module two
Randomness | Luck | Skill
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There is a never-ending, huge amount of trading "literature", in research, books and on the internet.
This literature covers overwhelmingly some component of skillful analysis, portfolio construction, stock picking,
and closer to home, strategy development, back testing, risk management, psychology of trading, behavioural
finance, and 'fundamental' analysis of economic factors, impacting on market prices. Yet, the almost complete absence of a systematic exposition of randomness and especially, luck is noticeable in finance.
Fooled by Randomness
Nassim Taleb became famous for his book BLACK SWAN, The Impact of the Highly Improbable. As luck would have it, it was published on 17 April 2007, shortly before the GFC (Great Financial Crash). By September 2008 the global financial industry almost came to a standstill as no-one could trust their counter parties as one after another big firm either had to be bailed out or unexpectedly failed.
But years before (2001), his FOOLED BY RANDOMNESS, The Hidden Role of Chance in Life and the Markets.
was published. I was lucky to come across it shortly after its publication, just as my interest in trading beyond my own account gained momentum. It was eye-opening and hugely influential in shaping my views..
In Fooled by Randomness, Nassim Taleb explores how randomness and luck play significant roles in shaping
outcomes, particularly in financial markets and life in general. He argues that people often mistake random events
for patterns and overestimate their own skill, attributing success to their abilities rather than luck.
Taleb emphasizes that luck can lead to success in the short term, but it's often mistaken for talent, leading to
overconfidence. He warns that those who thrive by luck are vulnerable when randomness turns against them,
highlighting the need to understand and respect the role of chance in decision-making.
Randomness in FX
The relevance for what we do should be very obvious. I want to bring this closer to home: Randomness of price changes increase the shorter the time of measurement. This should be common sense. Just think about price changes in all the typical trading time frames, daily, 4-hour, 60 minutes, 15 minutes, 5 minutes and even 1 minute and tick data. I have coined the following practical definition:
In short term and very short term currency trading prices are random with respect to the direction, duration
and extent of the very next price change or series of price changes in a particular time interval.
With respect to the luck - skill inter play much more luck is involved when a trading strategy does not allow
for discretionary decision-making between the opening and closing of a trade, either for a profit or a loss,
than in the case where it does and a skillful discretionary decision can be made to impact the outcome of
the trade.
The Success Equation
Another book that had a big impact on my views on this topic was written by an experienced investing professional, Mark Mauboussin, called The Success Equation, Untangling SKILL and LUCK in Business,
Sport and Investing.
Here follows a few quotes from Mauboussin, explaining skill and luck:
“Much of what we experience in life results from a combination of skill and luck .… Different levels of skill and
of good and bad luck are the realities that shape our lives .… yet we aren’t very good at distinguishing the two.”
“… understand the relative contributions of skill and luck and how to use that understanding in interpreting past
results as well as making better decisions in the future. Ultimately, untangling skill and luck helps with the
challenging task of prediction, and better predictions lead to greater success.”
“Untangling skill and luck is an inherently tricky exercise, and there are plenty of limitations, including the quality
of the data, the sizes of samples, and the fluidity of the activities under study. The argument here is not that you
can precisely measure the contributions of skill and luck to any success or failure. But if you take concrete steps
toward attempting to measure those relative contributions, you will make better decisions than people who
think improperly about those issues or who don’t think about them at all. That will give you an enormous
advantage over them.”
Luck
“Luck is a chance occurrence that affects a person or a group. Luck can be good or bad. Furthermore, if it is
reasonable to assume that another outcome was possible, then a certain amount of luck is involved. In this
sense luck is out of one’s control and unpredictable.”
Luck and Randomness
“Randomness and luck are related, but there is a useful distinction between the two. You can think of
randomness as operating at the level of a system and luck operating at the level of an individual."
Skill
The dictionary defines skill as the “ability to use one’s knowledge effectively and readily in execution or performance.
Skill and Luck
“Some activities allow little luck, such as running races and playing the violin or chess. In these cases, you
acquire skill through deliberate practice of physical or cognitive tasks. Other activities incorporate a large
dose of luck. Examples include poker and investing. [DdT – And investing’s sibling “Trading.”]
In these cases, skill is best defined as a process of making decisions".
"The distinction between activities in which luck plays a small role and activities in which luck plays a large
role:
The Luck - Skill Continuum
In the figure, on the right hand extreme you find elements such as chess that rely purely on skill. On the far left extreme you find activities like roulette and the lottery – luck only. But as Mauboussin says:
“Most of the interesting stuff in life happens between these extremes.” (p. 23) “… having some sense of where an activity falls on the continuum is of great value.”
The combination of luck and skill play an important role in many endeavours, like trading.
Take for instance the matter of “sample size”.
"If you have an activity where the results are nearly all skill, you don’t need a large sample to draw reasonable
conclusions. A world-class sprinter will beat an amateur every time, and it doesn’t take a long time to figure that out.
But as you move left on the continuum between skill and luck, you need an ever-larger sample to understand
the contributions of skill (the causal factors) and luck.”
Also consider "past performance".
"On the skill side of the continuum, feedback is clear and accurate, because there is a close relationship between
cause and effect. Feedback on the luck side is often misleading because cause and effect are poorly correlated in
the short run. Good decisions can lead to failure and bad decisions can lead to success. Further, many of the
activities that involve lots of luck have changing characteristics. The stock market is a great example.
What worked in the past may not work in the future."
Lastly, the matter of "reversion to the mean".
Any activity that combines skill and luck will eventually revert to the mean. This means that you should expect
a result that is above or below average to be followed by one that is closer to the average .… The important point
is that the expected rate of reversion to the mean is a function of the relative contributions of skill and luck to a
particular event. If what happens is mostly the result of skill, then reversion toward the mean is scant and slow.
If the outcome is mostly due to luck, reversion to the mean will be pronounced and quick.
Summary
As you can see from the above, many factors come into play when considering the role of both skill and luck in short-term trading. To summarize:
In short-term currency and CFD trading, subtle forces such as institutional trading, algorithmic trading, and cross-market dynamics contribute to the unpredictability and randomness of the market. Institutional traders often execute large orders without significantly moving the market, which creates volatility and variance on an intra-day or intra-week basis. Algorithmic trading can amplify these fluctuations by reacting to micro-level price movements, while correlations and non-correlations between different markets impact liquidity and price action. These factors blur the line between skill and luck, making it difficult to achieve consistent short-term outcomes, even for highly skilled traders.
We must accept that luck plays a role and recognize that anyone can be lucky or unlucky at any given time. In skill-dominant activities like chess or sprinting, skill is developed through deliberate practice. However, in luck-dominant activities like short-term trading, the associated "skill" is more about making sound decisions.
When luck has little influence a good process will always have a good outcome.
When a more luck is involved, a good process will have a good outcome, but only over time.
In trading, the dynamics of luck and skill are shaped by factors such as past performance (with sufficient relevant data), mean reversion principles, and cause-and-effect correlations.
Failing to acknowledge the role of luck and not fully understanding what trading skill truly entails is at the root of many unsuccessful attempts to profit from trading. To change this, we need to flip our thinking about these concepts and their impact on our approach as short-term traders.