Taleb on Bloomberg

Bloomberg has a big story on my favorite literary-philosophical-mathematical flâneur, Nassim Taleb. It appears his book, The Black Swan, is a huge best seller, and supposedly he gets $60k per speech now, all for his new theory: 'shit happens'. He's also saving us from the oppression of the Normal distribution, which statisticians believe exactly describes the world (fools!).

Why is Taleb so popular now? Perhaps you have heard of the Sub-prime debacle? Nassim called it. Whatever unexpected that happens you'll find that most of the experts didn't expected it--just as Taleb predicted. Space Shuttle? Berlin Wall? Britney's meltdown? Again, these thing were big events, and most experts didn't expect them, so Taleb did. Well, actually all he said was that unexpected things happen a lot. Is that a correct call? If you believe so, you are a Taleb fan.

The article starts by noting that Taleb was lecturing to a group of Morgan Stanley risk managers, lambasting 'stress tests'. This is strange because one would think that, to a guy that hates the normal distribution, or really any parametric distribution, he would love the stress test. Stress tests can be anything you want: what happens to your portfolio if the S&P goes up 10% and the dollar falls 10%? Improbable, perhaps, but these are nonparametric, their scope is only limited by your imagination. That he would say these are bad, leaves one to wonder, what, exactly, he thinks risk management should focus on. But that is not Taleb's oeuvre, which is merely to criticize any forecasting tool because it is imperfect. The only positive advice he gives, is trivial, things like, go to cocktail parties, because you might hear a good idea in such a nontraditional environment; or that you should invest in wacky investments that have Powerball-type upside. Good luck with that.

Success is mainly marketing, and you have to hand it to Taleb, he's slyly presents himself as a prescient speculator, someone who makes money taking positions, without ever really saying so. For instance, it is remarked in the story he 'made' $35MM on eurodollar options on Oct 19, 1987 (the market crash). As a trader, that just means he didn't have his risk hedged, because remember, we was primarily a market maker then, a guy who makes money off customer flow, and so generally you don't want these guys taking sides, they make money off the bid-ask spread. And so the 200 point move in Eurodollars that day (unprecedented) exposed him. That's simply a mistake, and others who didn't hedge their risk probably had the opposite pnl. But, elsewhere, if I remember, Taleb admits that his Oct 19th fortune was luck. Nevertheless, by putting out he 'made' $35MM, and that traders called him 'Nassim the dream', clearly it suggests he has the Midas touch. Subtle.

And then there's his hedge fund, Empirica Kurtosis, a fund he ran for 5 years, from 2000 through 2004. There was a joke when I was at one fund, where a bad idiosyncratic trade is always called a 'hedge' after the fact. That is, the money you lost on that punt on volatility, or the oil bet you made that goes against you, you say was hedging something else in your portfolio. It's a nice way to explain away a bad idea. So after the fund starting grinding out losses, Nassim started calling his fund a 'hedge', not a fund, later, a 'laboratory'. Now he says about the fund:

`Our aim was not to make money,'' Taleb says. ``I make no claims of being able to beat markets.'

But he makes sure any article that mentions his fund notes he made 60% in 2000. The only record of his total fund was a WSJ article on him in 2007, which notes he lost money in 2001 and 2002, made single digits in 2003 and 2004. That averages out to around 12%, and as the risk free rate was about 4% over that period, and the volatility was probably around 17% on a monthly basis, thats a Sharpe of 0.47. Not so good. And that's with his unaudited returns, so it's probably biased high (people have a tendency to round unaudited results upward significantly).

Like almost everything he writes, he is inconsistent, which makes taking him seriously pointless, because he can say that he said anything: his fund was a hedge, it made a ton of money; he was a lucky trader, he was a skilled speculator. I'm clearly a minority in my assessment of his insight, but then again, I didn't like Confessions of an Economic Hit Man or Nickel and Dimed either. Basically, my favorite books tend to be #347 in their category.

The story mentions his former assistants are starting funds based on capturing the Black Swan, a fantastic plan. If you write a best selling book about investing, clearly some of those readers will be rich hedge fund investors. Now pitch them with the following story that is totally consistent with your revolutionary insights: I get 2 and 20 fees. Your returns will be near zero, until we catch a financial Black Swan, whose return cannot be quantified, but think Google or Harry Potter. Of course, 'absence of evidence' is not 'evidence of absence', so if nothing happens after 10 years, that proves nothing. Heck, even a lifetime of zero alpha proves nothing. Meanwhile, on $1B, that's $20MM per year. Brilliant!

Nassim's Selective Returns

Nassim 'the Dream' Taleb's Universa is supposedly advising China Investment Corporation on buying some insurance on all their US exposure. Here's a pro tip for the CIC: if you want to hedge your exposure to US Treasuries, don't buy US Treasuries plus insurance on US Treasuries & the US Dollar. That's churning. Instead, invest more in a different country, like Canada or Iceland. You don't get the insurance for free, you pay the expected loss plus fees--otherwise no one would sell insurance. It's almost as if the Chinese exist to give their money away to Americans.

Nassim is fond of highlighting that public prognosticators, especially financial analysts, do not keep an accurate, testable track record, and so are deceitful, uncalibrated, and most importantly wrong. So it's fun to see his record bandied about in a misleading, tendentious way. Today's Wall Street Journal states the Universa Fund he is affiliated with (but run by Mark Spitznagel), had "client portfolios [in 2009] down an average of about 4%, one person close to the matter said". "This year, Universa clients on average have lost about 2% of their notional account value", but in 2008 "extreme market losses helped many Universa clients profit more than 100%."

There are a lot of qualifiers in those off-the-record statements. As implied vols went from 40 to 20 in 2009, I'd be surprised if his average client only lost 4% that year. Further, as vols peaked around early November 2008 around 80, and then fell dramatically to 40 by December 31 2008, I'd be surprised if that 100% number is representative for 2008, because that was the number bandied about by the credulous press during the top tic in November when vols were 80. Of course, without audited returns, who knows.

Janet Tavakoli busted a GQ article that stated Taleb made $20B for his clients, and Taleb angrily responded that he never said that number, and Tavakoli was on a smear campaign. It's very manipulative when you let an interviewer quote unidentified sources for returns in your piece, and then act shocked, shocked, when people point out they are incorrect: 'I never said that'. Technically true, but knowingly misleading, pathetic for a man who makes a big deal out of the fact that financial professionals are miscalibrated and hide their track records. I know three people he threatened to sue for defamation; he's not forthright when it comes to his own record.

NNT's returns from 1999-2003 were probably only 4% annualized (I don't have audited returns, so I'm going on hear say), and as it closed a year later, probably lower than that for its lifetime, pretty lame, but his 60% return in 2000 is all he needed for marketing. It's called the 'representativeness heuristic', a conspicuous focal point one then irrationally generalizes. Or it could be the 'anchoring heuristic', a number that once set, biases the final estimate towards this number. In any case, he's selling lottery tickets, an unfalsifiable strategy that generates really large returns in big crashes like 2008. Great, but as volatility, especially at the tails, is priced if anything too high, I don't think this strategy has a positive expected value to anyone but the fund owners (and their advisers!).

Nassim the Dream Top Tics It

There was a big story in the WSJ about one of Nassim Taleb-affiliated fund Universa Investments LP (he's merely an advisor, but he takes credit when it does well and it's run based on his long-Black Swan theory). Supposedly, they made a big trade around 2 pm EST on Thursday, just before the market tanked. As the electronic exchanges were spotty a large order like this didn't help, and wasn't very savvy on a pure tactical level (ie, don't make big trades when systems are down).

Anyway, lets look at the tape. Here's an S&P 115 June Put option from Thursday. Around 2 PM EST, it was price about $4.30. It went to about $8 (one bizarre print at $14), and is now about $2.50. Whatever he bought is probably down 50%.

I would bet that his Universa Fund will go exactly like his Empirica fund: up big in year 1, then slightly negative for the next five, when it is 5 times as large. Net net, it loses dollars, and like Emprical will have a Sharpe below the Hedge Fund Mendoza line of 0.5.

