Fooled by Randomness

A theme of Nassim Taleb's book, Fooled by Randomness, is that many (most?) successful traders are fooled by the random success of their strategies. With that caveat in mind, we must consider the implications of the success of funds affiliated with Taleb that presumably were long a lot of out-of-the-money options. The funds are up 50% or so this year, which is a stunning return in any market. Unlike other's who 'called the crash', Taleb advises putting money where his mouth is.

But, as Taleb's book argued, financial success is not proof of financial alpha because one year is a data point, not data. Alas, his old fund, Empirica Kurtosis, also had a 50%-ish return its first year, then he called it a 'hedge' not a fund (trader-speak for a bad trade seen in the 'bigger picture'), and eventually packed it up. As I have argued before, I think buying out-of-the-money options is a bad investment strategy because while it might have worked great this year, on average the return to this strategy is very close to zero because the volatility smile makes one pay up for these kind of risks. Indeed, given the current level of volatilities (VIX at 70%), I think the best thing Taleb and his investors could do is say 'woo-hoo!' and close up shop, because the price of disaster insurance is now so high that it is precisely the wrong time to be in this trade. In general, as opposed to the market underappreciating small risks, I think too many investors pay too much for them. Thus, the opposite strategy, as promulgated by Victor Niederhoffer, of selling wings is better over the long run, though I would do neither (alas, Niederhoffer's fund was shut down last year, luckily).

But his success will give him a bigger microphone to reiterate his earlier trenchant insights. I agree with him wholeheartedly that, say, Phillipe Jorion would be a very dangerous choice for any Chief Risk Manager position, as his seminal book on Value-at-Risk displays an insufficient appreciation for estimation errors, an over-appreciation on the value of parametric models, how this information aggregates, or is useful in actually estimating risk capital. Jorion is an academic, and shares their ignorance of various practicalities. But Taleb takes this good criticism, and extends it so strongly I find myself more on Jorion's side than his, because of the immoderate application of an argument, the straw-man caricatures of those who practice risk management apply to no one (eg, VaR is worse than useless, the normal distribution is an 'intellectual fraud').

For example, last week in Bloomberg he noted that “Recent events have proved that all risk management was wrong.” Such nuanced insights are usually confined to bigots discussing ethnic rivals. What I find especially interesting is how someone can make such sweeping generalizations and have such an enthusiastic following among those he criticizes. Clearly, a lot of frustrated risk managers enjoy seeing their betters brought down a notch, but I think such stupid criticisms (and 'all risk management is wrong' is a stupid criticism) are unhelpful, either for navigating the corporate hierarchy or correcting models that aided and abetted our current crisis. You may think you are smarter than your boss, and you may be, but he is probably not a moron. Indeed, he probably has some skills you lack, such as tact, or building coalitions in a complex set of people with different skills and goals. To the extent people error, one should always aim for a better diagnosis than more criticizing the fact that people believe in things that are often innacurate (see: QUOTES FROM THE BLACK SWAN THAT THE IMBECILES DID NOT WANT TO HEAR --all caps in link on web page).

His fans are keen to remind me that by criticizing someone so brave and true to call all sorts of people 'idiots', I am an envious player-hater with a specific DSM listing for daring to criticize the man, and his adherents remind me a lot of Ayn Rand acolytes in college (the Taleban, always true believers). But really, if he thinks all these people are idiots, after your little chat, do you really think he respects your opinion? I don't hate him, though I disliked it considerably when he would send emails to my old boss making bizarre allegations, and think his usage of 'moron/idiot/imbecile' and sweeping stereotypes reflects an unattractive temperament. Now that I don't have a timorous boss I find him merely amusing as he clearly has not acquired any sense of proportion or discrimination in his vast criticisms. As he discusses issues directly in my wheelhouse, I feel obligated to discuss where he is profoundly incorrect to the extent he is not inconsistent--which is rare, to be sure.

As Taleb lamented in an article in The Edge:

Spyros Makridakis and I are editors of a special issue of a decision science journal, The International Journal of Forecasting. The issue is about "What to do in an environment of low predictability". We received tons of papers, but guess what? Very few addressed the point: they mostly focused on showing us that they predict better (on paper).

Jeez, they just wanted to find a better way? Fools! The approach seemingly preferred by Taleb is to criticize from the sidelines those who attempt to model reality at all, while buying out-of-the-money options. In spite of returns to this strategy this year, it is not helpful for one's career as a quant, nor as an investment strategy.