I recently attended an investor conference where, as is typical these days, people gathered to reaffirm how clueless we are about the future of our economy.
Just to bang the point home, the keynote speaker was Nassim Taleb, author of “The Black Swan”; a “treatise” on how our failure to take into account eventualities that are possible only remotely, yet are highly consequential, can really hurt us.
These highly remote but highly consequential events are the black swans. The metaphor comes from the story that, before the discovery of Australia, everyone thought that all swans are white (what fools!). Moreover, according to Taleb, black swan events, in retrospect, appear very plausible--but only in retrospect.
Taleb seemed to draw tremendous pleasure from being invited to wine, dine and, for a nice sum, give a speech to those very “imbeciles” who got it wrong because “they didn’t want to hear” (him).
Before I go any further, let me say for the sake of full disclosure that I have not read the book, though I understand (from Taleb’s hour of self-promotional spiel) that it makes a number of good points about how reality is, as opposed to how we (fool ourselves to) think it is.
But this is not about the book, reviews of which there are aplenty. It’s about the suggestion that the present financial crisis is a validation of Taleb’s vilifying statements about economists, statisticians, finance professionals and their entire canon. Oh yes, and the French!
Well it’s not. First, because the current crisis is not a black swan. Alas, the world’s economic history has offered a slew of (very consequential) credit and banking crises (see here for a free sample from the IMF). So not only aren’t credit crises highly remote; they can be a no-brainer, particularly if they involve extending huge loans to people with no income, no jobs and no assets.
Monday morning quarterbacking, Taleb would counter. Not really. There were certainly a few "doomsayers" (stress "a few") in the academic and investor community, who did warn about the impending downturn and the consequences of loose credit standards. Some took contrarian positions and made money! Some had even attended the economics or finance programs that Taleb dismisses.
Getting the diagnosis right is critical for coming up with the right proposals. And Taleb's proposals are either impractical or secondary (barring the plain obvious).
First, because aside from our often inadequate models, there were a few other blatant failures that contributed to the current crisis: The collapse of oversight by regulators and investors themselves, driven by a mix of uncritical laissez-faire ideology, the avid search for yield as global liquidity ballooned and, in some cases, fraud. Unless we fix these, even the most perfect models will not shield us from a black swan.
But then again, Taleb does not ask us to seek perfection. Instead he proposes we acknowledge our ignorance and protect ourselves.
“Beware of the Black swan!”, he warns. But what does this mean in practice? For example, I work at one of the top floors of a high-rise building in Manhattan—with a (less than remote) probability that my floor might get hit by a flying suicide bomber dressed as Superman.
Pretty consequential, if you care. But what should I do? Change jobs? Move to Peoria? Maybe Taleb can get me a parachute, a golden one please, which would get me to the Bahamas and solve my life worries once and for all! Alternatively, I can keep on living as I do, aware that I’m running the risk of becoming a case number in Homeland Security’s terrorist statistics.
Taleb’s recommendations on asset allocation are as impractical—barring generalities (like diversification or more equity than debt) that are indisputable for being self-evident. But what about the specifics?
Sure, you can put 80% of your money to US Treasury bills, to make your portfolio more robust. But if the world were to follow his advice, we would be effectively delegating the bulk of investment decisions to the government! Is this the kind of world we should aspire for?
Taleb also recommends that we buy insurance against good black swans—that is, investments with a tremendous (though still highly remote) upside but limited downside. For example, you could buy insurance against the (unlikely?) disappearance of Botox due to the discovery of the nectar of eternal youth. And make tons of money if it happens. Perhaps, only that, during extreme events, insurers can go bust too (a three-letter acronym comes to mind).
Ultimately, no matter how imperfect our models are, the problem lies in our failure to use our brain. Only “using our brain” does not mean buying Treasuries. It means identifying investments that are productive and viable, improve our quality of life and create jobs. It also means knowing what our models are designed to capture and what they are not--in which case overriding our models is the appropriate response.
This crisis has offered plenty of food for thought and plenty of lessons to munch on. But Taleb’s proposals are impractical, inefficient and, arguably, boring. After all, for all its scares and potholes, New York is more fun than Peoria. And in the (highly remote) chance that I have any Peorian readers, you have a free invitation to come over and check for yourselves!
Friday, December 12, 2008
The barking swan
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21 comments:
Actually Taleb himself comments that the current crisis is not a black swan.
