The Good Years
Repeated success at buying market dips made Carlos feel that his judgment could not fail. Taleb uses the later reversal to illustrate the danger of treating a favorable market history as proof of skill.
THE IDEA
The Good Years
The reason Carlos had good years was not just because he bought emerging-market bonds and their value went up over the period. It was mostly because he also bought dips. He accumulated when prices experienced a momentary panic. The year 1997 would have been bad had he not added to his position after the dip in October that accompanied the false stock market crash that took place then. Overcoming these small reversals of fortune made him feel invincible. He could do no wrong. He believed that the economic intuition he was endowed with allowed him to make good trading decisions. After a market dip he would verify the fundamentals, and, if they remained sound, he would buy more of the security and lighten up as the market recovered. Looking back at the emerging-market bonds between the time Carlos started his involvement with these markets and his last bonus check in December 1997, one sees an upward sloping line, with occasional blips, such as the Mexican devaluation of 1995, followed by an extended rally. One can also see some occasional dips that turned out to be "excellent buying opportunities."
It was the summer of 1998 that undid Carlos—that last dip did not translate into a rally. His track record up to that point included just one bad quarter—but bad it was. He had earned for his bank close to $80 million cumulatively in his previous years. He lost $300 million in just one summer. What happened? When the market started dipping in June, his friendly sources informed him that the sell-off was merely the result of a "liquidation" by a New Jersey hedge fund run by a former Wharton professor. That fund specialized in mortgage securities and had just received instructions to wind down the overall inventory. The inventory included some Russian bonds, mostly because yield hogs, as these funds are known, engage in the activity of building a "diversified" portfolio of high-yielding securities.
When to use it
An investor who has had several profitable years might increase risk, failing to account for market conditions.
A trader who successfully bought dips in the past may assume all dips are buying opportunities, leading to losses when the trend changes.
An entrepreneur who experienced early success might become overconfident and ignore warning signs, risking the entire venture.
A gambler who wins several hands in a row may continue playing, believing they are on a hot streak, only to lose everything.
FROM THEORY TO EVERYDAY LIFE
In practice
Carlos's Trading Career
Carlos earned close to $80 million for his bank by buying emerging-market bonds and adding during dips. In summer 1998, the dip did not recover and he lost $300 million. His sources attributed the initial sell-off to a hedge fund’s liquidation, an explanation he heard after years in which dips had been followed by rallies.
A MOMENT TO REFLECT
Put it to work.
Have you ever attributed a series of successes to your own skill when external factors played a role?
How can you distinguish between a genuine skill-based edge and a period of favorable randomness?
What steps can you take to avoid overconfidence after a string of good outcomes?
CONTINUE THE CONVERSATION
Source texts
- Fooled by Randomness The Hidden Role of Chance in the Markets and in Life (Nassim Nicholas Taleb)