Thursday, June 25, 2009 11 comments ++[ CLICK TO COMMENT ]++

Dr. Black Swan - Is Nassim Nicholas Taleb overrated?


(Illustration by unknown artist. Blowing Up by Malcolm Gladwell.The New Yorker, April 22 & 29.)


Nassim Nicholas Taleb is a controversial man these days. Some of it probably comes from the envy of others, but some of the criticisms are quite valid. For those not familiar, he is, without a doubt, Mr. Black Swan. He successfully profitted off the stock market crash, and has suggested that investors understate risk. Not just once or twice, but almost perpetually.

I haven't linked to any of his works or commentary because his investing style isn't suited to me—he is essentially a trader and I am not—and I don't think his views can be successfully executed in the long run, at least when it comes to small investors. Some traders may profit from his strategies but it is a painful strategy. From what little I know of Taleb's work, I think most of it is useful for academics, risk officers, executives, policymakers, and the like.

I was writing this post a few days ago and Blogger lost my post (didn't save properly :( ). The original post was more critical of Nassim Nicholas Taleb. The current one, upon some reflection, will be more neutral.


Writing for The Big Money, Mark Gimein criticizes the strategies of Nassim Nicholas Taleb and suggests he is overrated. It's a good article capturing the key flaws of Taleb's strategy:

But the failures of the Niederhoffers and AIGs do not translate to a validation of Taleb-style catastrophism because these two approaches turn out to be linked. They are mirror images. In noncatastrophic times, the Niederhoffers and AIGs make money consistently and quietly and then end up losing it conspicuously and painfully. The Talebs make money rarely, amaze everyone because they do it when everybody else is getting killed—and so make it easy to forget about years of steady losses. Over the long run, the anti-catastrophists often do fairly well (if they don't get too greedy and make bets that cost them all their money in even a small market drop). But it is the catastrophists, a la Taleb, who look smarter. If you're always planning for crisis, you look like a genius when it does come.


I think there is some merit in the criticism levelled at Taleb. Betting against some outlier events, usually by buying way-out-of-the-money options, seems like a dumb strategy. But when it does work—it will work once in a while—you look like a genius.

Taleb and his team probably price the odds better than the competition. Even then, the problem I have is the following. What if the outlier doesn't materialize for a long time. You can easily bleed to death. What if the outlier occurs in year 11 but you are bankrupt by year 10?

Taleb, as Gimein suggests, is betting against investors like Victor Niederhoffer (you may recall him from the entertaining New Yorker article, The Blow-up Artist by John Cassidy, I linked many months ago.) Niederhoffer blew up twice and has basically been washed out permanently, like the captain of the ship that ran into Moby Dick. I'm not sure if Niederhoffer is a good opponent of Taleb, given my impression of Niederhoffer as a pure speculator. But what if Taleb is betting against more seasoned veterns?

Left unsaid by many is how Taleb is also indirectly betting against Warren Buffett. At least I think so. Recall how Buffett was writing long-dated put options on various stock indices. Well, Taleb is buying long-dated options as well. I'm not saying Taleb is directly buying what Buffett is writing—Buffett's options are probably purchased by some insurance company or pension fund—but the positions are opposite each other. The price also matters but let's say that neither Buffett or Taleb and grossly mispricing the options. (There are some differences* but I don't think they detract from my comparison.)

Now, whose view is right? Buffett is essentially saying that he is willing to write a put option on a stock index, at the right price, because he believes the market will go up. Is Taleb saying that the market will go down? Not quite. Contrary to popular opinion, Taleb doesn't bet on a bearish case per se. Even some of the bears who are fans of Taleb don't understand that he isn't a bear like them. Rather, Nassim Nicholas Taleb bets on the possibility of something adverse, that no one imagines, may occur. In Blowing Up, the excellent Malcolm Gladwell article for the New Yorker, Gladwell says the following about Taleb's thinking:

The men at the table were in a business that was formally about mathematics but was really about epistemology, because to sell or to buy an option requires each party to confront the question of what it is he truly knows. Taleb buys options because he is certain that, at root, he knows nothing, or, more precisely, that other people believe they know more than they do. But there were plenty of people around that table who sold options, who thought that if you were smart enough to set the price of the option properly you could win so many of those one-dollar bets on General Motors that, even if the stock ever did dip below forty-five dollars, you'd still come out far ahead.

