Taleb on Mistakes that Market Traders can make

DS: What are the most common mistakes you see traders and risk managers making?

NT: As a trader, my job is to understand biases and trade on them. There are all kinds of biases. The most common is the small sample bias. Let's say you have 1:1,000 odds you will come home every day with a dollar and once in a while you lose $1,000. Many traders show very steady incomes but they could be fooling themselves because they don't have a long enough period to chart their performance. Their Sharpe ratio will not be indicative.

In option trading there is a similar bias. Short premium option traders, typically those who sell out-of-the-money options, are more likely to make money on a daily basis and then blow up. Likewise the yield hogs, those traders who would take any risk for a few basis points. You can fool yourself with your Sharpe ratios, and you can fool all of the financial engineers, but you can't fool an old Chicago trader who went bankrupt twice.

Another bias is what I call the size bias. If you have 20,000 traders in the market, sure enough you'll have someone who's been up every day for the past few years and will show you a beautiful P&L. If you put enough monkeys on typewriters, one of the monkeys will write the Iliad in ancient Greek. But would you bet any money that he's going to write the Odyssey next? You know that because of the sheer size of the sample, you're likely to find a lucky monkey once in a while. But the same applies to traders.

A third bias is the survival bias. Everybody will tell you that stock investing is a great idea because it's been back-tested by some serious guru and if you had bought one share of some stock during the Revolution you would now own the GNP of some banana republic. But you forget that your back-testing is only on stocks that are alive today and does not cover stocks in imperial Russia that a rational investor would have bought at the beginning of the century. Many continental stocks were recycled into wallpaper. When you look at markets you are only looking at the remnants, the parts that have survived. Or take real estate. People always say it goes up. But that works only if you always bought in places that became fancy.

Taken from Talebs interview to DS

This appeared in 1997. Wallstreet as well as regulators could have done well to pay heed to his rants.