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Now that we’ve explored some of the ways in which randomness affects success and failure, we’ll start to examine our difficulty in understanding and anticipating it. In Part 2, we’ll explore three concepts that reflect this difficulty:
One reason we’re bad at assessing and preparing for risk and random events is that we are not good at learning from the past. We mistakenly believe that because something has never happened before, it can’t happen now. We then defend our lack of planning accordingly: “That had never happened before!”
A longer-term examination of history shows that rare events of all kinds do, indeed, happen. The very definition of a rare event is its unpredictability. History is littered with examples of events that never happened before. If history’s past brought surprises, why shouldn’t our own past do the same?
Even when we do remember a past rare event, we tend to falsely believe that we now understand the events that led up to it, and we therefore think we can “predict” it; that is, if it were to happen again, we wouldn’t be taken by surprise. We’d be more prepared for, and therefore less exposed to, any negative fallout from a similar rare event.
We also tend to falsely believe that mistakes of the past that led to these events have been resolved, making it even more unlikely that they would happen again. For example, people know that 1929 proved that stock markets can crash, but they often chalk that up to specific causes of that time. They believe, in other words, that the event is contained and non-repeatable.
We thus like to imagine that if we were to live through certain historical events, such as the stock market crash of 1929, we would recognize the signs and wouldn’t be taken by surprise in the way that people at the time were. This is the “hindsight bias,” otherwise known as the “I knew it all along” claim. However, seeing something clearly after the fact is much easier than seeing it clearly in real time.
In the same way, a manager taking over a trading department might do an analysis and find that only a small percentage of the trades made that past year were profitable. She might then point out that the solution is to simply make more of the profitable trades, and less of the losers. Unfortunately, such a statement of the obvious doesn’t provide any usable guidance for future trading decisions.
One reason it’s hard for us to understand the risk of rare events is that when we examine the past, we are looking at a specific set of events that actually did happen, while ignoring the possible events that might have happened. This points to a fundamental problem with inductive reasoning: While deductive reasoning tries to make sense of the world by coming up with a theory and then finding data to support it, inductive reasoning works in the opposite direction: You observe data, detect patterns, and formulate a theory based on those observations.