Niccolo Machiavelli’s “The Prince”: Luck, Randomness and the Financial Markets.
Looking at several excerpts from chapter 25 of Machiavelli’s letter to Lorenzo de’ Medici written in 1513, it is interesting to note that a large portion of this particular chapter is particularly relevant to investment management. It seems that ideas that were once known and respected have since been forgotten or largely ignored; modern day investors would be wise to revisit Machiavelli’s prescient advice on luck and randomness and the implications for financial markets.
The chapter begins with the idea one must understand the overwhelming effect of luck on life events, and by extension, the financial markets:
Nevertheless, since our free will must not be denied, I estimate that even if fortune is the arbiter of half our actions, she still allows us to control the other half, or thereabouts. I compare fortune to one of those torrential rivers which, when enraged, inundates the lowlands, tears down trees and buildings, and washes out the land on one bank to deposit it on the other. Everyone flees before it; everyone yields to its assaults without being able to offer any resistance.
Machiavelli’s opening words are even more relevant today, as the complex world of finance is highly influenced by randomness, yet few people realize the impact of luck on business or investment performance. Because of the overwhelmingly large sample size (number of fund managers or investors), it is inevitable, based on randomness alone, that during our lifetime we will encounter someone like Warren Buffet. With that in mind, it is easy to see that “the number of managers with great track records in a given market depends far more on the number of people who started in the investment business (in place of going to dental school), rather than on their ability to produce profits”.
In the next line, Machiavelli alludes to some of the phenomena that we often witness in the financial industry; here, we can replace “prince” with “investor” (or hedge fund, etc.), “safely in power” with “outperforming”, and finally, “overthrown” with “blow-up”.
But limiting myself to particulars, I would like to point out why it is that we see a prince safely in power on one day and overthrown the next, though there has been no change in his character or behavior.
Some examples that come to mind here are high-flying hedge fund stars like Julian Robertson (who turned $8 million in start-up capital in 1980 into over $22 billion in the late 1990s, and subsequently blew up in 2000) and Victor Neiderhoffer (who after years of superb performance had to mortgage his house after his fund blew up), as well as LTCM. Machiavelli then goes on to explain the reason for this phenomenon:
This derives first of all, I think, from that fact that a prince who relies entirely upon fortune will fail when his fortune changes. It also derives, I think, from the fact that a prince is successful when he fits his mode of proceeding to the times, and is unsuccessful when his mode of proceeding is no longer in tune with them.
Performance in financial markets is heavily influenced by factors such as sample size (as mentioned above) survivorship bias (we only look at the successes). Because of the effect these factors, it is impossible to determine (based on performance alone, at least) whether skill or luck is the driving force.
The next passage is particularly relevant as it relates to the different methods of investing that are employed by the various market participants::
We note that men pursue the ends they have in view, that is, glory and wealth, by different ways. One uses caution while another is impetuous, one resorts to violence while another relies on craft, one acts patiently while another does the contrary; and each reaches his goal by a different route. We also note that of two men who employ caution one will gain his objective while the other will not, or that both will gain their objectives by different means, one by being cautious, the other by being impetuous.
The prior passage alludes to the fact that the outcome (in this case investment performance) does not necessarily validate the methods (investment strategy) employed to arrive at that outcome. The reason for this is as follows:
The case of this is nothing other than the character of the times to which these modes of conduct may or may not be suited. It is this, as I have said that explains how tow men using different methods will achieve the same results, and two others using similar methods will achieve contrary results – the one succeeding, the other failing.
In short, many investors “never considered that the fact that trading on economic variables has worked in the past may have been merely coincidental, or, perhaps even worse that economic analysis was fit to past events to make the random element in it.” This generally occurs because the markets produce a vast amount of noise (random, short-term price/level movements that do not contribute to the overall long-term trend) that is often mistaken by market participants for information. Aside from the coincidental benefit of favorable returns, luck can also entail the temporary avoidance of a particular risk. In the case of LTCM (mentioned above), luck was the only reason that the fund did not blow up sooner than it did; many investors reap profits for years by taking on huge unseen risks, and are wiped out when their luck runs out and they experience a “black swan” event. The next passage elaborates upon this idea:
This also explains the inconsistency of prosperity. If one is cautious and patient in his method of proceeding and the times lend themselves to this kind of policy, he will prosper. But if the times and circumstances change, he will fail, for he will not alter his policy […] because having prospered in pursuing a particular method, he will not be persuaded to depart from it. Hence, when the times require it, the cautious man will not know how to act impetuously and he will be overthrown. If he were able to adapt his nature to changing times and circumstances, however, his fortunes would not change.