See for example:
http://www.bloomberg.com/apps/news?pid=20601103&sid=aDVgqxiT9RSg&refer=us#
Although I agree with you that most of what Taleb is saying is impractical and quite boring, Taleb is right in pointing out that the financial industry is being too "optimized" with many big companies boasting of their "perfect" risk hedging strategies.
They should use more of their time not boasting of their perfect mathematical formula, but in identifying good investments in the real world. Moreover rethinking again and again what the actual consequences of using those mathematical models are.
Its a tough thing to deny those models they have been using for years, but I believe the current crisis gives them no choice.
It is difficult to comprehend the relevancy of Taleb, or a host of other economic gurus, who do most of their navel gazing through a crystal ball in New York City.
After all, from where did each and every Finance Engineering scandal-of-note since the Great Depression emanate?
Wall Street and New York cohabit the same space. As such, the values and standards are shared values and standards. Which is the problem, isn’t it.
When will the next Finance Engineering scandal take place? Black Swan or no Black Swan (because one does not need yet-another-tired-metaphor to describe that which is pure happenstance in any finance market). Because it WILL take place. Wall Street spawns them the way faeces attracts flies.
All this is Much Ado About Nothing. Put marginal tax rates back to where they were pre-Reagan and watch the Consummate Cupidity diminish. Not all that much, mind you, but perhaps enough to do away permanently with the far-to-often colossal stupidity of Finance Engineering foisted upon the world by Wall Street Wannabe Zillionaires.
This strikes me as the standard "semantic" response to Taleb's black swans. That is, re-define them to your convenience, and they no longer apply.
Taleb's first book ("Fooled by Randomness") was all about the punctuation of crises in markets. Cross-read Mandelbrot for where he gets it.
For me, Taleb is amusing, and outspoken enough to get himself heard. Round off the sharp edges and the semantic distinctions, and his books told it ... maybe not first, but he has certainly been drilling it in to people who didn't want to listen.
- odograph
Here are my views on this, as someone who has been inside academic finance:
I have worked with this kind of mathematics in finance (for example). I think it can be very valuable, and eventually will provide a great deal of value, but the process of learning how to use it properly, and utilizing it in general, will be long because the mathematics is so complex, so few finance and economics academics know it, and it takes a long time to learn (at least relative to how much pressure finance and economics academics are under not to undertake even very high NPV projects if the payoffs are long term).
The big problems with quantitative finance are problems you find throughout finance and economics academia:
1) People often grossly misinterpret models, usually because they take their assumptions literally (act as though the model is exactly reality, without thinking how things will differ due to how much the assumptions differ from reality), or too literally.
2) Finance and economics academia is so specialized. An economist may understand his narrow (or super narrow) area well, but little else in economics very well, yet he thinks he does because he has tenure at Harvard, and much of the public thinks he does too for the same reason. A lot of these quant guys have gotten all kinds of accolades and rewards and high level positions because of their understanding of advanced mathematics and workaholism, but they understand very little of anything else in finance and economics.
3) Intuition and high level thinking is grossly under-rewarded in finance and economics academia. You can get tenure at Harvard and a Nobel Prize just from strong mechanical skills and workaholism from age 5. You get to the frontier quickly and be the first to do valued mechanical work, in a formal way, with a pedigree so that it gets published in a top journal, so you get credit and not all the unknown less pedigreed people who thought of it before you.
However, as I've noted many times, academia may have serious flaws -- very largely due to ginormouns asymmetric information -- but it's still a fantastically high return investment. It's like modern scientific medicine. There's a lot of room for improvement, but it's still a tremendous investment, extremely well worth a lot of money, and we certainly would not want to be without it.
Economist provide the intellectual
basis for the economic powers to continue taking while providing little social benefit. They have a variety of University degree's and produce an endless stream of papers and research that is used both by gov't and private industry to create more bubbles & support growth via credit expansion all the while making a good living.
Economic thinking has become model locked as the high thinkers have little or no realtime experience beyond a few parttime jobs before landing their degree and hitting the exective suite.
Serlin: I think it can be very valuable, and eventually will provide a great deal of value, but the process of learning how to use it properly, and utilizing it in general, will be long because the mathematics is so complex
The mathematics is complex because it deals in probability theory. More complex than that is difficult to obtain.
No, I don't see this sort of Financial Engineering getting to be of any great use to the economy for some time to come. The mean-time-between-failure has become too short.
