(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.
* 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: Nassim Nicholas Taleb