Because the lucky investor does not realize that he is lucky when things are going well, he will be caught off guard and suffer massive losses when his fortuitous circumstances change. (The adjectives cautious and impetuous in this case should not be taken literally, but instead serve as describing any two opposing methods or styles of investing.) Because he is ignorant of his luck (instead, attributing his success to skill), he will not change his methods when it becomes necessary to do so. One example of this is the fate of many internet start-up companies and their owners during the tech bubble; as the bubble pushed the valuations of these essentially worthless companies to their peak, many prudent entrepreneurs, realizing their serendipitous circumstances, sold their companies before their “value” evaporated. Others – attributing the success of their companies to their sheer entrepreneurial skill – continued to own and operate their businesses and were wiped out as their luck suddenly changed when the tech bubble finally burst. Machiavelli makes the point that the impact of luck, or more specifically bad luck, is most severe on the unprepared:
[..]The same can be said about fortune, which tends to show her strength where no resources are employed to check her. She turns her course toward those points where she knows there are no levees or dikes to restrain her.
Finally, Machiavelli offers his advice on how to operate, and perhaps succeed, in this type of randomness-prone environment:
Therefore, since fortune changes while human beings remain constant in their methods of conduct, I conclude that men will succeed so long as method and fortune are in harmony and they will fail when these are no longer in harmony. But I surely think that it is better to be impetuous that to be cautious, for fortune is a woman and in order to be mastered she must be jogged and beaten. And it may be noted that she submits more readily to boldness than to cold calculation.
(It should be noted that impetuous is used here as “moving with great force and energy” and not in its more common usage as “done without though as a reaction to an emotion or impulse”. Conversely, cautious is taken to mean “timid” or otherwise weak.) This concluding passage offers timeless advice to market participants: traders and investors must incessantly question their methods and beliefs – especially when things are going well. During periods of strong performance, it is easy to be lulled into a sense of false security, unquestioningly attributing success to an inherent skill. However, unless we continually and aggressively (or impetuously) test our methods and allow for the idea that some (or all) of our success can be the result of luck, we will be setting ourselves up for a huge loss if, and when, our fortunes change.
November 19, 2008
Large numbers – which did not play as big of a role in the prehistoric era – do not elicit the same emotional response that images and descriptive words do, and as such, “concrete words – apple, car, gun – do better in our memories than abstractions like numbers.” Paradoxically, a vividly detailed news story about one specific dying child will elicit a stronger emotional response from viewers than a purely factual, non-descriptive report about the death of 300,000 people in an earthquake. The reason statistics evoke less emotional response than images and words is because the human mind – which, as mentioned above, evolved into its current state well before the advent of advanced mathematics – is ill-equipped to deal with large numbers and complex probabilities. (In fact, to fully grasp the concept of a large number, we must often evoke an image – it is much easier to comprehend a distance of 500 yards if you imagine five football fields back-to-back).
November 19, 2008
“Fear means more newspapers sold and higher ratings, so the dramatic, the frightening, the emotional, and the worst case are brought to the fore while anything that would suggest the truth is not so exciting and alarming is played down or ignored completely”.
– Daniel Gardner, The Science of Fear
In the current economic environment, it is difficult to ignore the gloomy forecasts offered up by newspapers, financial websites and television “experts”. Each day, we as readers and viewers are inundated with stories that predict the Dow will fall to 4000, or that the world economy will fall into a deep and prolonged recession, or worse, a depression. Each day, new predictions about the outcome of the current global economic crisis – each more elaborate than the next – are presented in the pages of the WSJ and discussed on CNBC. However, it is important to keep in mind that the media industry profits by a) sensationalizing rare and extreme events and b) by constructing equally extreme and misleading predictions. Emotionally stimulating stories and images – such as Great Depression-era footage showing long lines outside of unemployment offices – grab our attention far more effectively than realistic scenarios based on less exciting, but more accurate, statistics.
