Our Fundamental Misunderstanding of Randomness

Having forged neural pathways in my efforts to “understand” complexity, in reading Nassim Taleb’s great book, “Fooled by randomness” and listening intently to, such as, Prof Andrew Lo, this whole issue has really come to fascinate me.

In considering potential applications for our (Ontonix) Complex Systems Management solutions the appreciation of the close relationship between risk, uncertainty and complexity became apparent pretty early on. I probably owe a debt of thanks to Donald Rumsfeld with all his “known knowns” and “known unknowns” mumbo jumbo…at least, at the time, it sounded like the ramblings of a man whose brain had gone into meltdown!

But when your thirst for knowledge touches areas like Systems theory, Complex Adaptive Systems, Chaos theory, Behavioural and Complexity Economics, etc. you really start to understand that no amount of eloquent math of PhD risk-modelling was ever going to form a sound basis for the sheer scale of the financial risks that the Banking sector, knowingly and recklessly took on! They weren’t fooling themselves or the Regulators and their Political masters.

They knew they were too big and too powerful to pay for their failure…but they fooled us…and, apparently, it isn’t really that difficult. Read on:

Humans are fascinated by randomness and yet we fundamentally misunderstand it. One misunderstanding is our belief in the hot hand–the intuition that a short run of consistent, but statistically independent, events is likely to continue. Another is our belief in the gamblers fallacy – the intuition that a short run of consistent events is likely to reverse. Although these two tendencies appear contradictory, they are often explained by the identical mechanism – the representativeness heuristic.

According to a recent study (abstract below), when observing streaks, people appear to make inferences about the characteristics of the agents generating them. For instance, people tend to predict that streaks generated by a non-random agent (such as a basketball player) will continue whereas those generated by a random agent will revert (such as a roulette wheel). When we see someone performing an action consistent with an intention to obtain a specific result (like shooting a three-pointer), we (erroneously) conclude that the person is skilfully guiding that action and therefore controlling the outcome.

From psychology today:

These authors tested this idea with a series of clever experiments and studies. In one experiment, people watched a video of someone flipping a coin. One group was told to focus on the intentions of the coin flipper to understand “what he is trying to accomplish with his tosses.” A second group was told to focus on his actions, “the specific movements of his hands and fingers.”

At various points, the groups made predictions for what the next coin flip would be. For one prediction, the previous 8 tosses involved a random-looking sequence of 4 heads and 4 tails. For a second prediction, 6 of the previous 8 tosses had been heads including a streak of 4 heads in a row. When the sequence was random, people in both groups predicted that the coin would come up heads about half the time. When the sequence ended with a streak, though, people who focused on the person’s intentions predicted that the coin would come up heads 68% of the time, while those who focused on the person’s actions predicted the coin would come up heads 28% of the time. That is, thinking about intentions led people to think the streak would continue, while thinking about the mechanism of the flip led people to think it would end.

In another study, people made predictions about stock prices. They were shown graphs of the performance of some stocks over a two-week period. The critical items in this study were graphs that had trends in the stock price. In one graph, the price of the stock went up consistently over the two week period. Another second graph had a decreasing trend. Participants were asked to predict the next day’s stock price. Unsurprisingly, people shown the increasing trend assumed that the stock would keep going up. People shown the decreasing trend assumed that the stock would keep going down.

However, the authors had participants complete a questionnaire about an individual difference in anthropomorphism. That is, some people have a tendency to give human traits and mental characteristics to inanimate objects, while others do not. Those people who were most likely to think that the stock market has a mind of its own were the ones who were most likely to think that the streak in stock prices would continue. Those people who were most likely to think that the stock market has no intentions were most likely to think that the streak in stock prices would end.

This last study has important implications. In daily life, we must often make predictions about what will happen in complex situations. It is important to recognize those situations in which we have a good causal understanding of the situation and know whether the data we observe are good predictors of future performance and those situations in which the most recent observations are just the outcome of a generally random process. In these situations, we must take some care not to ascribe intentions to processes that are really random.


People can appear inconsistent in their intuitions about sequences of repeated events. Sometimes people believe such sequences will continue (the ‘‘hot hand”), and sometimes people believe they will reverse (the ‘‘gambler’s fallacy”). These contradictory intuitions can be partly explained by considering the perceived intentionality of the agent generating the streak. The intuition that streaks will continue (reverse) should emerge in contexts involving agents that are perceived to be intentional (unintentional), and should be most common among those who are most inclined to attribute intentions to other agents. Four studies support these predictions, identifying both situational and dispositional determinants of the perceived continuity of streaks. Discussion focuses on the foundational nature of intentionality for perceptions of interdependence between events, the relationship between these findings and existing theoretical accounts, and the inverse possibility that people use perceptions of streakiness as a cue for an agent’s intentionality.

For more information, read the Psychology Today Article or the Complete Study.

If you like this article, you’ll probably like How Underdogs Can Win, Can You Lose on Purpose: The Role of Skill and Luck, and Three Common Mistakes on Mean Reversion. I also recommend reading Think Twice and More Than You Know.

Follow Farnam Street on Twitter.
Subscribe to Farnam Street by Email. A consistently interesting blog.

Enhanced by Zemanta

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s