All the while, however, he makes huge fees, because 1% on $4B is a lot of money, and his wealth will serve as proof that he's an investing genius. More importantly, he then selectively presents to a credulous press he makes billions off his market savvy.

Gee, someone should write a book about blow-hard traders who misrepresent their track records and take excessive risk with other-people's money, all due to cognitive biases they are too shallow to notice in themselves. Oh yeah, Taleb has done that! I guess his insider status gives him better insight.

Taleb Calls Fannie Mae

Portfolio.com has an interview with my favorite flaneur, Nassim Taleb. He notes that he called the Fannie Mae meltdown, citing a footnote on page 225 of the Black Swan that

Likewise, the government-sponsored institution Fannie Mae, when I look at their risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry, their large staff of scientists deem these events 'unlikely.'"

He notes he wrote this in 2003, after talking with Alex Berenson about a NYTimes article on Fannie Mae's risk. But the article, and Nassim's comments in that article, are all about interest rate risk. Fannie Mae's current problem was adjusting the criteria of the underwriting--with the explicit goal of increasing home ownership of minorities--which increased their credit risk. For a guy who spends a lot of time discussing how fraudulent experts and forecasters are because of their hindsight bias, and lack of candor and honest evaluation, he seems to be speaking from first-hand knowledge. Being right for he wrong reason, is not trenchant. And being right when one makes many blanket statements, and calls multiple disasters, is not impressive, because it neglects all the disasters that did not happen: the general strategy of being a chicken little, buying out-of-the-money puts, is a bad general strategy, as Taleb discovered. You aren't evaluated on you best calls you are evaluated on your portfolio. Taleb basically said you might want to short these 50 stocks, and when 1 goes down 90%, says, 'told you so'! Sounds like a lot a brokers I know.

Priorities are essential when talking about risk, because simply listing all the things that can happen, or that 'you should check your assumptions', or that 'you could be wrong', gives one no sense of importance. If Taleb was hired by Fannie Mae to run their Risk Management in 2003, and they adjusted the interest rate risk management as a result, it would not have mattered. As one who criticized economists for not having been traders, he should be wary of criticizing risk management never having been a risk manager (except in the broad sense that everyone, at some level, is a risk manager). A risk manager has to do specific things: generate methods for monitoring risk, limits, reports. What, pray tell, would he do, just write 'shit happens--don't say I didn't tell you!', shut his door and browse the internet?

Trivially, everything is possible, and so we cannot insulate against everything, but you have to do something, and this is based on probabilities and payoffs. Simply listing 50 things or companies that can blow up because anything can happen, and then when one of them blows up, saying 'aha!', highlights the depth of Taleb's understanding of risk, because this vague statement was not actionable. What about all those companies or scenarios that did not happen, what would have happened if you retreated there as well. You can't mention lots of disasters, in no particular order, with no specifics about nature of the risks, and then when something happens claim one was prescient. Further, logically certain statements like 'something unexpected and important will happen' are incapable of being wrong and therefore meaningless. It's like saying, there will be a humanitarian crisis in the Third World next year unless we act now! Of course, we won't, because one needs to be more specific, and something will go wrong, it always does.

The Talebs and David Smicks and Kevin Phillips of the world are all very loud, certain they know something really really important, viz, the world is complicated, and many things can go wrong, or right, in unpredictable ways, and it is getting more so. Now, except for the latter point, this is all indubitibly true, but that observation is not useful to anyone, nor interesting to me.

Nassim Taleb Imitates Kanye West

The often angry-looking Nassim Taleb just published a book of unlinked tweets: The Bed of Procrustes. It is short and has a Kindle version that costs 72 cents less than the hardcopy.

As to its flaws, it reminded me of one of my favorite aphorisms: "the man who early on regards himself as genius is lost.” He inverts the observation that geniuses are often misunderstood to the insight that misunderstood people are geniuses, and critics of such people are imbeciles who don’t even have the taste to appreciate genius. My criticisms are therefore consistent with him being right or wrong, but falsification is not symptomatic of punditry in general or Taleb in particular.

It is a golden rule not to judge men by the opinions but rather by what their opinions make of them. His many fans highlight the effect of Taleb's thinking as they speak like Renfield discussing Count Dracula:

”excellent; it's a must read ... I'll refrain from demonstrating my foolishness and ignorance by trying to interpret any of them in this forum.” ★★★★★

“Those who understand the book will refrain from summarizing its message.” ★★★★★

They sound like a cult of scared guru worshipers.

I suspect that Taleb dreams of someday winning the Nobel Prize in Economics for his popularization of Rietz’s peso problem (1988), fat-tailed distributions (Mandelbroit 1963), or Knightian uncertainty (1921), at which point he would refuse it and then raise his stature above all those before him. Alas, as defective as the econ Nobel is, it ain't the Peace Prize. He has not added any new significant idea to any of these richly researched threads, rather merely tries to convince readers he and his followers are the only ones in the world who really understand them. For example, he extensively documents that financial time series are not exactly Gaussian, something financial standard bearer Eugene Fama investigated in his 1960's dissertation. He meticulously proved something everybody in the field has known for decades.

Winston Churchill said ‘It is a good thing for an uneducated man to read books of quotations’, and I agree. Many useful truths in mathematics and physics are old hat but essential pillars of wisdom, concise, and so too for the many proverbs that have been handed down to us. Readers usually retain aphorisms they parse out of an author’s sustained argument, a pithy summary (eg, Smith’s ‘By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it’). Taleb knocks out the middle-man and publishes a couple hundred of his random thoughts.

Such a book needs a certain predisposition because when Chauncey Gardiner said 'there will be growth in the spring' in the movie Being There, it was considered profound basically on how you perceived the vehicle spouting such statements. Consider that the most absurd economic proposition will be taken seriously if you can find it in Keynes's General Theory, in which case, it's an argument that deserves consideration (Pay men to dig holes and fill them in again? GT p.220, really). Thus Taleb gives us these beauties:

"Fortune punishes the greedy by making him poor and the very greedy by making him rich."

"Karl Marx, a visionary, figured out that you can control a slave better by convincing him he is an employee."

"Sports femininize men and masculinize women."

"Every ten years collective wisdom degrades by half."

"The nation-state: apartheid without political incorrectness."

Perhaps his acolytes are correct, these remarks defy exegesis. But if you aren't going to make sense, you might as well be funny: Marx's 'time flies like an arrow, fruit flies like a banana.' Taleb's humor is less like Groucho, more like Karl.


Kanye West is also very popular and like Taleb tweets his fans with petulant rants. Consider these Kanye Classics:

“Because I have sacrificed real life to be a celebrity and to give this art to people, which is great. It is great that I was able to do that…”

“I am God’s vessel. But my greatest pain in life is that I will never be able to see myself perform live.”

“You want me to be great, but you don’t ever want me to say I’m great?”

"George Bush doesn't care about black people."

Modesty is a virtue not because it implies servile humility, but because it implies a combination of honesty and knowledge. Using self-righteous anger to justify immodesty just highlights one's immaturity. Here's Taleb channeling his inner Kanye:

"Your reputation is harmed the most by what you say to defend it."

"A genius is someone with flaws harder to imitate than his qualities."

"It is a waste of emotion to answer critics."

"Bad mouthing is the only genuine expression of admiration."

"People reserve standard compliments to those who do not threaten their pride; the others they often praise by calling 'arrogant'."

"It is the appearance of inconsistency, and not its absence, that makes people attractive."

The last thing most people need to think is that criticism is mainly from fools who misunderstand genius, because as I've entered middle age and had children I have found 1) children are learning and a fast rate while most adults have stopped learning and 2) adults can avoid criticism, whereas a child cannot. These are not unrelated.

It is frustrating when people dismiss your ideas and it's comforting to imagine they are all envious fools not worthy of your genius, yet this is just succumbing to your baser instincts. Like everyone else, I don't like criticism, and when I was young I was insecure and immodest, and this hurt me in many ways. Over time wisdom has made me more confident and humble. Thus, while my CPU may be slowing and RAM shrinking, I'm processing feedback more efficiently than I used to, and I wish I appreciated the value of modesty earlier.

