This article is the second part of the story of two very different traders: one is aware of the power of random events, and the other believes he is an investing superstar on Wall Street.
So if you haven’t read the first part, read it before you go on, so that you don’t miss the context of the story.
Read part 1 of the article here.
This story is taken, and heavily modified, from Nassim Taleb’s book Fooled by Randomness (published in Spanish as ¿Existe la suerte?), a highly recommended book for anyone who wants to understand the traps of chance.
John, the successful investor who ignores the power of randomness and luck
Opposite Nero’s modest house lived John, a successful trader, a Wall Street superstar. Anyone could see at a glance that John was doing much better than Nero, or at least he made sure everyone saw it.
While Nero lived in a very modest house, John lived in a huge house with every kind of luxury.
Nero drove a Volkswagen Cabriolet that was more than 10 years old, while John had two high-end cars parked outside his door, one of them a collector’s Ferrari, and there was talk of exotic trips to exclusive places where he often went on holiday with his wife.
John represented everything Nero was not, and didn’t want to be either. At least not until then.
Nero had fulfilled all his dreams: substantial wealth, a house more than suited to his needs, a family, and a well-paid job that gave him plenty of free time to enjoy himself. But when John arrived in the neighbourhood, Nero started to wonder whether he had missed some opportunity on Wall Street because of his personality and the way he invested.
To any outsider looking at the situation, John would be considered more successful than Nero, and even a better trader.
And it is hard not to give in to the social pressure that says if your neighbour has more, it’s because he is better and smarter than you, especially when both neighbours work in the same industry.
A yokel who makes a lot of money
But after several encounters between the neighbours, Nero would eventually describe his rich and successful neighbour as “a yokel with a high income”.
And of course, as Gordon Gekko said, a yokel, or a fool, and his money don’t stay together for long.
For all the reasons mentioned above, Nero was much smarter than John, and his analytical skills and knowledge of the stock market and of randomness were far superior to John’s.
Nero knew this, and he knew that it was only a matter of time before someone like John “blew up” as a trader. So it was only a matter of time before Nero lost sight of John as a neighbour.
Nero’s analysis was very simple. After several conversations with his neighbour John, and seeing that he was really just a yokel with some financial knowledge and a spendthrift personality, he knew that if John was making those huge amounts of money that let him live like a multimillionaire, it was only because he was taking on hidden risks that were far too high. Risks John couldn’t see at the time because he hadn’t been trading in the financial markets for long.
Put simply, John hadn’t seen what Nero had already seen over his career. Let’s just say Nero had already seen plenty of Johns “blow up”.
Probability and randomness in the financial markets
When a trader is riding a wave of profits, it is very hard for him to stop and look at the history of other traders. And certainly, don’t talk about luck to someone who currently believes he is a genius.
How can a yokel make so much money?
Traders need to know about “probabilistic possibilities”, that is, calculating the probability that rare or random events will occur. “What does a yokel know about that?” is the question Nero asks himself.
Most traders use quantitative tools that give them probabilities, and Nero disagrees with the results these widely used methods produce.
He puts it like this:
“The high-return market is like taking a nap on the railway tracks. One afternoon, an unexpected train runs you over. You make a lot of money for months or years, and that train makes you lose a multiple of your accumulated return in just a few hours.
One day you are trading on the exchange, and the next you are being escorted off the trading floor by security guards so that you don’t make a scene. And no one ever sees you in the markets again.”
Nero has seen this happen more than once, and in John he sees a high probability that it will happen.
The main differences between Nero and John
John’s huge house is on loan, while Nero’s modest house, with its more than 4,000 books, is entirely his own.
If John blew up, he would have to look for a job where he probably couldn’t afford to keep paying the mortgage on the house and those trips to exotic places.
Nero could blow up and not lose his house, but the main difference is that Nero can’t blow up, because his investing is designed to withstand anything that might happen in the market. Let’s say he has already factored in the random element of any kind of event and allowed for it in his plan.
However young and successful you are, never ignore the advice of someone who has more years and more experience than you.
John thought Nero was a loser. In fact, he called him a “second-rate trader” and said traders like him were dying out. “They think they’re smarter than everyone else, but they’re past it.”
Incidentally, we can see something similar right now. You listen to young people who are just starting out in investing, and when they talk about investors like Warren Buffett, they tell you these old men are already obsolete. We have kids of 20 to 25 who have barely gone half a round in investing, putting their money into highly speculative products, and they are already intellectually ahead of Warren Buffett’s more than 70 years of investing experience. These young people show real promise.
See also: The most common and serious mistakes people make when investing in the stock market
And in the end John was fired
One morning in September 1998, Nero went out into his garden and saw John without his suit on. His arrogance had vanished. He even looked like a humble person. Nero knew what had happened just by looking at him. But it had been even worse.
John had not only been fired: he had lost everything he had.
At that moment, Nero didn’t rejoice at his neighbour’s fate, but he was glad he had stayed true to his investment strategy for so many years and had not given in to showing off his wealth to prove to people that he was smarter than his neighbour.
Benjamin Graham described this kind of situation rather well: “Only when the tide goes out do you discover who’s been swimming naked.”
Here the tide went out, and it became clear that Nero, despite earning less money, was a much smarter trader and investor than his neighbour, who, when all was said and done, was just a show-off unaware that random events can take away what you have if your strategy doesn’t factor luck into your skills.
“A lucky idiot doesn’t have the slightest suspicion that he may be a lucky idiot. Otherwise, he wouldn’t be such an idiot. They will never admit that luck may have played a part in their achievements.”
My personal view on stock market investing, returns, chance and show-offs
Those who know me already know that I have always approached personal finance and stock market investing from a common-sense point of view, based on quite a few years of my own experience and the experiences of all kinds of investors, big and small.
Ever since I started writing online, I have been “on a crusade” against investing methods that promise to make you rich quickly. I have criticised trading on more than one occasion, because with the data in hand we can say today that you are not going to make a living from trading while travelling the world, unless you sell trading courses or trading training.
See also: Warren Buffett’s annual letter: what can you learn from my real estate investments?
On the other hand, if you stop listening to the nonsense of the trading snake-oil sellers with their miracle methods for instant wealth, the sooner you can start using the financial markets the right way, the way recommended by the people who really know this business, even if some say they are out of date.
The long term was, and will remain, the most profitable way to invest
Let me just say that we shouldn’t overcomplicate stock market investing, because it is actually simpler than people want to sell you. Earning a 10 or 12 percent return a year may not seem like much to you, especially when there are people telling you that you can make 50% a year, or even 1,000% a year.
But the curious thing, and this is something I have been able to confirm over the years, is that the show-offs who promise you can earn these astronomical returns turn out, over a 10-year period, not to have achieved an average annual return even of the 12% they look down on so much.
You just need to understand that choosing a good moment to enter the markets, with a good margin of safety in your investment, is a good start. Diversifying your investment across a few solid companies, preferably ones that pay good dividends, is a good next step. In fact, you can choose a dividend investing strategy.
And if you don’t want to complicate things, you can buy a whole index through index funds or ETFs and apply the DCA strategy. We covered all of this when we talked about the investment strategy a young person without much money should follow.
And always remember that the stock market is not a game. Nor is it there to make you rich by treating it like a casino, because that way you will lose. The stock market is there to multiply your wealth. It is there for you to keep putting in part of the money you earn from your main activity.
Forget this and you are very likely to end up with serious problems in your finances.
See also: 14 things you should know before you start investing in the stock market
Featured image: Train approaching Dawlish by Philip Halling, CC BY-SA 2.0, via Wikimedia Commons.
