilistic concepts, i.e., quantum mechanics, radiation science, etc., sweeping the mind free of deterministic biases requires constant attention. How is some MBA derivatives specialist going to temper her/his enthusiasm to buy or sell when phantom patterns appear in the market? Good question.