Criticism and advice are often wrong, but that merely highlights it is not a sufficient condition to becoming a better person, only a necessary one. Life is too short to learn everything by trial and error, so watching and listening to others is essential. A bias that critics are cretins leads to a life guided only by errors so great they can not be ignored, an inefficient path to enlightenment.

I do agree with a lot of what Taleb says, but as he is pridefully inconsistent (it makes one interesting, supposedly), this does not mean much because once you say 1+1=1, everything, true and untrue, is implied. For example, he states the detection of false patterns is a major problem, excluding the pattern of increased falsely perceived patterns; he's a rebel telling the academy what they don't want to hear, yet his arguments are based on academic science and mathematics; data are definitive and the past is misleading. These are not profound paradoxes but rather confused ramblings. It would take a lot of psilocybin for his oeuvre to seem deep to me.

An unqualified glowing NY Times review of "The Bed of Procrustes" references this interview as exemplifying his trenchant criticisms, as he states ‘we should eliminate value-at-risk.’ In The Bed, Taleb argues that 'knowledge' is knowing what does not work as opposed to what does, but this is just letting perfection being the enemy of the good. All theories are wrong, some are useful. If you eliminate Value-at-Risk, what do you replace it with?

As a tool, Value-at-Risk is better than nothing. It is also better than something like the TSA's nonquantifiable terrorist threat indicator. Indeed, one very nice thing about Value-at-Risk, it can be wrong! It can be tested and calibrated at reasonable extremums to capture some of the nonlinear risks in a portfolio, whereas threat level 'orange' remains not even wrong. A metric that captures 1 in 20 events balances the objectives of calibrating a risk metric and capturing some nonlinearity, because you need to generate real observations to calibrate (it isn't applicable to portfolios with assets held for several weeks or more). There’s a trade-off between capturing only the tail events that really matter, and empirically validating the metric.

Value-at-Risk is not perfect, but prior to this you had a jumble of indicators that were not comparable, and logically you usually can't say an array of indicators is 'high' or 'low', just that some items are higher and some are lower, and this leads to an ambiguous interpretation, and impossible testing and calibration. Imagine trying to have a discussion about risk at a desk with currency, equity, and bond exposures, all with their various derivatives. If you are not allowed to bucket risks into groups and add them up using some consistent methodology it would be an endless narrative with lots of adverbs.

As to Taleb’s admonition to not ‘confuse the map for the territory’, that was a cliche in the 1960s. More importantly, the problem is not omnipresent but rather selective, because theory-free observation is not suboptimal, rather impossible. The real issue is which theories are bad and in what ways, not that theory is bad.

For example, like Taleb, I find many economic models excessively rigorous because such theories do not add precision or clarity to an idea, only faux sophistication. Thus, Romer's growth theory, or Krugman's increasing returns to scale theory, did not add clarity to an existing debate, only false rigor to ideas more clearly and accurately stated in words. Note that even Romer and Krugman don't build arguments on their models, rather they merely use them for presenting their bona fides. The models are mainly for proving one is clever as opposed to making a novel point. A formalization of well-known arguments that disingenuously presents itself as a new theory is bad because this leads to a wasted focus. Further, some models become so convoluted they make falsification impossible, allowing an intellectual error to persist for a generation as true believers can always point to different parameterizations that work (eg, input-output macro models, large-scale Keynesian macro models, stochastic discount factors).

Hayek's theory of the importance of markets and profit-seeking in decentralizing incentives, Adam Smith's Invisible Hand, the Coase Theorem, and George Stigler’s theory of search and information, meanwhile, were real advances in our understanding of economics, and these did not entail sophisticated mathematical equations. ‘Example’ is more intellectually honest than ‘theorem’ when presenting an economic argument. Representing an idea using measure theory is considered top academic work, but it’s usually pure pedantry.

Unfortunately, the idea that some rigor is good got turned into an arms race in rigor. Really important economic ideas that necessitate heavy mathematics are rare, confined almost exclusively within game theory (eg, Arrow’s Impossibility Theorem, Harsanyi’s general Bayesian model of games, Hurwicz’s mechanism design, Meyerson’s revelation principle), and game theory itself has been much less fruitful than originally thought. Continuous time, Hilbert space, real analysis, have not added to our understanding of economic problems, they merely remind us that any simple mathematical idea can be made more rigorous.

As per unlikely events being under appreciated, I would say it is the opposite. Most internet spam and investment scams are based on things that could happen but probably won't. Improbable events, when priced, are generally overpriced, largely because they can't be hedged and markets are thin, so as a buyer of these things, you tend to overpay: out-of-the-money options, wacky investment or business ventures. As Tyler Cowen wrote in his otherwise positive review in Slate, this big idea does not work in Taleb's main field of expertise, options (peevish Taleb violated his aphorism to ignore criticism back then, and got very mad at Cowen).

This focus on the improbable can lead to excessive risk taking, such as buying lottery tickets or joining multi-level marketing schemes, and too little risk taking, as when we forgo nuclear power or irradiating eggs because of improbable nightmare scenarios. Pity the investor who bought volatility based on the idea that people under appreciate it, as the straightest volatility play, the ETF VXX, has lost 90% of its value since inception in Jan 2009. The key is not to increase the perceived probabilities of small probability events, rather get them as correct as possible. Some should go up, some down, and this is hard work.

A really good aphorism is distilled in the context of a broader set of work, such as Bertrand Russell's remark that "One of the symptoms of an approaching nervous breakdown is the belief that one's work is terribly important", which for a man who spent a decade on the futile task of trying to axiomatize mathematics (later proven impossible by Kurt Gödel), is truly profound. It is advice Taleb would do well to take.

fyi: my old review of Taleb's Black Swan

Mauboussin on Success and Luck

My 5-year old daughter recently was very excited to discover a new solution to a pressing problem. Her mother had told her she was not allowed to eat cookies and left the room. 5 minutes later Izzie told me she had a great idea: I give her a cookie but we don't tell mom, so mom wouldn't be upset.  Win-win! Her pride in independently discovering the tactic of lying reminded me that many skills are no less interesting to others simply because I know them.  Such it is with Michael Mauboussin's book, The Success Equation, which investigates how to navigate in a world filled with skill and chance.

The book spends a couple pages explaining the reversion to the mean by noting Galton's original observation on the heights of parents and their children, and much of the book involves the concept of bayesian updating. These aren't new ideas.  Yet, when he noted that while small schools are overrepresented in data on excellent and really bad schools, it reminded me that this is a real problem because invariably they are used as templates for some system-wide initiative, neglecting the fact that often some very unique circumstances as opposed to any efficient method are at work. Like everyone, I need reminding of some of these patterns sometimes.

The author recounts a fortunate interview he had with Drexel back in the days this was one of the most coveted positions out of college. He astutely noticed the senior interviewer had a Redskins trash can and so mentioned something casually about football, after which the interview went extremely well, talking mainly about football.  Clearly, that wasn't just luck, but after the fact appeared the key to him getting hired, creating a career path that would never be the same. Most big events, good and bad, are a mix of skill and chance.

In dealing with success and luck Mauboussin presents a useful model:

estimate=population mean + c*(sample mean - population mean)

c is a constant between 0 and 1, 1 for activities involving all skill, 0 for those that are purely chance. So, a chess, which is mainly skill, should have a c, or 'shrinkage factor', near 1, hockey games something near 0.  This is like updating a prior belief with new data (see here for how to do this more formally for various distributions). More relevant to investing, if your backtest generates a Sharpe of 2, one should remember most investment strategies have Sharpe's near 0, and so adjust your sample mean (ie, backtest) closer to that population mean. Any new idea does worse than its backtests because these aren't population data, but rather selective sample data.

He could have added something on how to address robustness as he did with his shrinkage factor approach to bayesian updating, say by showing how you could optimize over a set of parameters from different subsamples.

The book mentions research by Pinker, Gazzaniga, and Haidt, and I love these authors so I found all that very interesting.  Some of his other inspirations I'm less fond about. He calls Peter Bernstein 'one of the investment industry's greatest thinkers', though I'm at a loss as to what Bernstein insight might deserve such praise.  And then he mentions my favorite flâneur, Nassim Taleb, and suggests his great insight is that when payoffs are uncertain and complex, these are great situations to go long, specifically, go long out-of-the-money options.