...


Taleb's hero, on the other hand, is Karl Popper, who said that you could not know with any certainty that a proposition was true; you could only know that it was not true. Taleb makes much of what he learned from Niederhoffer, but Niederhoffer insists that his example was wasted on Taleb. "In one of his cases, Rumpole of the Bailey talked about being tried by the bishop who doesn't believe in God," Niederhoffer says. "Nassim is the empiricist who doesn't believe in empiricism." What is it that you claim to learn from experience, if you believe that experience cannot be trusted?


Taleb is essentially saying that you cannot be sure of anything, let alone be confident that the stock market is going to be higher in 10 or 20 years. Warren Buffett, on the other hand, is betting that the stock market is indeed going to be higher or at least not any lower (Buffett will lose money if the market has declined at expiry of option. Strictly speaking, the market has to decline more than the amount Buffett would earn by investing the premiums that are paid up-front.)

Is Taleb wrong here? If Mark Gimein's dismissal of Taleb's strategy were correct, Taleb has to be wrong with his thinking here. That is, Taleb is incorrect is suggesting that we can't be certain of the future. So who is the loser here: the option buyer who bleeds constantly, or is it the option seller who gets blown up once in a while? Regardless of what one thinks of Taleb's strategies or his persona—some view his as somewhat arrogant—one has to commend him for introducing the unpredictability of fat-tail events into our investing lives. I don't necessarily think small investors benefit from this; but those at hedge funds, investment banks, and the like, should think about Taleb's suggestions. In addition to reading his books, anyone interested may also want to check out the academic paper suggested by some commentator for The Big Money article.



---------
FOOTNOTE:
* Buffett and Taleb aren't taking as much of an opposite bet as Niederhoffer and Taleb were positioned. First of all, Taleb is a trader and hence can be short-term-oriented whereas Buffett is long-term-oriented. So it's possible for both of them to lose money or both to make money. Buffett also wrote European options whereas Taleb likely uses American options (for those not familiar, European options can only be exercised on a specific date, whereas American options can be exercised at any time before expiry.) It is far more difficult to profit off crashes if one uses European options (since the fallen price may recover by the expiry date.) It is not clear to me if Buffett would consider writing American options to be a sound strategy (if Buffett would never write long-dated puts on a major index using American options, then Taleb and Buffett may be on the same page.) In the grand scheme of things, though, Buffett and Taleb can, indeed, be considered as taking opposite positions.

Tags:

11 Response to Dr. Black Swan - Is Nassim Nicholas Taleb overrated?

John Y
June 26, 2009 at 3:25 AM

As a Taleb fans, let me respond this on 2 fronts:

1. I think Gimein misses a key point in Taleb's worldview: the market doesn't only underestimate the likelihood of catastrophic events (the thickness of the fat tail), it also underestimates their out-of-portion magtitudes (the length of the tail) because, as Taleb puts it, the systems are non-linear. So, the 2 sides of catastrophism/non-catastrophism aren't "mirror images". They are anti-symmetric. As for the "long waiting", isn't that precisely Taleb asserting: people underestimate the likelihood? You think it takes too long to wait, but Taleb says it appears far more often.

2. Taleb's trading strategy is based on his worldview: a probabilistic worldview. As layman, we may not be able to employ his trading strategy. But that doesn't mean we can't utilise a probabilistic framework understanding events around us. Charles Munger says "you got to have [mental] models in your head". A probabilistic worldview is one of them that I found vital in many aspect of investment.

p.s. Not sure if you're interested in reading Taleb. If you do, I would suggest skip "Black Swan". Try "Fooled by Randomness" first. More concise.