-- Lafayette
This interview with Nassim Taleb with Charlie Rosie is worth watching.
http://www.charlierose.com/view/interview/9713
The term "black swan" comes from a point of epistemology: that one instance of a black swan would disprove the assertion that all swans are white, while no amount of evidence would prove that assertion. The point is that just because something is outside of our realm of experience doesn't mean that it isn't possible or doesn't exist.
Keynes, talking about the efforts to go back to a post WW I gold standard, pointed out that any idea that gold had been historically a highly erratic measure of value. 1 oz bought very very different quantities of goods at different times.
People measure the stability of anything -- gold, currencies, banks, bonds, based on the very short term. Maybe just a single business cycle.
He also pointed out that putting money in the standard govt savings bonds - which people had been doing for a hundred years in England - was also a very dubious source of stability. Government bonds (even of the biggest governments) default with amazing regularity. Things have been stable since WW II relatively. But ... that's not forever.
Keynes "Essays in Persuasion" (great book. Sorry. Forgot which article.)
Chevelle, great post. I've been following Taleb's work to the degree that a non-economist, non-mathematician can, and while I do appreciate his points, I agree that he goes farther than necessary, particularly in ridiculing your profession.
But I think he would agree with you that the point is that people have to use their brains. As a compliance professional in the financial services I've seen too many stupid decisions being made simply because of blind obedience to mathematical modeling. And now we're all feeling the effects of such foolishness.
Finally, as the son of a Peoria native who has fond memories of a wonderful midwest city, I'd suggest that an excessive interest in the stimulative properties of large metropolitan areas like New York City might also bear some responsibiity in the current mess. Perhaps the shoe shopping in Peoria doesn't match up to New York, but it's probably not going to suffer the reputation of being the place where the economic world melted down in 2008.
You fault Taleb's strategy by pointing out about how insurers can go bust during extreme events. Taleb himself has said that Universa never trades CDS contracts because buying a CDS is like buying insurance on the Titanic from someone who is on the Titanic. Please do your diligence (this is simply one of your many inaccuracies) before writing at length about any topics going forward--it's for your own good.
modeling is physics Vs systems affected by human creativity is fundamentally different ....... quant finance makes little sense.
Taleb gives us a way to think about the systems we build ....... again it is not the solution, but an approach to think.
As my teacher use to say, don't follow what they say, follow what they do. Correct me if I'm wrong but I seem to recall Taleb ran a hedge fund specializing on buying way out of the money puts. And it also went belly up. Hmmm . . . I wonder why? Of course, he'll never be truthful as to why his fund failed.
Sorry, but there is so much dis-information in both this post and the associated comments that I will never read this blog again.
I have concluded that wise people understand what Taleb's message really is, and clever people do not (can not).
By the way, Taleb's fund did not fail, as in it did not blow up, but he did close it and return all the money to his investors - all of the money. And his current venture in Santa Monica is up 110% (or something) for 2008.
Any other clever people want to opine on things about which they know absolutely nothing (or its practical equivalent)?
taleb's previous fund, empirica capital, closed because unlike what inexperienced, militant and distant observers (like a few of the commentators here) think, investors will not stick around for long if you keep underperforming. Which empirica capital did. Call it human nature, call it stupidity even, call it having to explain to your board/pensioners why you cant make money for them. Not to mention of course the logistical/capacity difficulties in implementing this kind of an extreme trategy when you manage not $2bn (like universa) but $600bn for institutional cloents. It's easy to criticize from the outside, but come and get a taste of the business first and then try again
It would be advisable to read Taleb before leveling these criticisms. He explicitly addresses your Peoria/New York problem(though in different terms, i.e. why we shouldn't stop crossing the street to mitigate the risk of getting hit by a car, or something along those lines). Do you have any insights about albums you haven't listened to? I'd be really interested in some more of your opinions based on limited information and conjecture. Perhaps in your next post.
Well, all the _Europeans_ thought all swans were white...
TBS is worth half hour's reading because there is some good material in there. The egotism and bluster make reading the whole thing a waste though.
Some very intelligent commenters you have here.
As for whether modern financial engineering is useful: I think the Wilmott article "A Quant in King Arthur's Court" is worth a read. Enough with the maths, its economic value comes from diversifying risk. (That can be b/s but, really, people do have different risk preferences.)
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