Out-of-the-money options aren't underpriced on average. Sure, you will do well when the market tanks, but it's expensive insurance. Remember, when you cross the spread on a 3-delta put, your are giving away a lot of vig. If you think you can trade at mid or close you are being naive (I hear Taleb has a new book out advocating the same thing, buying gamma).

Also riffing on Taleb, he says we are better off using no model than a faulty one. This is a straw man. A faulty model is harmful almost by definition.  Yet  if you are acting, you are acting on some kind of theory, which is at some level a kind of model. One is better served by an attempt to formalize as well as possible one's strategy rather than to merely trade on intuition, the key being how well one deals with the uncertainty by simplifying the functional form, or accurately calibrating the probability of loss, or the time series nature of losses, etc. When people say they have an atheoretical or non-parametric approach they are neglecting a meta-assumption: any idea about how the world behaves involves a theory at some level, which can also be some kind of model (eg, a Venn diagram, or an if-then statement, a linear best-fit through an ellipsoid of data).

I'm not the audience for this book, but as most people are prone to overfitting, it has an audience, such as people who like Taleb's books.

Lastly, I noted he has 5 children, and I'm always  amazed when I read a sustained argument written by someone around my age with more kids than me. Having children is like putting a bowling alley in your head, and makes writing very difficult.  That's skill.

The Audacity of Hopeful Investing

Warren Buffet and many old experts note the distinction between gambling or speculating, and investing. Gambling is investing without an edge, such as when one plays the lottery, or invests in stock without alpha. Investing is what Warren Buffet does.

Nassim Taleb has become a prominent talking head with the advice to invest mainly in Tbills, but then a modest portion in something with large and unquantifiable upside: the potential next Google or Harry Potter. I think this is foolhardy, because uncertainty is correlated with volatility and factor loadings, and historically, earnings estimate variability, high volatility, or high beta stocks, all underperform, statistically (ie, on average). So too for the biggest longshot horses, or highest payoff lotteries, call options, movies, etc. Things that can generate lottery-like payoffs, have lottery-like returns.

The annual per capita lottery expenditure in the US is about $150, and the rate of return is about -47% per dollar played. These investments clearly cater to what is commonly called those seeking risk, or positive skew, in particular. A study of the popularity (sales) of lotteries found that average payout (expected return) did not matter, but the size of the top prize was highly significant in motivating popularity. In other words, the $100 million super lotto has a lot of sales even though the probability of winning is so small it basically is outside the realm of intuition (1 in 150 million). A St.Louis Fed article finds that those with household income of less than $25,000 spent twice as much on lotteries on a per capita basis, than those with a household income over $100,000. Such bad decision making is probably not orthogonal to their poverty status. Investing in lottery tickets, however packaged, is a great way to stay poor.

So I found it interesting that the otherwise sober Arnold Kling fell prey to the bias of finding these highly volatile--and uncertain--investments:

What if, instead of borrowing, students could arrange for investors to pay their college bills in exchange for a fixed percentage of their future income... If I were an investor in this market, I would be inclined to make Black Swan style bets. Philosophy majors, for example. Sure, a lot of them will end up as pathetic adjunct professors. But some of them will eventually apply their intellect and creativity to business.

to reiterate, in a different post he noted:

I'd invest in philosophy majors! (But I still think they have the best option value, and that a few of them will be very rich in a decade or two)

Basically, Kling hypothesizes that those wild, free thinking philosophy majors will have a higher average income because of a few 'whales' in their sample. A couple Steve Jobs or some other dreamer. Kling has fallen victim to the allure of hope, in that for things we have no data on, the classes of investments with conspicuous winners seem attractive. Thats why every millionaire from Ebay or Amway, or home forex trader prominently shills a 'system' and says you too can be rich 'just like me'. It's a nice thought, usually packaged with lots of motivational speaking themes, stuff from What the Bleep do You Know, etc. But its all untrue. These are scams that make money for those selling hope . There are a couple success stories to be sure, but they are exceptions, and not sufficient to make the mean look good, any more the success of famous athletes and rappers implies it is a financial advantage to be a poor black kid.

Of course, I can't prove this (I bet it's in a paper somewhere), but the bias suggests Kling is wrong because he thinks too much of conspicuous successes, and using the dreaded 'availability hueristic', does not adequately represent the mass of philosophers who end up wearing a name tag at work. Gambling, Buffet would note, is investing based on hope as opposed to an edge, and hope is anything but audacious, it is all too common.

Experts are Curmudgeons

The word 'corny' comes from the way mawkish stage scenes would pay off in the Midwest where the corn is, even though jaded New Yorkers found them hackneyed. I was reading a negative review on Slumdog Millionaire, and it highlighted the strangeness of the movie reviewing profession. It reminded me of a bad review of the teen vampire movie Twilight. I'm a middlebrow moviegoer (I liked both movies), having gone to enough to find the car chase scene in the latest Bond movie not very suspenseful, but I still like it when the guy gets the girl, or the bad guy gets eviscerated by his nemesis's nephew (note to self: don't kill Bruce Lee's uncle).

If one is paid to watch movies, it is very important to keep a perspective on your audience. Thus, after one sees the 50th high speed car chase, or woman falling down while the zombie is chasing her, it becomes boring. Such reviewers want to see scenes that are new, fresh, and have some resonance. But your average movie goer has nowhere near this amount of experience watching movies and so might appreciate these scenes, because it is not a cliche to them. This 'problem is not just in movies. Those who have never heard classical music find Eric Carmen's hits "All By Myself" and "Never Gonna Fall in Love Again" beautiful melodies, which they are, whereas the music expert might dismiss these as stolen riffs from Sergei Rachmaninoff. There is an inevitable difference of opinion between an expert of any kind, and popular expositions in his field, because experts dominate reviews, whereas dilettantes dominate the audience.

I find Nassim Taleb's observations on statistics and models banal (see here), his hope for the potential for Knightian uncertainty or fractals naive. All models are wrong, some are useful. Fractals and knightian uncertainty are not wrong, but in part because of this (they can't be wrong), they are pretty useless. I have not met any full time risk managers, those actually making day to day risk management decisions, generating reports for senior management, who like the nihilistic focus on improbable events, who agree that Value-at-Risk should be abolished. Instead, the promoters of this extreme nihilism are lots of intellectuals and intellectual wanna-bes who understand risk management, the profession, from 10,000 feet up. I can see how, from the outside, his observations may appear a fresh, interesting view of finance, pregnant with implications for making improvements. Yet, criticisms of models for making 'wrong' assumptions is quite different than proposing a model with better assumptions.

I don't begrudge the popular people in my field who I think are very misguided. They are usually inspiring people to look further, always a good thing. Most aren't wrong, like Taleb (he suggests the most highly uncertain assets have the best returns--I argue that it's exactly the opposite), but rather merely boring. Suze Orman says sensible things, they just aren't very interesting to a professional.

I don't want to be like those movie reviewers saying that some movie stinks because it uses cliched imagery that most people find appealing. Not that I feel obligated to like what I perceive as tripe, but that I should appreciate the fact that others like it, because it's all new to them. Nothing wrong with that.

Why Volatility Innovation Can't Save the Risk Premium

I noted that a paper referenced the fact that an asset's correlation with volatility changes is a priced risk factor. Thus, instead of the CAPM, where you have

E(R_i)=R_i+E*Beta*(R_m-R_f)

You have

E(R_i)=R_f+E*Beta*(ShortVolatilityInnovation)

In the 'volatility innovation' story of risk, you are worried about not some market return proxy, but rather some volatility index. We all wish we had assets that appreciated when markets go crazy, like in 2001 or 2008, but we would have to pay a premium for that, which is why (supposedly) there's a market premium for it.

Research on option strategies tend to find that selling volatility does make more of a premium than buying volatility. There are large transaction costs to this direct strategy, especially historically, so it is not clear how economically meaningful this all is in terms of a realizable premium to selling volatility. See Sophie Ni (2008), Bonderanko (2003), or Shumway and Coval (2000), for data on the returns from selling volatility (all w/o good data on transaction costs). The VIX index is derived from 30 day implied volatilities on the SPX index. Since 1995 the average has been 21.5, whereas realized vol was 20.3. Thus, it seems you could have made money 1 vol selling at-the-money volatility.