Vishnu
June 26, 2009 at 5:58 AM

Hi,

You have missed a crucuial point..if you lose , how much you lose...and if you gain , how much you gain..

Bleeding startegy is fine as long as your loses are extra thin..your gains are extra big...

Regards
Vishnu

MrParkerBohn
June 26, 2009 at 6:41 AM

Taleb speaks of the 'negative skewness' of the returns on many investments.  By this he means an investment that predictably yields profit most of the time, but very occasionally 'blows up', yielding a large loss.

Taleb seems to say that investors irrationally seek situations of negative skewness.

Unfortunately, however, it is impossible for investors (as a whole) to avoid negative skewness.  This is because life events commonly exhibit negative skewness.

Most complex things are built brick by brick, but can fall apart very rapidly under the wrong conditions.  For instance, ships, cities, cars, and houses are all constructed one step at a time.  All of these goods yield a predictable persistant utility, until disaster strikes.  Ships sink, cars wreck, houses burn down, and cities are destroyed by earthquakes or hurricanes.  These are all real-life examples of negative skewness.

There are many more examples of negative skewness in life events.  A worker may produce consistent value year after year, until unpredictably laid low by accident or illness.  Electronics serve their function, until one day, they simply stop.  Entire products serve a society, until rapidly becoming obsolete.

It is very much harder to think of real-world situations with positive skewness.  What good produces a constant small loss, with a rare large gain?  The only things I can think of are economic constructs that exist specifically to provide positive skewness, such as insurance, and the lottery.

So it seems to me that while it is possible for a trader to bet against negatively skewed situations (which is what Taleb seems to do), it is impossible for investors or society AS A WHOLE to bet against negatively skewed situations, since life and the economy are themselves negatively skewed.

What do you think?

Sivaram
June 26, 2009 at 10:37 AM

Interesting thoughts by all three of you. Thanks for the comments. Here is a question:

Isn't Warren Buffett (at least with his bet on the 4 stock indexes) going completely against what Taleb is suggesting? It's possible that Buffett extracted a high premium but even so, isn't Buffett doing the complete opposite?


The interesting thing will be to see if more participants start betting against low-probability fat-tail events. Will we see more people trying to use strategies similar to Taleb? So far, my impression is that Taleb is one of the few to bet on fat-tail events.

Vishnu
June 26, 2009 at 10:38 AM

Hi MrParkerBohn,

You are correct. Peolpe can deal with negative skewnewsss in physical entities..like cars , ships..

But in financial market , there are two layers of skewness..One in underlying entity..and another on Price (influenced by people's emotion)..

People drive cars , travel in ships..there are necessacities in urban life..But none force you invest in stock/ bond markets..

People can simply protect themselfes by keeping their cash in their pocket.

Regards
Vishnu

MrParkerBohn
June 26, 2009 at 11:22 AM

It seems to me that Taleb and Buffett are not just taking opposing trades, but that they are engaging in two completely different activities.

Taleb is speculating, based on statistics and behavioral science.

Buffett is not speculating, he is providing a service (insurance against fat-tail events), and is being paid for the service.

Sivaram
June 26, 2009 at 12:17 PM

MrParkerBohn: "Buffett is not speculating, he is providing a service (insurance against fat-tail events), and is being paid for the service."


What's the difference between that and speculating? Was AIG speculating or providing a "service"?

I would say that Buffett is also speculating based on statistics and economic history. Taleb probably relies on human psychology and behaviour more, whereas Buffett relies on economic history.

Strictly speaking, one can perhaps argue that one side is a speculator while the other side is doing it for a commercial reason (sort of like how one side of a commodity futures contract is classified as "speculators" while the other side is "commercials".) But in the grand scheme of things, it doesn't make much difference from an investing point of view. Buffett is trying to make money and so is Taleb.


