Wednesday, March 13, 2019

Antifragility is just Hormesis (to the extent it works)

In Nassim Taleb’ book Antifragile he emphasizes that ‘if you see a fraud and do not say fraud, you are a fraud,’ I am thus compelled to note that Antifragile is a fraud because its theme is based on intentional misdirection. The most conspicuous and popular examples he presents are also explicitly mentioned as not the essence of antifragility. Indeed, incoherence is Taleb’s explicit strategy, as the Wikipedia entry on Antifragility notes Taleb presents his book in a way to make it difficult to criticize.

I bring this up because last month I was listening to a Joe Rogan podcast where they mentioned hormesis, the concept that small amounts of a toxin or stressor strengthen an organism. The guest noted hormesis was discovered in the 1950s when researchers noticed a little bit of herbicide paradoxically makes plants stronger. Actually, this phenomenon was found back in 1888 concerning yeast, though the basic idea is probably timeless in that everyone understands exercise strengthens muscles while immobilizing a limb after an injury leads to atrophy. A glass of wine a day is a tonic, though too much leads to cirrhosis. The term Mithridatism comes from King Mithridates (160 BC) self-administering small amounts of a toxin to build up his immunity, so this is a very old idea. 

tweeted that Taleb thinks he invented hormesis, whereupon Taleb quickly noted that antifragility is not hormesis, and Antifragile explicitly mentions hormesis and its 1888 discovery, as well as Mithridatism. A snippet of his Twitter rebuttal is here. Tweets are not the place for snarky subtlety. My point was that far as antifragility works, it's hormesis, in spite of Taleb's qualification that "hormesis is a metaphor" for antifragility. This got me wondering how such a contradiction happened.

Taleb states his neologism antifragility is "beyond resilience or robustness." He defines antifragility more precisely as "a convex response to a stressor or source of harm, leading to a positive sensitivity to increase in volatility." Thus hormesis is not an example of antifragility, because, in the parlance of finance, hormesis is like having a positive but modest beta, while antifragility is increasing the value of a portfolio by increasing its gamma. Gamma is a measure of convexity, the signature feature of a put or call option, and in uncertain environments, a higher gamma leads to a higher value.

The common takeaway of Antifragile, however, is simple resilience. For example, in Jonathan Haidt's book the Coddling of the American Mind he credits Taleb’s concept of antifragility for arguing that protecting students from ideas they find offensive leads to them becoming more fragile, anxious, and easily discouraged. Actively confronting ideas we don't like makes us tougher and smarter, or as JS Mill wrote, ‘he who knows only his own side of the case knows little of that.’ Haidt's book mentions unstructured play for children, the immune system, and exposure to peanuts as examples of Taleb's concept of antifragility. Wikipedia’s entry on antifragile gives as its primary example that of bone density being strengthened by exposure to stress. These are all examples of hormesis.

Convex Payoff
If you own an option you have positive convexity and benefit from higher volatility; you are long volatility (aka long vega). It has long been known that financial options, especially out-of-the-money put and call options, have poor average returns. A good example is provided by VXX ETF, which is long vega and loses money with about the same Sharpe ratio as the SP500 index. Being long vega is like shorting the market, good in bad times, but in the long run a bad investment.

Taleb is aware of this and states that good antifragile things are not financial options because they "are sold by someone," but rather real options, which he thinks are free: "we don't pay for options given to us by nature and technical innovation." His prominent example here is Thales of Miletus. Aristotle gave us the story that Thales secured the rights to wine presses at a relatively low rate, which is an option: he had the right, not the obligation to use the wine presses. When the harvest proved to be bountiful, and so the demand for the presses was high, Thales charged a high price for their use and reaped a considerable profit. Taleb states the key to Thales's fortune was his awareness of his 'lack of knowledge,' in that as he owned an option he enabled himself to benefit from uncertainty.

I do not have data on wine presses circa 600 BC, but currently, such options are generally over-priced. For example, in futures markets, there is a thing called the basis, the difference between the future and cash price of a good reflecting the yield on the asset vs. the opportunity cost of money (ie, the interest rate). One of the components of that basis is the convenience yield, in that if there is a shortage, having the actual commodity will have a great value. For goods subject to shortages (eg, wine presses), this increases the cash price over the future price because having the good on hand can be very valuable in a crisis. William Easterly has argued that Western countries dumping grain on African countries during shortages deprives farmers of essential farmer revenue that comes from crises; often this profit pays for breaking even during normal times, so removing it discourages endogenous markets. Spikes in demand are a large part of any asset owner's income, statistically anticipated and priced into well-functioning markets. Simple awareness of a 'lack of knowledge' about future demand is not helpful, because it presumes the seller assumes the convenience yield or option value is zero. It may have worked in 600 BC, but markets have removed that inefficiency. 

Taleb gives other examples, for instance: avoiding doctors, having different alternatives on vacation or for dinner, the ability to switch jobs, a rent-controlled apartment, or being married to an accountant but an occasional fling with a rock star. To the extent these options are desirable, they are not underpriced, and certainly not free. People realize this, which is why they are rarely mentioned as examples of antifragility by Taleb's many supporters. The bottom line is that things with convexity are too costly in general because people love lottery tickets; convexity is not the essence of any antifragile example because they are generally not good investments (antifragility is supposedly a good investment or strategy). 