Note this is the 'selling Black Swans' strategy, or Victor Niederhoffer as opposed to Nassim Taleb. As we know from Niederhoffer's record, this strategy can be dangerous, with fat tails wiping out years of returns, so it might not be a good strategy everything considered. I have backtested such strategies using historical option data and find that over time selling vol makes a decent profit. Just good luck telling your investors that after events like in 1987, 2001, or 2008, when you get crushed. One paper argues that 'jump risk' underlies the premium to selling volatility, and that makes sense, in that, you simply can't sell volatility as easily as buy, because of the capital requirements, so, return per underlying might look different, but on capital required via the market, not so different.

The problem with volatility correlations saving the risk premium story is that it is highly correlated with the market. Here is a daily return scatterplot:


and a monthly:


If sensitivity to volatility innovations captures the risk premium, then the flat (at best!) return to standard CAPM beta implies there must be some risk factor that offsets the negative correlation between volatility and the market. Whatever that could be makes absolutely no sense. That is, it probably had good returns in the October 1987, Sep 2001, and October 2008, yet still a positive average return. I'm open to suggestions, but this sounds the Flying Spaghetti Factor.

Note that a sign of an unsuccessful theory is that as the data become more clear, and more numerous, the theory becomes less clear. First, risk was the covariance with the stock market, but ever since then it has become more nuanced, and there's always a new proxy for the risk premium(s) that 'powerful new econometric techniques' are supposed to uncover.

von Neumann...Mandelbrot?

A 'straw man' argument is to set up a weak counterproposal, and then criticize it. It is a 'straw man', easy to knock down. I thought this was a discredited technique that would generally make the author look bad, but the more I read popular books, the more I see this approach taken. Best selling critics of the free market, such as John Kenneth Gallbraith and Lester Thurow, would criticize any misfortune as an anomaly to libertarians who thought markets were perfect.

But then I was in my local Borders, and was reading Michael Mauboussin's More Than You Know, which is about investing and such, with an academic/practical slant, something I would like. The book has its moments, and its short chapters and easy reading make it a great book to read while drinking a cup of coffee, and then return to the stack. The book has lots of graphs and tables. I love books with graphs and tables, and wish more books did, as I find it odd that a 300 page book on investing would not have these thing (eg, Against the Gods, or Random Walk Down Wall Street has but a few), as these make points so much better than mere words. So bully for Mauboussin. But he had a chapter on "frequency versus magnitude in expected value", and highlighted that some really smart people like Warren Buffet assess expected value as probability times payoff, so an improbable event may actually be a good buy, because its payoff is sufficiently large. Who knew? He even quotes my favorite flâneur, Nassim Taleb, for noting that as a trader he would be short sometimes even when he thought the market was going up, because the size of a downturn would make the expected return negative [forget about the fact that trading floors hate it when their traders have directional bets]. Supposedly, most rubes merely look at the probabilities, ignoring payoffs.

An expected value is the weighted average of the payoff times the probability. It has always been that way. To think this is subtle, or rare, strikes me as daffy, after all, most options expire worthless, yet have a positive price. Contradiction? No.

Then I moved over in the stacks and found Benoit Mandelbrot's Misbehavior of Markets, and there's a blurb by Paul Samuelson:

On the scroll of great non-economists who advanced economics by quantum leaps, next to John von Neumann we read the name Benoit Mandelbrot

ORLY? von Neumann is famous for his von Neumann-Morgenstern utility function, the workhorse of most economic analysis. He had a macro model too, but I think it's safe to say that was a noble effort, but a dead end. But Mandelbrot? He is usually the first reference of fat tails for financial distributions based on a 1963 article on cotton prices, but I fail to see this as a truly earth-shattering finding because almost everything natural has fatter tails than a normal (gaussian) distribution, so who was suspecting otherwise? Mandlelbrot's book points out (and so does Mauboussin's) that the stock market has fat tails, and states that models like Black-Scholes, and the CAPM, are based on the Gaussian hegemony that forces us to think that such things can only have normal distributions, a legacy of Bachelier from his work on brownian motion in 1903. But these models use the Gaussian model as an expositional device, because it generates nice, clean closed form solutions. Markowitz's earliest book (Portfolio Selection: Efficient Diversification of Investments, 1959) looked at semi-deviation, maximum loss, and other asymmetric loss functions. Thus since the very beginnings of the MPT, researchers have been aware that distributional assumptions were important, and obvious paths for alternative hypotheses. Looking at the Journal of Portfolio Management, “skewness” is mentioned in no less than 66 articles, kurtosis in 44. The bottom line is that after 40 years, this obvious fix—adding a cube or square term, effectively—appears only episodically as a solution, invariably not standing up to subsequent scrutiny.

In general, the first order effects are not great when ignoring these complications, so the cost of messing up the formulas to include more free parameters, at little benefit, is not done. But the CAPM doesn't work regardless, and Black-Scholes is fit to a volatility smile--always has. No one I have met has ever confused the map with the territory, when it comes to asset pricing models,

In 1987, James Gleick published a best selling book Chaos, highlighting Benoit Mandelbrot's fractals, and suggested he had a new insight that was about to revolutionize all of science, including finance. But as Rubinstein states in A History of the Theory of Investments , "In the end, the stable-Paretian hypothesis [ie, fractals] proved a dead end, particularly as alternative finite-variance explanations of stock returns were developed".

Ever since I have paid attention to option prices in the 1980's, options were priced anticipating fat tails, via a volatility smile, yet Mandelbrot would have you believe that no one knows this, or at least, that The Establishment thinks Gaussian distributions are perfect replications of reality. The 1987 crash was a 22 standard deviation event, happening once every 60 bazillion years according to the Gaussian knaves. Now truly people did not anticipate this, because the previous largest move was less than 10%, but I don't think his model is any great improvement because anticipating a 22 stdev movement in any option with a significant probability will cause you to overpay severely for illiquid options with wide bid-asks. I actually was actually bought an out-of-the-money S&P500 put option on October 16 that I sold in the last 15 minutes of trading on October 19, 1987, and made $38k on a $3k investment (my life savings at that time, see here). I remember not getting my mark for a day, and finally being surprised to see my option sold with an implied vol of around 70. Great return and all, but it wouldn't pay for a lifetime of buying 3-delta options (i.e., the way out-of-the-money options). However, if you include that investment in my arithmetic average annualized return, my life-to-date Sharpe in my personal account is around a 5--highlighting the problem with arithmetic averages.

Benoit Mandelbrot is a very smart man, but I have a feeling that he truly believes his great idea in finance is that prices follow these power-law distributions with extra parameters. That is simply a not a good idea, and I can imagine his brother-in-law thinking 'why does everyone think this guy is so smart?'

Anyway, are such straw man arguments necessary to sell a book? I should write a book on the theory that some assets go up, some go down, but very few stay exactly the same price. This proves that everyone who thinks prices are 'right' is a fool, because prices change, proving the old price wrong. The Man tells you that prices are the best estimate of market value, but he is proved wrong every day. QED. (patent no. D696,243).

Academics Document Dead Strategies

In the latest Journal of Finance, there's an article by Ni, Pan and Poteshman about volatility trading. Basically, they argue that increases in demand for options by non-market makers helps predict realized volatility. OK, fair enough. Someone hears a rumor, buys options to capitalize, the rumor is realized, and volatility increases. Implied volatility and option volume help predict realized vol.

But here's where I lose interest. They use daily data from 1990 to 2001. The option market has become so much more liquid and efficient since 2001, I doubt anything in this period is relevant. Prior to 2001, it was pretty hard to trade this stuff algorithmically, picking up on things, because spreads were very wide (and still are), and quotes posted weren't very deep (ie, you couldn't do much size at the bid or ask), and systems for trading these things with electronic algorithms were very difficult in those days. Heck, even Nassim Taleb's fund made a lot of money in 2000.

