Swan Song
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Swan Song
First he was very famous, now he's very rich. But Nassim Taleb is still wrong.
By Mark Gimein
Posted Monday, June 15, 2009 - 2:16pm
Well, maybe. Or maybe they just think that you're steadily losing money. Taleb's basic trading insight was that he could buy "deep out of the money" options that would pay off in a dramatic market fall. Most of the time, such options expire worthless. But in a market crash, they deliver a big payoff. In effect, Taleb's strategy has been to buy insurance, reasoning that folks underestimated the likelihood of catastrophic events. It's a lot like buying $200,000 of insurance on a $150,000 house. If it burns down, you've made money. Taleb's idea was that this insurance was underpriced.
The problem with catastrophism, however, is that it's very difficult for anyone in the market to wait around for the unexpected. And while Taleb buys insurance, most other market players prefer to sell it. In the New Yorker profile that first brought Taleb to prominence, Malcolm Gladwell cannily contrasts Taleb with Victor Niederhoffer, a hedge-fund manager whose stock in trade was selling the same kinds of options that Taleb bought. At the end of Gladwell's story, Niederhoffer loses a lot of money. It's a pattern that Niederhoffer repeats over and over—a later story about him christens him "The Blow-Up Artist."
By this point, what's wrong with the Niederhoffer approach has become abundantly clear. Offering insurance without knowing the odds is a strategy that is prone to blowing up in spectacular ways. It doesn't matter whether the instruments involved are options or credit-default swaps (which are literally insurance against defaults on corporate bonds) or any of the other tools of finance. In the worst case, you wind up with Niederhoffer—or AIG (AIG).
But the failures of the Niederhoffers and AIGs do not translate to a validation of Taleb-style catastrophism because these two approaches turn out to be linked. They are mirror images. In noncatastrophic times, the Niederhoffers and AIGs make money consistently and quietly and then end up losing it conspicuously and painfully. The Talebs make money rarely, amaze everyone because they do it when everybody else is getting killed—and so make it easy to forget about years of steady losses. Over the long run, the anti-catastrophists often do fairly well (if they don't get too greedy and make bets that cost them all their money in even a small market drop). But it is the catastrophists, a la Taleb, who look smarter. If you're always planning for crisis, you look like a genius when it does come.
Arguing against Taleb is a little embarrassing; who among us wants to side with the plodders when for the price of a paperback you can join the elect? But the experience of the markets here is important because it shows that neither consistently discounting the chance of unforeseen risks, as AIG did with such gusto, nor betting day after day on unforeseen catastrophes is a reliable way to make money.
In his books Taleb presents a wealth of examples of how prone we are to discount the unexpected and unlikely, but what is notably missing from The Black Swan are examples of just how likely we are to overestimate the chances of unlikely events when they are presented to us under a spotlight. Taleb is, of course, right that we fail to anticipate what we are not looking for. But we also overanticipate when we are looking too hard for the outliers. Lottery players overvalue their chances of winning $10 million, and horse bettors put too much money on 100-1 long shots. People who watch the local news too avidly believe there is a child kidnapper around every corner, and followers of Taleb assume that every time they pass a dark alley, catastrophe is about to pop out with a bloody knife.
Photograph by Carsten Koall/Getty Images.
Comments
The trouble with Talib's strategy
Taleb's strategy is reasonably obvious, which he admits. He buys options that are way out of the money and hopes for volatility. His theory, which someone needs to run the data to check, is that options far out of the money are significantly underpriced. The players who price options based on a normal (Gaussian) distribution based on the Black-Scholes model of market behavior will, Taleb claims, systematically underprice options far out on the curve. His strategy exploits this. Whether that's a correct analysis is tough to check, because you have to look at decades of data to see enough outlier events, i.e. big crashes. As Talib admits, his funds bleed in boring years, then make money during crashes. There's another problem. If you buy options that are way out of the money at a low price, can your counterparty pay up if the unlikely event happens? The AIG fiasco, the CDO market collapse, and further back,"portfolio insurance", indicates that the answer is sometimes "no".
