Friday, March 28, 2008

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!


Bill Drissel said...

"mm" is the abbrev for millimeter. Abbrev for million is "M".

Bill Drissel

Anonymous said...

More on Taleb by Pablo Triana (that is sure to annoy).

Eric Falkenstein said...


I never thought that everyone took the Normal distribution as gospel. The funny thing is, Wilmott's text on derivatives uses no more but no less of the guaussian distribution. So if Wilmott 'gets it', who are these derivative users and expositors who naively think everything is gaussian? I think it's a straw man, like saying everyone who doesn't like Obama is a racist, a caricature.

Anonymous said...

I actually looked at the book when I was at Barnes & Noble last week. It's just like the Mandelbrot book, a big rant.

It seems to me that Taleb rehashes what everyone already knows = fat tails.

The real problem is not the fat tails; arbitrage as a strategy is the problem. By definition, the margins are thin. Levering a nickel 20X to transform it into $1 is the problem.

Even regular "turbulence" is enough to blow them over.

Anonymous said...

It's false to describe his $35m eurodollar profit as an unhedged or risky position. Most likely, he owned a bunch of far out of the money options on the cheap, which paid off huge on the move, the trading equivalent of a wacky investment with powerball-type upside.

Eric Falkenstein said...

Traders make money off flow. You don't want traders habitually taking bets that an unprecedented event will happen. on average, that bet is a loser, and its outside the scope of a trader's job description.

Anonymous said...

Did you happen to see this recent interview with Taleb?

I think my favorite part was this:
Did your personal portfolio benefit or suffer from the subprime crisis?
I prefer not to answer that, as I am trying to avoid talking about my nonintellectual activities. .

That's Taleb, Mr. Discreet. Link via Free Exchange , which unbelivably starts its post with this:
“RISK GURU” Nassim Taleb saw the current financial crisis coming. He anticipated it; while those on the street stayed ignorant, taking false comfort in their models of risk.

Anonymous said...

"Traders make money off flow" True, ONE of an innumerable number of ways they make money. If you limit it to market makers, you move closer to the truth.

I will grant you that it is not easy to trade as a market maker while simultaneously trading positions. But market makers regularly skew their markets depending on their big picture view, which you apparently have a problem with. To criticize Taleb because you feel he stepped out of your strict definition of a market maker is silly.

Eric Falkenstein said...

"True, ONE of an innumerable number of ways they make money. If you limit it to market makers, you move closer to the truth."

Traders would like to think so. They like betting with other people's money. If they lose, they move across the street to the next firm. Good traders make money off flow. I've worked with several trading groups, and to the extent traders are taking bets, their bosses want these small and put in an explicit account to keep score, not mingled with their basic business. When this is done, inevitably the trader stops taking bets after a few months.

Bad traders, and the stupid organizations that employ them, take speculative bets with other people's capital at risk. Most traders want people to think they are really savvy speculators, because its obviously a harder job, justifying their large pay. Alpha deception.

Anonymous said...

"Traders make money off flow. You don't want traders habitually taking bets that an unprecedented event will happen. on average, that bet is a loser, and its outside the scope of a trader's job description."

You're simply failing to understand the nature of option market making. Nobody, absolutely nobody, bothers to button-up every single out of the money option they might happen to be long or short. It's both a waste of time and money.

What's more, if I've been making markets in a given name for the past year, I might be long a bunch of in-the-money calls, which are hedged 100% versus short stock. I'm not going to bother trying to find someone to sell the put against. No one would buy it. But if the market craps out, like it did Oct 19th, I look like a genius, because now I've got all that curvature. I'm buying in my short hedge and making a fortune.

Option market making is a lot more than simply making money off the bid-ask spread. Maybe 20 years ago guy's would button everything up in a reversal or conversion, but not today. There's a ton of position and risk management to it.

"Traders . . . like betting with other people's money. If they lose, they move across the street to the next firm."

You could say the same thing of most "mean-variance optimizers".