There are lots of strategies that made money in the 1990's, such as any short-term mean-reverting strategy in stocks. Most of these are merely of historical interest, because they are long gone. High frequency data from 10 years ago is about as interesting as reading that if you created a search algorithm for the interweb (aka World Wide Web), you would be rich! It's true. And sharing videos online, another money maker.

Tail Volatility and 1987

There was an interesting paper on estimating the probability of the tails via option prices (see Backus, Chernov, and Martin here). Barro seems to have really revived the Rietz 'peso problem' model, by looking at a variety of large macro-economic shocks related to wars and revolutions in the twentieth century. There's an excellent summary of this work here.



One person noted that things could actually be pretty boring. That is, in 1987 the market fell so much on one day (23%), ever since then there has been a large premium for out-of-the-money options. The graph above is from Jackworth and Rubinstein (1994). This shows that basically the market did not anticipate the 1987 crash, but since then, has this event priced in.

The funny thing is how far back and how deep this literature on disasters is. Nassim Taleb and his acolytes (the Taleban) seem to think economists are totally wedded to the Gaussian distribution, which ignores fat tails and extreme events. That is, he sees the naive Black-Scholes model, and ignoring the volatility smile, infers that this means economists don't believe disasters matter. This is just a really ignorant and misleading statement, fun for dilettantes who love to lampoon experts via a caricature, but it is really a waste of time.

Radical Uncertainty's Long History

A debate between Bryan Caplan and Peter Boettke on whether Austrian economics is really fruitful is available on sequence of YouTube videos. Austrian economics is based primarily on the works of Friedrich Hayek and Ludwig von Mises, (Carl Menger, Eugen von Böhm-Bawerk, Henry Hazlitt, and Murray Rothbard are also big). I like a lot of what the Austrians write about, and generally have their biases. But some areas of their focus I find less appealing.

What I found most interesting was the crux of the discussion seemed to be on how to treat uncertainty. Caplan finds the Austrian conception rather unhelpful. True uncertainty, to an Austrian economist is 'radical' uncertainty, not amenable to mathematical manipulation. If you look at the work of George Shackle, you see him defining uncertainty as that which generates a potential surprise in some mysterious way that seems only defined ex post. I tend to agree with Caplan that this isn't helpful.

Boettke, however, highlights the old saw that it's better to be approximately right than precisely wrong, yet a precise answer leads to corrections, whereas the fuzzy answers that are surely approximately right are so vague it is not clear how to make better forecasts. The bottom line is the Austrians have been talking about uncertainty of this kind for a couple generations now, with not much to show for it. In that way, it is identical to Keynesian or Knightian uncertainty, concepts that have a certain indubitably true idea, that the the uncertainty we face is quite different than the objective probabilities generated by a fair roulette wheel, yet ultimately I think one has to put this into some formal footing, say by introducing Bayesian priors.

This thread has a very long history (Keynes going back to 1921, Knight to 1919, I'm sure one could go back further), and so it's a main reason why I find Nassim Taleb rather tiresome, because he brings up these old arguments in new contexts as if they are a radical break, and so pregnant with practical application. It is a radical critique--outside standard probability models--but it is not new, so based on history, a rather barren insight by itself. The 'uncertainty' thread remains outside the canon because no one has figured out how to amend standard statistics to incorporate the realistic idea that sometimes we are 'wrong'. It seems reasonable to ask that such criticism can be formalized using the very general tools available in standard probability theory.

It is important to remember that a theory that is approximately right (ie, precisely wrong in some cases) is better than a vague criticism. What is needed is something constructive, something the Austrians, Post-Keynesians, or Taleb, have failed to do.

Betting on Black Swans

Nassim Taleb has become popular, though I don't think he has anything really profound to say (see my book review here). Indeed, a reviewer of my book Finding Alpha lamented I did not mention Taleb, but I did not see the point because I was making a serious point about asset pricing theory and Taleb is a pedestrian populizer, who like all popular populizers, is successful at convincing a lot of people he is saying something new and true. This is not the same as actually saying something new and true. His book does not add any new data, or theoretical insight, to this corpus of knowledge (e.g., the Rietz-Barro Peso problem). But as funds affiliated with Taleb are becoming popular I think it would be helpful to address those specific strategies. The basic premise is that financial economists, and investors, systematically neglect improbable events. The result is that out-of-the-money options, especially qualitative analogues like unconventional investment ideas picked up at cocktail parties, offer the best reward-to-risk ratio. Let's consider these.

You can invest in a Black Swan fund that buys out-of-the-money options such as Universa Investments run by his former partner Mark Spitznagel. Taleb, and Spitznagel, would argue their implementation is much more sophisticated than merely buying out-of-the-money options in that it also takes advantage of 'behavioral biases'. Now, as 'prospect theory' implies people ignore, or overweight, improbable events, such 'behavioral biases' allow a strategy a great deal of latitude. In practice simple ideas, such as the underpricing of out-of-the-money options is too simple to sell, so the vendor feels compelled to confabulate a pretentious but useless tweak. In this case, that just means one sells in-the-money options to lighten the expense (more gamma, less vega). Do the math, and this strategy simply shifts your payoff distribution so it has a funky nonlinearity, shifting returns from the [-10%,0] space to the [-∞,-10%] and [0,∞] space, but the same expected return. That is, say you buy $2 worth of out of the money put options, and offset this a little by selling $1 worth of in-the-money put options. This means you still hit a home run in the extreme event like 2008 (which was, statistically, improbable); you make less in the more probable adverse event; you lose less if the market rises. As empirical studies have found option returns to decrease as one goes out of the money (see Ni, or Bondarenko, or Coval and Shumway), the in-the-money vol sold is relatively underpriced, so the only behavioral bias this is leveraging is a marketing one. Considering that out-of-the-money options are most overpriced, this is a bad strategy.

Clearly in big moves such as 2008 this strategy outperforms. Yet on average, I doubt it. That is, much was made of the "65% to 115%" return reported in October of some Black Swan Funds (see WSJ here), but the VIX peaked then at 80, and is now at 23, while the market has rebounded. It would be interesting to know the subsequent returns, but everyone merely quotes the hearsay (always, 'a person close to the fund reported...') reported on their top tic. As Taleb is insistent that too many investors naively chase last year's winners, it would only be consistent to not make too much of one year's returns. Indeed, Empirica Kurtosis, his earlier hedge fund, also started out with a widely reported 60% return in 2000, but then folded quietly in 2004. I earlier said I would donate $10k USD to his favorite charity if he sends me audited financials showing the cumulative Sharpe ratio of Empirica Kurtosis LLP over its lifetime was greater than 0.5 (which is a poor hedge fund return, consistent with exit), and the offer still stands. Thus, over the long run, not a sequence of 2008s, this is a crappy strategy.

The other problem with out-of-the-money strategies is that option market makers hate being naked low-delta options. You don't have to buy too many to move the price, implying market impact is high. This makes these strategies even more expensive than any simulation when done in size. That doesn't bode well for these now-popular strategies.

Another claim by Taleb is that 'wild' risks from cocktail party chatter is especially useful. At some level this is like saying things that can't be quantified are really important, which has the nice property of being tautologically untestable, but in practice we understand what this means: funky investments outside of stocks, bonds, bank deposits, etc. Llama farms, gold medallions, and no-money-down real estate, are all unconventional, and all scams. Sure, the people pitching them show someone who got rich doing this, the same way Amway lines up its multilevel marketing operation, it is an appealing idea—why not me? Airport Holiday Inn conference rooms are always full of conferences on how to become rich following their 3-point plan, which invariably involves trading through them, or buying their $100 instruction manual. They have a horrible average return, because 'fraudulent scam' is not rare in this space, rather de rigueur. Staffcentrix offers advice and due diligence on home-based businesses offered on the internet. A principal there, Christine Durst, states that the ratios of scams to real home-based businesses is 54-1 on the internet, most following the plan of selling a modestly priced but useless information brochure, enough to make money, not enough to elicit a lawsuit. But the bottom line is that virtual out-of-the-money options are, if anything, more expensive than those traded on exchanges.