He's got a point
I haven't read “The Black Swan” but from the discussion it is clear that the book is about"The Impact of the Highly Improbable." When everyone else's fortunes have shrunk, Taleb's have risen. The Wall Street Journal report also showed that Universa, a hedge fund for which Taleb serves as guru and adviser, gained more than 100 percent last year and now holds $6 billion. This proves that he has got a point here.
Needed info
Enjoyed reading your piece on Taleb. While I'm a big fan of his books (which are more philosophy books than anything) and generally subscribe to his views, it's always good to hear the other side. The question left unanswered by your piece, however, is just how badly did he do in the down years? If he went up 60 percent in 2000 and 100 percent just last year then he could theoretically have decades of small declines and still be well ahead of the historical average. He has always described his strategy as being willing to lose pennies at a time. I would guess since he shuttered the first hedge fund that the losses were pretty bad (maybe dimes and quarters), but still, it would have helped to know. Is that data not public? Is there not an investor available to leak a few reports?
Bleed or Blowup
Here is Taleb's academic article on the idea behind his trading strat. http://www.fooledbyrandomness.com/bleedblowup.pdf Mr. Gimein seems not to be able to understand this simple concept very well. But I think Taleb could run the risk of being a victim of his own theory, in that the market can stay irrational longer than you can stay solvent. Got to gamble somehow though.
Real life
The subject of Taleb is simple: real life can't be modelled. Suckers think it can. Don't be a sucker. In other news, registering for this site is like trying to crack a Defense Dept computer. It's only a blog. Get over yourself.
nassim
Nassim is famous because he cloaks intent with a veil of plausible deniability. He not only provides an alibi for those who profited, but his concept of randomness makes victims more likely to give up and not look too hard for answers.
Envy
It sounds like envy to me.... Taleb was not outstanding during the "normal" periods of market activity, nor was I. My returns prior to 1987, 2000 and 2008 were somewhat average. Not a shining star and many times ridiculed and scorned by many of my peers. I even had a few of my clients whom I was advising drop me in and guess what, they went with Madoff. Imagine that...... after all the money I made for them during the dot-com bust, they called me an idiot and took their money to a genius. I am happy for them. The message that NNT sends is..... "Go ahead and cross the quiet intersection, just don't do it with a blind fold on..." Pretty simple stuff, if you ask me, quite similar to the advice that my grandmother would give... Best regards, Econolicious
A testable proposition
I haven't read Taleb and I thank all the prior commentators whose expositions helped me understand the issues better.
But in the end, I wonder, hasn't anybody tested Taleb's claims vs Gemein's criticism by empirical test? If Taleb's wins and losses were converted into total return on investment over a 30 year period, would he beat or miss the returns on a market index fund?
No, you're wrong actually
I have read the article and the Black Swan book and I really do not understand Mr Gimein's argument. How you can refer to someone who not only survived but flourished during the three biggest market crashes of our generation as "wrong" is quite simply beyond me. What does it matter if he had indifferent performance during the "in-between" years when the times he got it right he got it so massively right that he could retire instantly?! Ask the average investor whether they would like to make "$35-40 million" and then have ten or fifteen years "without much success" investment wise I think they would take it. The point that the author of this article seems to miss and is a central tenet of the Black Swan philosophy is that failure is a necessary component to benefiting from these unusual, "asymmetric outcomes" that NNT has succeeded in benefiting from not once, not twice but 3 times (!) in 20 years. Do you think he might be on to something?! And while the investment advice is limited in the Black Swan (it doesn't claim to be an investment book anyway) it does lay out the central idea of keeping around 80% of your assets in safe/conservative investments, while spreading the other 20% across the riskiest investments you can find, namely private equity that can provide a huge return on a relatively small initial investment.
The main point of the book however is to simply raise the reader's conscientiousness in all walks of life, from how you gauge investment risk, to what you choose to do for a living, to how you think about terrorist attacks or work projects. It teaches you not to put your trust in the hands of the so-called "experts" with their fancy models that got us into this mess in the first place.
Mr. Gimein seems not to be
Mr. Gimein seems not to be able to understand this simple concept very well. But I think Taleb could run the risk of being a victim of his own theory - date ideas for Moz-invest