Sunday, November 09, 2008

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.


Anonymous said...

"Had he got his forecasts for the fall of banking wrong, the error would only have strengthened his general theory of black swans."

sums it up the best. he's right in some respects though, but you're too blinded by your biases to admit it. the return is appalling anyway; even if you make 100% in the catastrophe-of-the-century year and 1% in the rest, it's underperforming big time.

Anonymous said...

I agree with you 100 percent,

I like a lot of what Taleb has written previously and was a devout follower of him after he wrote "Dynamic Hedging". He was way ahead of anyone at the time and what he wrote about in that book at the time few of us options traders globally were actually trading that way.

Then came "fooled by randomness" and taleb used the options framework to start to explain life in general. He followed up that global hit with the "black swan" and failed to see that he has become one himself.

All he is constantly doing is purchasing some wings (for his fund and writings) and loving the attention. He bought some insurance, shit happened, he made money...hhhmmm let me see..Skilled trader ? or lucky idiot? using his vernacular.

Unfortunately he is to busy stuffing himself with his own self importance to see it.

Taleb was a good trader.

That was a long time ago.

Today he is a just a mouth !!!

Anonymous said...

I think Taleb has stated he is an example of a black swan--at least with respect to his books' popularity. And I've never seen anything to suggest he claims to be a 'skilled trader,' lucky idiot is probably more accurate. Incidentally, he recently told an interviewer the banking bust wasn't a black swan, since plenty of people saw it coming and knew it was potentially a 'huge impact' event.

The way I read Taleb (and I've been following his writings for about tens years), he's just saying: don't believe there's ANY certainty in future returns calculated using past returns & bad models of risk. Hey, lots of people swear by technical analysis and some even get rich--expertise in using a rigorous method or dumb luck?

Taleb: Former good trader who's just a bitter, attention-hungry mouth?--or, Gifted author who survived throat cancer (despite the grim odds) and decided life's too short to waste on anything you're not passionate about?

Anonymous said...

I dunno, dude. You just seem to say Taleb twists your panties. I sincerely think you need to get far, far away from your little world and go out and live. Then you might understand why endless tweaking of technical points is silly, particularly when you are as cocky as you seem to be.