There are really only a few things you need to understand about probability and the stock market.
1. Stock markets are Complex, Emergent, and Adaptive Systems (CEAS). Which means no mathematical model on earth can predict them accurately all the time. Instead, the best you can do is think of the future in terms of probability. In my view, most economists would do better to study meteorology than econometrics.
2. There is an important difference between risk and uncertainty. The famed University of Chicago economist Frank Knight elucidated this idea (known as “Knightian uncertainty”), and it’s imperative for market forecasting. There’s “risk,” which can be computed, and “uncertainty,” which can’t be computed. For instance, you know the odds of flipping a coin: 50/50. This is quantifiable risk. But in events of much greater complexity, where the actual parameters or possible outcomes aren’t known, an actual understanding (in a mathematical way, anyway) isn’t possible. This is uncertainty. The degree to which you believe the market is “risky” or “uncertain” will drive a significant portion of your investing philosophy. (Most economists and stock analysts want to believe more in the “risk” part than the uncertainty part because that makes their jobs seem more relevant.)
This second notion in particular is a core idea at the heart of probability theory still hotly debated today. (I detail perspectives on risk and probability at length my book, 20/20 Money.)
In this spirit, four books on probability and randomness.
The Drunkard’s Walk: How Randomness Rules our Lives– Leonard Mlodinow
This is an excellent primer on probability, free of jargon and mathematical ornament. That’s important because in investing, it’s better to understand probability as a concept than as pure mathematics. Because of Knightian uncertainty (above), there really isn’t a lot you can put a definite number to--instead assigning possibilities often needs to be more qualitative.
A disappointment of this book is that it fails to really separate randomness and probability in a memorable way for the reader. This is a darn shame. Mr. Mlodinow at one point actually uses the phrase “the patterns of randomness.” Which is of course an oxymoron. Randomness, true randomness, has no pattern. And this is principally why stock markets are not purely random—they have patterns that don’t recur exactly the same every time, but often do. (Bulls, bears, panics, euphoria…you know the cycles by now.) But they have enough variance and false alarms, and there is such a general ignorance about market history, that most investors get thrown off the scent by greed and fear each time.
Drunkard’s Walk also integrates a bunch of neat behavioral psychology into the framework of probabilistic thinking. Errors like the “post hoc ergo prompter hoc fallacy” (because something happens afterward doesn't necessarily mean the former caused it) are common in life and in investing.
The discussion of stocks in this book is a few pages and very shallow—there is no consideration here of the particulars of stock market probability and randomness tied to the efficient market theory, which deserve far greater treatment if they are to be commented upon. This makes Drunkard’s Walk good for thinking about probability and how it affects your life generally, but not so good for investing.
Fooled By Randomness: The Hidden Role of Chance in Life and the Markets– Nassim Nicholas Taleb
I am so ambivalent about Mr. Taleb. His books are thought-provoking, eloquent and often smack-dab-right-on true. But I’ve never been on board with his investing strategies or constant doomsday forecasts.
That aside, this is the best book in recent memory on investing and probability. Mr. Taleb has a feistiness to his prose that is so engrossing, you’ll scarcely realize you’re reading about a very dry subject.
Where I believe Mr. Taleb is wrong is his total belief in randomness. He even goes so far as to describe the last 100 years’ rise in the stock market as “stochastic drift” and that all perceived cycles and patterns therein are nothing more than illusion. This can be debated among philosophers forever, but MarketMinder has long believed that at a minimum human psychology features semi-repeating patterns over time that manifest in market cycles.
A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (Revised Edition)– Burton G. Malkiel
Never have I met with such a bipolar book. The first half constitutes simply one of the finest explanations of how stock market efficiency works I’ve read. Malkiel understands this issue like few do and debunks a litany of common investing strategies, from charting and technical analysis to value investing and discounting dividends. The first half of this book is a tour de force in right thinking about the stock market and its ability to reflect widely known or believed information.
So I was profoundly confounded by the book’s second half, which ignores many of the first half’s natural conclusions. This part is the “practical” investment advice for “laypersons.” I find the advice to be neither practical nor executable for the general public. As Malkiel lays out each complex financial instrument and describes how much detailed analysis and work it takes to efficiently manage one’s own money, the strikingly (almost hilariously) obvious conclusion is that no layperson should be doing this on their own. The fees incurred by a competent money manager—whether they have a record of beating the market or not—clearly deliver value for the non-professional in simply navigating the territory.
As has been said in this space over and again—investing is not a game for geniuses, it’s about discipline. Those who make the most money over time are those who make the fewest errors. It’s not about being the smartest; it’s about not being dumb repeatedly. Everyone will make forecasting errors, but great managers at a minimum can deliver the market’s return over time—a feat most folks on their own cannot do. That much alone is a tremendous wealth builder.
Siddhartha– Hermann Hesse, Sherab Chodzin Kohn, trans.
Ok, forget about the math and the logic for a moment, and let's end things by thinking in terms of true human experience.
Herman Hesse’s Siddhartha is a book I read about once a year—a true classic, a quasi-biography of the Buddha story. (Note: It’s a rendering of the “story” of Buddha, which is archetypal. The actual historical person and his biography matter less than the story, which here is more or less repeated as fiction.) It’s a classic heroic adventure in the Joseph Campbellian arc and focuses on the life journey of seeking after “enlightenment.” What it ends up being is an adventure highlighting the importance of cultivating awareness and the integration of experience.
After many adventures, many futile attempts to gain enlightenment, Siddhartha returns to a river he encountered in his youth and finds that simply being with the river—observing it and paying it careful attention—yields the simple wisdom he’d sought all along.
A few weeks ago, I was rafting down the American River in Northern California with my dad and brother to celebrate Father’s Day, and I had all these books about randomness and probability on my mind. If you watch a river, even just for a short time, it becomes a near-perfect metaphor for the stock market and probability.
At any given time, in any given place, a trillion unique things are happening in a river, yet patterns are discernable—ultimately the waters flow in a similar way, yet no single water molecule will ever take precisely the same course. As you steer through the rapids, you have to think a couple moves ahead, you can’t truly control the river, just influence where you steer your raft; you have to go along for the ride in the right way—that's the job (this is basically what good money managers do). One minute the waters are calm, but rapids can be just around the corner. It sometimes looks like you'll careen into a rock if you keep on the current course, but that's often the place you want to be—the trend doesn't continue, and by the time you get there the water moved you to safety. And sometimes, completely unexpected things happen. Yet, the experienced and skilled guide gets you through every time, every river cycle, even if occasionally you get a little soaked.
I find most of those lessons to be true of the stock market. Specifically though, read Siddhartha for the joy of it and for one of life’s most important lessons: Don’t just seek after experience for thrill or adventure, seek to integrate experience in the project of self development. Experiences are as random as life without reflection.