If Taleb claims that market participants are under-estimating the tail risk, in both probability and magnitude of outcome, then that applies to Buffett as well. Perhaps Buffett is charging an appropriate price but we don't know that--that's the whole point of Taleb: we just don't know.

MrParkerBohn
June 27, 2009 at 11:13 PM

I agree with what you saying.  Both Taleb and Buffett believe that risk is being mispriced, and are exploiting it.  In this sense both are speculators.

But lets imagine a perfectly sane world where the risk is known to all parties...

Under these conditions, Buffett would still on average make money, since he would be paid to provide a service (taking on the risk of insuring against fat-tail events), and Taleb would on average pay money, since he would have to pay for the service of moving his fat-tail risk to another party.

Another way to put this is that if the real risk were known to all parties, Taleb would no longer have any reason to trade (since he couldn't exploit a perceived mispricing of risk), but Buffett could still demand premiums for selling his put options, since insurance would still be in demand.

MrParkerBohn
June 28, 2009 at 3:38 AM

Thank you for the response.

I guess what I'm saying is that both physical goods and organizations often exhibit negative skewness.  A company, country, institution, or civilization typically must be painstakingly built over time through the ceaseless efforts of a group of people.  But all of these organizations are prone to unpredictable but rapid collapse.

This can be seen by simply examining how many organizations from, say, 1000 years ago still remain today.  Very, very few.  Most generated whatever wealth or utility they gave, continuously year after year, until finally, they collapsed.

You are right that it is possible for an individual to protect their assets (to an extent) by keeping cash, or even by using a Taleb-like strategy of betting on fat-tail events.  However, it is not possible for society as a whole to protect itself from negative skewness.

Society as a whole cannot turn its stocks its cash (the stocks and companies must exist in somebody's hands).  Society as a whole cannot withdraw from its companies, governments, and cities, all which seem to me to be negatively skewed.

I suppose all I am saying is that Taleb may be right about people mispricing assets with negative skewness, but it seems to me that he is wrong about people preferring assets with negative skewness.  It looks to me like our economies, organizations, and lives naturally and unavoidably have negative skewness.

move entirely into cash.  All of the goods and companies still exist, and must be owned

MrParkerBohn
June 28, 2009 at 3:42 AM

Thank you for the response.

I guess what I'm saying is that both physical goods and organizations often exhibit negative skewness.  A company, country, institution, or civilization typically must be painstakingly built over time through the ceaseless efforts of a group of people.  

But all of these organizations are prone to unpredictable but rapid collapse.
This can be seen by simply examining how many organizations from, say, 1000 years ago still remain today.  Very, very few.  Most generated whatever wealth or utility they gave, continuously year after year, until finally, they collapsed.


You are right that it is possible for an individual to protect their assets (to an extent) by keeping cash, or even by using a Taleb-like strategy of betting on fat-
tail events.  However, it is not possible for society as a whole to protect itself from negative skewness.

Society as a whole cannot turn its stocks its cash (the stocks and companies must exist in somebody's hands).  Society as a whole cannot withdraw from its companies, governments, and cities, all which seem to me to be negatively skewed assets.

I suppose all I am saying is that Taleb may be right about people mispricing assets
with negative skewness, but it seems to me that he is wrong about people preferring assets with negative skewness.  It looks to me like our economies, organizations, and lives naturally and unavoidably have negative skewness.

John Y
June 28, 2009 at 9:12 PM

I think you're right that, in this particular instance, Buffett and Taleb are both speculating. Taleb doesn't publicize and boast his investment activities nor their performances. (This is a point worth mentioning. His books focus on the intellectual ground. He never preaches the idea of using his philosophy to do trading.) But I remember reading that Taleb doesn't betting on the broad market. Instead he puts his bets on individual stocks. We don't know how he picks the stocks. But one would guess it's technical/statistical based. So, Buffett and Taleb are not quite betting against each other.

Post a Comment