Another misleading application is in biology or economics, where populations or markets that have had to withstand more competition and external variability dominate those with benign environments. A bacteria population in the lab loses its ability to withstand stressors, an industry protected from new entrants loses its ability to compete when technology changes the game, or an industry protected against failure becomes bloated and less robust. Systems that allow or even encourage failure thrive relative to those that protect its members from failure. In economics, the basic idea of exiting losing businesses is perhaps the most crucial advantage of the free market over socialism. Failure strengthens the herd, whether animals or firms

Taleb states that his notion of antifragility is behind the following: "evolution, culture, ideas, revolutions, political systems, technological innovation, cultural and economic success, corporate survival, good recipes, the rise of cities, cultures, legal systems, equatorial forests, bacterial resistance." Success within these domains comes from looking at the competitive success of groups benefiting from hormesis vs. those insulated from it. Competition leads to the resiliency and efficiency needed to survive.

Back to his definition of antifragile, it is not that the prospering agents are convex to stress, rather that as survivors their progeny takes over the extinct's lebensraum; the dynamic effect of robustness in a system based on survival of the fittest looks like convexity.  Indeed, Taleb notes the property applies to the group, not the individuals: "the surviving cohort is stronger than the initial one—but not quite the individuals since the weaker ones died." So here, like with hormesis, he notes it is a metaphor, not a precise analogy. He is quite aware that such systems are not direct examples of antifragility because the agents that generate convexity at the higher level are merely robust, via hormesis, and their germline exhibits convexity. 

A robust business has to innovate because every business model changes over time. Jeff Bezos notes success takes someone with a stubborn vision yet flexible on details, because without a strong vision one's strategy overreacts to current failure or success, while without flexibility one cannot adapt when things do not work precisely as planned, as they always do. Note here we see a classic example of 'moderation in all things,' where the optimum lies between an excess and deficit.  In contrast, Taleb describes a caricature of vision via his "teleological fallacy" which is the "illusion that you know exactly where you are going." One could go on all day about the inadequacies of strawmen, as Taleb does.

An industry protected from failure or change via union work rules or bailouts removes the micro-instability needed at all levels of a company to develop innovation, robustness, and a healthy familiarity with failure. While some rules and regulations are good, most are merely a pretext for barriers to entry protecting current workers and firms. This is just an argument for allowing stress, and the resulting failures it implies; that is, for hormesis to do its thing.

Becoming excellent first requires a lot of domain-specific hard work, with a focus that enlarges some things while excluding others. Jordan Peterson argues that flow comes from operating at the edge of our competence, with enough mastery to generate satisfaction yet enough novelty to be challenging. To an outsider, such explorations can seem like random tinkering, but for an expert, it is a variation on their unusual intuition. Suggesting that the general strategy of accumulating convex exposures is the key to success is a profound error, as in the difference between the benefit of anger, and anger directed at the right person at the right time and in the right way.

An essential attribute of someone who innovates is their ability to embrace failure. Adversity is a great teacher, why mother giraffes knock their newborns down just after first learning how to stand;  they have to learn quickly on the African grasslands. Embracing failure is easy to say but hard to do, which Taleb acknowledges. Actually, he doesn't explicitly acknowledge this, but as he never mentions why he worked for several banks while he was a trader (blow up?) or the fact that every close friend he mentions in Antifragile is highly successful, suggests he sees failure as a characteristic of unremarkable losers.

Failure will always be costly, and due to moral hazard, no one will sell you a put option on your failures (you would fail on purpose to cash in on your put option).  In addition to acclimating ourselves to failure, just as useful are the Christian virtues of faith, hope, and love. If you have faith in what you hope for regardless of your economic success and love someone who loves you for who you are, failures under the sun are not so terrible. This allows you to explore more virgin territory so that when the unexpected happens, you might be in the right place at the right time.

There are two ways to generate an option payoff. One is to buy an option; another is via dynamic replication, which involves doubling down a position as it becomes more in-the-money. The outsized success of winners over losers in dynamic systems generates large convexities, but to be a winner, the keys are not buying options, but rather, via resilience acquired through hormesis, surviving long enough to achieve success indirectly via a combination of vision, excellence, and flexibility (obliquity). To describe the essence of this as creating option payoffs focuses people on explicit optionality, as opposed to the optionality that comes via hormesis. Resilience generates outsized winners in dynamic zero-sum competition over time as the survivors take over. This is why everyone mentions examples of hormesis, waves their hands, and hopes no one notices the bait-and-switch.

Promoting the new idea that acquiring options on the next Black Swan is the basis of "our own existence as a species on this planet" is the sort of hyperbole you hear at TED talks. It is the sort of thing bureaucrats love because they are generally too high up to have much domain-specific expertise, and the incoherent but plausible-sounding theme allows one to talk about strategy without actually knowing anything specific. Then you give examples of your great idea that are really something else entirely, and fade to black...


Caveat B said...

Rhymes with cold fusion and MMT?

Thanks, Eric, you have been given such deep wisdom, and it's always great to read your thoughtful work.

The truth sets us free.

Anonymous said...

Great critique.

Anonymous said...

We regularly consider the concept of antifragility in the process of managing our equity portfolio. One way that we've increased the antifragility of our portfolio successfully in recent years is by owning the shares of companies such as CME Group or MarketAxess, to name two such examples.

We can clearly differentiate here between antifragility and hormesis because we're not adding even a slight bit of 'toxicity' to our portfolio by including the shares of these companies in it. Yet when markets go haywire and investors desperately need to do a lot of hedging, or do a lot of bond trading - more than in normal situations - both of these companies tend to benefit from that activity that often takes place when markets are imploding. As a result, the shares of these two companies tend to outperform when things are getting hairy. One could argue that the shares of Oaktree Capital declined just 1% in the fourth quarter in the face of much deeper declines for broader equity indexes for the same reason.

Eric Falkenstein said...

I like it! It's a good story for investors, and it targets low vol/beta. Low vol equity investing is a good strategy, but it's robust, resilient, not convex. The betas, while low, are still very positive.

capitalistic said...

Interesting view. Taleb is brilliant, but his views are more philosophy laced with science and mathematics.