In my book Finding Alpha, I argue that people tend to pay for hope, and nothing offers hope better than the lottery-like returns available in potential Black Swans. Hope is a good thing, and motivates a lot of hard work and creativity. But it would be foolish to think that the more improbable, the more speculative, the more derided by economists, the better the risk-adjusted return merely because of this. This tendency to buy into lottery ticket leads to all sorts of really bad investments:

• Higher volatility stocks have lower return than low volatility stocks
• Higher beta stocks have lower returns than low beta stocks
• out-of-the-money options have lower returns--and higher betas--than in-the-money-options
• higher leveraged firms have lower returns than lower leveraged firms
• firms is greater financial distress have lower returns than firms with low financial distress
• Junk bond mutual fund returns are lower than investment grade mutual fund return over the past 22 years
• sports longshots such as 50-1 odds horses, have lower returns than favorites
• lotteries with the highest payouts have the lowest expected returns
• IPOs have lower-than-average stock returns

[This is in my book, and also summarized on an SSRN paper I wrote here.] Notice a pattern? The more volatile, more uncertain, the lower the return. People pay a premium (accept a lower return) for 'Black Swans', because in one fell swoop, they can get rich and prove they were RIGHT! Instant satisfaction. Plus, if you really have the touch, why waste time choosing Coke over Pepsi, when you can choose between GM and Citi!

Basically one would be better off not chasing dreams via Black Swans, and stick to boring investments. Finding alpha—a risk-adjusted return premium—is very difficult, and it involves a niche specific to an individual's skills, which almost surely is not in investing anymore than the average person has alpha singing or writing romance novels. Black Swan investing is a sucker's game, endemic in markets, a perennial loser, and highlights asset classes to avoid, not pursue.

RiskMetrics Goes Corporate

I always have admired RiskMetrics, because they offer straightforward advice about how to measure risk. My career as a risk manager started as an attempt to implement the then-new (1994) RiskMetrics Value-at-Risk methodology to the KeyCorp trading operations. Sure, for any nuanced strategy, they are 'academic', in that they do not understand a lot of parochial issues related to, say, risk arb, but for setting a benchmark, understanding certain tools are useful, and being clear, I give them an A+.

Thus, I was saddened to see their acquisition of the KLD Research & Analytics, "a leader in environmental, social and governance (ESG) research and indexes for institutional investors", because it highlights the essence of Risk Management as a corporate enterprise. KLD's politically correct indices are lame, allowing companies to justify holdings to investors via moral preening. Having the imprimatur of some socially conscious busybody just says you are trying to get by on good intentions as defined by conventional wisdom.

Who's to say if investing in, say, Al Gore's latest initiative is morally superior, better for the world's people, than giving more money to Exxon? After all, Gore's senate tie breaking vote back in 1994 started this corn-based ethanol boondoggle, which is now an entitlement that will take decades to undo. Meanwhile, farming for ethanol takes more energy than it produces when you add up all the indirect cost (as any good economist should). Further, it raises the price of corn, and hurts natural aquifers. In contrast, Exxon produces oil that can then be used by centralized power plants or machines, instead of burning biomass, which is much less efficient.

That RiskMetrics thinks moral posturing complements their activities highlights how senior risk management as a profession is mainly about appearances and going through the motions. To be specific, official risk management, which is what RiskMetrics now advises upon, is mainly staffed by prigs and props. A prig is someone wedded to a theory that explains everything, and can be highly mathematical and conventional, like Phillipe Jorion, or highly obtuse, like Nassim Taleb's insight that 'risk is what you don't expect' [which I find not profound, but irrelevant]. The key is they are true believers, have credibility as experts, and are true idiot-savants: they have a lot of knowledge, and a lot of ignorance.

Then there are the props, the suits who actually run senior risk management posts, and they basically have a full time PR job, catching flak from outsiders about decisions not made in their presence. Official Risk Management futility comes from the fact they are graded on their ability to generate reports read by people three levels removed from a business, so that why the props need the prigs, for references. The prigs need the props to add credibility to what they do, though I think it would be most accurate to say there's some truth in what prigs do, but only if you know where to find it. Nuance, the things that really matter for a businesses survival, don't travel up the chain well, so everything is fit into cookie cutters based on the most recent conspicuous financial failures.

I wonder if the RiskMetrics management has convinced themselves this really addresses risk, or they realize it's simply the way the game is played, and they have to make a living. I'm too cynical to pull it off convincingly. I'm saddened by the whole thing because I understand a lot about actual risk management, but realize how irrelevant that knowledge is to risk management as practiced by large, regulated firms.

Macro, Risk Management. These are two fields I know enough about to avoid.

Fama on Taleb

From French and Fama's website:

Q: It would be very enlightening if you would comment on the Nassim Nicholas Taleb ("The Black Swan") attack on the use of Gaussian (normal bell curve) mathematics as the foundation of finance. As you may know, Taleb is a fan of Mandelbrot, whose mathematics account for fat tails. He argues that the bell curve doesn't reflect reality. He is also quite critical of academics who teach modern portfolio theory because it is based on the assumption that returns are normally distributed. Doesn't all this imply that academics should start doing reality-based research?

EFF[Eugene Fama]: Half of my 1964 Ph.D. thesis is tests of market efficiency, and the other half is a detailed examination of the distribution of stock returns. Mandelbrot is right. The distribution is fat-tailed relative to the normal distribution. In other words, extreme returns occur much more often than would be expected if returns were normal.

There was lots of interest in this issue for about ten years. Then academics lost interest. The reason is that most of what we do in terms of portfolio theory and models of risk and expected return works for Mandelbrot's stable distribution class, as well as for the normal distribution (which is in fact a member of the stable class). For passive investors, none of this matters, beyond being aware that outlier returns are more common than would be expected if return distributions were normal.

Stiglitz is an Idiot

Ok, I read on Tyler Cowen's blog that using negative words like "idiot" and "moron" increases the number of commenters, and presumably readers. Clearly my favorite flâneur, Nassim Taleb, has climbed the best-seller ranks with this rhetorical style, so, I'll give it a try. I think Stiglitz is intelligent and educated. But he is also incredibly biased in a totally predictable, simple-minded way. This is not a partisan critique, just look at his activity: he gives speeches about once every two days. Guys like that don't have time to look at the detailed data, or derive a fresh view, but rather fit it to their internal templates. They are using their position to 'make a difference', which sounds nice, but it just means you are an amoral, confabulating advocate. Think lawyer.

In that way, he is not thinking when he writes, merely advocating the best case for his big picture idea that markets should be sublimated to government control whenever there is not perfect information (no uncertainty or asymmetric information, ie always). He edited volumes 1-3 of the collected works of Paul Samuelson, with a heavy emphasis on market failures. He loves pointing out scenarios where a market equilibrium is not a Pareto Optimum or vice versa (Pareto Optimum being the idea you can't make anyone better off without making someone worse off, a rather modest definition of optimality). Government failure is not interesting to those obsessed with market failure, a common blind spot in the Marxist tradition (very little in Das Capital outlines how communism actually works, it's mainly a criticism of free markets).

Anyway, in today's NYT he rails against Geithner's plan for several dubious reasons, but fundamentally because it is a subsidy to banks and investors. It isn't clear if his distinction between banks and investors is the difference between management and equity, or equity owners and bond owners. Whatever, his Big Idea is that there is always imperfect information, therefore markets are not optimal, therefore have the politburo control it. Here's the Nobel Prize winning argumentation in block quotes:

Let’s take a moment to remember what caused this mess in the first place. Banks got themselves, and our economy, into trouble by overleveraging — that is, using relatively little capital of their own, they borrowed heavily to buy extremely risky real estate assets.

Where's the data? Bank leverage, as measured by common equity to total assets, did not materially change over the past 15 years for banks. Did you mean "Investment Banks"? That did change, but only for a handful (ie, Citi and Morgan Stanley). It's not true merely because you say it every other day when lecturing as Expert on Everything.

In the process, they used overly complex instruments like collateralized debt obligations.