The prehistoric mind
We tend to respond to vivid images and storytelling much better than numbers and probabilities because of evolution. As complex as it is, the human brain was formed approximately 150,000-200,000 years ago, and was mostly shaped and transformed into its current form during the “Old Stone Age”. Needless to say, most of this time was spent hunting and gathering, and not making economic forecasts or engaging in other activities that dealt with complex numbers and statistics. As it evolved, the brain developed cognitive processes (essentially rules of thumb which the brain uses to quickly process information) that helped man survive the day-to-day dangers of the prehistoric world. As the world became increasingly complex, some of these rules of thumb became less useful and increasingly misleading. As a result, most people today exhibit what psychologists call “cognitive biases” – an inherent tendency to make errors in judgment when processing information. We exhibit two specific cognitive biases that make us particularly susceptible to the extreme-but-unlikely predictions and forecasts made by financial journalists and reporters.
The cognitive bias called the “representativeness heuristic” leads us to believe that a combination of two plausible (in our view) scenarios that are causally linked are more likely than either scenario in isolation. For example, an investor may assign a higher probability to the scenario of a company going bankrupt as a result of the discovery of accounting irregularities (given A, accounting irregularities, then B, bankruptcy) than to the probability of a company going bankrupt because of an unspecified event (B occurs as a result of A, C, D…). This does not make logical sense, because the second scenario allows for many things to cause the company to go bankrupt – including accounting inconsistencies – and therefore should carry a significantly higher probability. Paradoxically, the most convincing predictions are those that the most elaborate, which as we have shown, are logically the least likely to come true.
Possible but unlikely
Another cognitive bias, the “availability heuristic”, leads us to believe that unlikely scenarios are more probable than they really are. This bias predisposes us to believe that events that we can recall easily are more likely to happen than events that are difficult to recall. It is easy to see how this bias could, for example, lead borrowers and lenders to underestimate the likelihood of declining house prices; home values had never previously fallen (at least not since record-keeping began), so it was very difficult to assign a realistic probability to this event occurring. More interestingly, “it is not even the number of examples that are recalled; it is how easily examples come to mind”. So even though we can think of only one major depression in the United States (i.e. the Great Depression), because we are easily able to recall this event (because of incessant references by journalists), we are likely to believe that the chances of it happening today are much higher than they really are.
Predicting the past
It is easy, then, to see how financial news reporting can greatly skew investors’ perception of the world. Scenarios depicting economic collapse capture the attention of viewers, so the financial media outlets have an incentive to come up with the most unlikely scenarios imaginable. Studies have shown  that “the media adore bad news, so journalists often – contrary to the advice of the old song – accentuate the negative and eliminate the positive.” The fact that most people will tend to seek out more information (which is most easily accessed through newspapers and television) during times of crisis further compounds the problem. After increased exposure to various emotionally stimulating news stories, it is difficult even for well-informed investors to override the effect of cognitive biases on their perception of reality. It is easy to see how periods such as the current economic crisis can create a negative feedback loop: shocking news reports effectively scare viewers, causing them (the viewers) to seek out more information (by watching more news reports), which, in turn, scare them even more, and so on. Another element that makes the current economic environment seem very negative, and the future very bleak and uncertain, is the effect of yet another cognitive affect called “hindsight bias”. This is the illusion that situations encountered in the past were never as difficult as those in the present. Because we are able to look back at past events with the knowledge of how everything eventually turned out, it makes the past appear more predicable, and the outcome more likely. “Simply put, history is an optical illusion: The past always appears more certain than it was, and that makes the future feel more uncertain – and therefore frightening – than ever.”
 Gardner, Daniel. The Science of Fear. Penguin Group, 2008 p.23
 Gardner, Daniel. The Science of Fear. Penguin Group, 2008 p22
 Gardner, Daniel. The Science of Fear. Penguin Group, 2008
 Sullivan, Rodney N. “Taming Global Village Risk”, The Journal of Portfolio Management, Summer 2008. p59-67
 Gardner, Daniel. The Science of Fear. Penguin Group, 2008 p41
 Gardner, Daniel. The Science of Fear. Penguin Group, 2008 p 47
 Gardner, Daniel. The Science of Fear. Penguin Group, 2008 p 47, paragraph 6
 Gardner, Daniel. The Science of Fear. Penguin Group, 2008 p 172,173
 Gardner, Daniel. The Science of Fear. Penguin Group, 2008 p 172 paragraph 4
 Gardner, Daniel. The Science of Fear. Penguin Group, 2008 p 297
 Taleb, Nassim N. The Black Swan: The Impact of the Highly Improbable. New York: Random House, 2007.
 Gardner, Daniel. The Science of Fear. Penguin Group, 2008 p298, paragraph 1