Derivatives are the tail of the dog. If mortgage prices did not collapse, CDOs would not have collapsed. CDO's facilitated risk transfer, if anything, it prevented a worse crisis by moving the effect of the housing price collapse out of banks and into Hedge Funds and Government (ie Fannie and Freddie). This diversification is generally considered a good thing, but here it is insinuated that it was the fuel for the risk taking. Sorry, the impetus was at the other end, with $5 Trillion in Community Reinvestment Act pledges for investing in 'traditionally underserved communities'--ie, groups previously not lent to because they were bad credit risks. Mortgage innovations like low, and even no, money down, implies the greatest leverage was to the individuals, not the banks.

The prospect of high compensation gave managers incentives to be shortsighted and undertake excessive risk, rather than lend money prudently.

Anytime a bubble collapses we can say this, but this criticism needs more flesh on it. It seems to imply that any payment scheme that is a function of revenue generated, that does not have an infinite clawback provision, encourages excessive risk taking. That's a nice bargaining position for a socialist like Stiglitz. That may seem like a partisan shot, but it's true: he's always for giving the state more control into economic activity, to the point that it always has veto power and generally sets the agenda and mission statement, compensation, etc. His ends dictate, with perfect predictability, his interpretation of events and his prescription for rectifying the situation.

Banks made all these mistakes without anyone knowing, partly because so much of what they were doing was “off balance sheet” financing.

Partly to be sure. But for commercial banks this was pretty small. The biggest problem was on balance sheet. Look at the data. Look at a regional bank like KeyCorp. Their stock has fallen 75%, and they lost $1B last year. Most of this was an increase in the provision for loan losses on their books. They had $1.25B in credit default swaps at the end of 2008, and noted (page 60 of 10-K) "These swaps did not have a significant effect on Key’s operating results for 2008." Banks, as opposed to Investment Banks, are not primarily hurting because of derivatives. Their exposure would have only been worse without them.

The problems of AIG and Lehman were of taking too much risk in CDOs and credit default swaps, and to this day I have not seen specifics of their balance sheet. That is, until I see what the reference assets for the swaps, I can't assess their actual solvency, or potential for insolvency (and thus a logical run by short-term debt holders). But those problems are not the problems of our banks, 7000 little companies that try to intermediate between savers and investors. Most Commercial Banks are not Investment Banks, their balance sheets are not dominated by marketable securities.

Stiglitz notes the problem of offering banks basically 6:1 leverage, and a 50% match-funding, by looking at the following scenario. Assume there is an asset with a price of $150, that will pay off $200 or $0 next period. A $12 investment by private companies, a $12 match funding by the government, and a $126 senior debt by government. The return on the 'total value' of this transaction is either +33% or -100% [$200 or $0]. Well, with 6:1 leverage and match funding, that means a 208% return in the up state, or a -100% return in the down state. The expected return: 54% {(208-100)/2}. What a deal! Meanwhile, government gets an expected -40% return on 7 times the capital.

A key here seems to be what the prices and returns really are. If you suppose such a bad transaction, clearly, it is a greater subsidy to the private sector. But given the government is trying to fix things without nationalization, presumably a subsidy is a given. The issue is, are these deals this much of a give away? I doubt it. When was the last time a pool of mortgages was worth zero. Geithner's plan refers to pools of mortgages, not mortgage tranches. A tranche of a pool of mortgages can easily go to zero, especially the mezzanine tranches, but the pool itself? If this seems possible to you, you are, well, an idiot.

It seems like you are giving money away, to fat-cats. The problem is, these are mortgages, so they are not 'idiosyncratic risk assets'. You can not buy 100 of them, with a 54% return, and lock in that return. Instead, investing through time, and I doubt any investors are willing to put up large amounts (billions) in investments with a 50% chance of a negative 100% return. Further, the auction method of selling assets implies that even if this were a case of idiosyncratic risk (say, adverse selection made it 50% of these were worth $200, 50% $0), then somehow investors would be colluding to keep the return at these insanely high (54%) levels. Ah, the deals Captains of Industry make in the back rooms. The nice thing about greed is that it implies competition, and competition abhors easy profits the way nature abhors a vacuum.

Stiglitz notes how efficient government is in nationalizing banks. Who's to say how much value was saved, or destroyed, via government's take over of IndyMac (sold at a loss of $9B last January)? But this will only be worse if they take on lots of banks because then their portfolios will be politicized to the n-th degree, as then broader considerations will be in play. Consider that once they took over IndyMac they halted foreclosure on mortgages, leaving zombie properties where 'owners' had no equity in the properties, and bank's could not resell them. That merely added to their losses, and didn't help the little guy, it just delayed the inevitable resale of that property to someone who was a viable homeowner. Do that with 100 IndyMacs and you have really depressed the market, and a larger impact on poor communities that do not need more unowned properties. When the effective owner has no money in the house, it is not maintained, managed, or re-allocated. It just serves as a place for punks to cause trouble. Indeed, the 'owner' of the house in foreclosure limbo has zero incentive to do anything with the property, just wait and pray for hyperinflation (a potential plank II of the Treasury plan).

After the Great Depression, John Kenneth Galbraith wrote 'The Great Crash', and it was a best seller. The thesis was that greed and short-sighted risk taking, especially by corporate executives, caused the Stock market crash, which then caused the Depression. This was the standard perception for decades. Today, I doubt more than 10% of economists think that greed or short-sightedness was a singular, or useful explanation for the 1929 crash and subsequent collapse, or that the Great Depression was caused by the stock market crash.

Subprime Spawn

This recession hasn't been all bad. Housing is now more affordable, and now we have Kentucky Grilled Chicken, Pasta Hut, Domino's Subs, and $5 burgers at Morton's. Necessity is the mother of fast food invention. On the other hand, we are awash in books reflecting the proverbial blind men describing an elephant.

Two new books are out of the financial crises. One's a recap of Nassim Taleb's arguments in Lecturing Birds to Fly by Pablo Triana, the other a journalist's expose of greed and hubris in Fool's Gold. As this crisis was peaking in October, I imagine many editors got contracts to pen their dramatic explanation of what the heck is going on, so like making babies, we will see a bevy of of such books for the remainder of the year. Right now, I put them into the following themes for laying the blame:

The Fed: Getting Off Track (John Taylor), Two Trillion Dollar Meltdown (Charles Moris), Too Big to Fail (Stern and Feldman)

Too much government: Meltdown (Thomas Woods), Bailout Nation (Barry Ritholtz).

Bubbles: The Subprime Solution (Robert Shiller)

Greed/Hubris: Fool's Gold (Gillian Tett), Meltdown (Paul Mason), Chain of Blame (Muolo and Padilla), Looting of America (Les Leopold), Meltdown (Katrina vanden Heuvel)

Models/Quants/Math: Lecturing Birds (Pablo Triana)

Everything: Panic (edited by Michael Lewis), Financial Shock (Mark Zandi)

That's three 'Meltdown' books on the same subject by different authors! Mark Zandi is the chief economist at Moody's, and he supposedly saw this all coming, highlighting my earlier claim about Simon Johnson, that no one listens to their Chief Economist, which is very useful in hindsight recollections because no one would ever think a Chief Economist was a driving force behind anything an institution actually did (of course, there's a reason no one listens to them).

Bloggers and Journalists are more on the models/quant side (eg, Taleb, Felix Salmon), but some emphasize regulatory arbitrage via derivatives (Arnold Kling).

Clearly, each view has some valid points. There was, and is, greed and hubris. Models are not infallible maps of reality. People--investors, homebuyers--chase trends. The Fed had low interest rates in the early naughts, regulators and legislators were encouraging lower mortgage standards, derivatives were increasing in complexity, and with hindsight housing followed a classic bubble trajectory. The key is to focus on the primary drivers, the theory, because the facts themselves are rather ambiguous. Thus, descriptive books on the Bear Stearns collapse or Dan Gross's Dumb money are somewhat useful, but really are just like reading newspaper stories about what happened. History without a good theory is very barren, and it's easy to focus on irrelevancies, especially because it's tempting to focus on personalities (hubris anecdotes or emphasis on pot-smoking CEOs) or diagnoses that would be really clever and interesting if they were true (obscure math errors).

For me, the best explanation comes from two parts. Stan Liebowitz's account on how we slowly eroded mortgage standards with the best intentions, led by academia, regulators, legislators, and investment banks. And then the accelerator mechanism outlined by Gary Gorton. Neither are books.