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The Black Swan by Nassim Taleb: A Book Review

Taleb is a former broker, wrote a quasi-textbook on options and market making, and then got more philosophical in his best seller Fooled by Randomness. He considers his current occupation as an “essayist & epistemologist of randomness”. His thesis is that improbable yet important events are under anticipated. True enough. Specifics are always unexpected, like when 21-42-53-26-11 wins the lottery. But Taleb suggest in his new book The Black Swan a more meaningful hypothesis, that economically important things are consistently unexpected, in that people underestimate, on average, the probability and impact of improbable events (e.g., Black Swans).

From Taleb's Wikipedia entry circa July 2006, we see where this Black Swan thinking goes when applied to an investment strategy:

When he was primarily a trader, he developed an investment method which sought to profit from unusual and unpredictable random events, which he called "black swans". His reasoning was that traders lose much more money from a market crash than they gain from even years of steady gains; and so he did not worry if his portfolio lost money steadily, as long as that portfolio positioned him to profit greatly from an extremely large deviation (either a crash or an unexpected jump upwards).

Taleb recently co-authored a paper arguing that most people severely underestimate volatility. Furthermore, he argues there exists not only an unappreciation of fat tails, but a preference for positive skew, in that people prefer assets that jump up, not down, which would imply the superiority of buying out-of-the-money puts as opposed to calls because those negative tails that increase the price of puts are unappreciated.

These assertions present some straightforward tests. Specifically, buying out-of-the-money options, especially puts (because of negative skew), should make money on average. But insurance companies, which basically are selling out-of-the-money options, tend to do well as any industry (Warren Buffet has always favored insurance companies, especially re-insurers, as equity investments). Studies by Shumway and Coval (2001) and Bondarenko (2003) have documented that selling puts is where all the extranormal profit seems to be. So of all the option strategies, selling, not buying, out-of-the-money puts has been the best performer historically. Oh well, just a sign error!

Martin Gardner wrote a popular column for Scientific American, and in the process received a lot of mail from ‘cranks’ telling him about perpetual motion machines and the like. So he wrote a book called Fads and Fallacies. In the book he describes "cranks" who he describes as having five invariable characteristics:

A profound intellectual superiority complex.
Regards other researchers as idiotic, and always operates outside the peer review system.
Believes there is a campaign against their ideas, a campaign compared with the persecution of Galileo or Pasteur.
Attacks only the biggest theories and scientific figures.
Coins neologisms.

On Taleb’s personal website he describes himself thusly: He is also an essayist, belletrist, literary-philosophical-mathematical flâneur. The third-person is perfect pitch for describing himself, and the rest, well, literary-philosophical-mathematical types—especially flâneurs—tend to be full of themselves, supporting Gardner’s characteristic #1. He prides himself on not submitting articles to refereed journals, and considers most people who are indifferent to him as fools, disdains editors, even spellcheckers (#2). He pridefully notes that someone told him “in another time he would have been hanged [me: for what, inanity?].” Wilmott Magazine, a quant publication published by his colleague Paul Wilmott, wrote a fawning article about him where they noted that he is “Wall Street’s principal dissident. Heretic! Calvin to finance’s Catholic Church” (#3). His website states his modest desire to understand chance from the viewpoint of “philosophy/epistemology, philosophy/ethics, mathematics, social science/finance, and cognitive science”, supporting #4. Lastly, for #5, has gone so far as to print a glossary for his neologisms (eg, “epistemic arrogance” for “overconfidence”). In Martin Gardner’s taxonomy, Taleb is a classic crank.

The Black Swan argues that standard statistics is flawed because it is backward looking—I too prefer statistics on future data—and argues that standard measures of risk like the normal distribution are a ‘fraud’. All models or theories are simplifications of a more complex reality, parochial and incomplete; they don't work in all circumstances, and are irrelevant at certain levels of aggregation or for certain applications. That doesn't mean they are fraudulent. Taleb makes perfection the enemy of the good, and winds himself into knots of contradictions, such as calling himself an empiricist yet relying mainly on anecdotes, or having extreme confidence in other's overconfidence. He states he teaches how to take advantage of uncertainty, but skewering traditional forecasting tools leads him merely to nihilism, or simply overestimating the probability of improbable events (see put studies, above). How would one draw the line on which unseen data should be ignored (it's a large set, after all)? He argues we reward those who imagine the impossible, but what does that mean in practice, that we encourage people to enumerate everything possible no matter how improbable? Such risk reports are all too common because they reflect a lot of work, but without some sort of prioritization they are useless. One can remember Richard Clarke’s vague warning about Al Qaeda (and cyberterrorism, and ...) prior to 9/11, or the hundreds of ‘mission critical risk’ overrides on the Challenger space shuttle before it blew up, as examples of beautiful hindsight but useless foresight.

I could imagine him teaching a statistics class to freshman and instead of starting with the arithmetic mean and standard deviation ask 'what was the probability of an airplane taking down the World Trade Center on September 10, 2001?', and waxing poetic about how ‘we just don’t know!” Students might think such talk is much cooler than boring formulas, but such confused thinking leads nowhere in particular and can be indulged indefinitely without producing anything useful, as Taleb demonstrates over 400 pages.

HedgeFundGuy - am 2007-04-20 03:35

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a.t. (anonymous) meinte am 20. Apr, 12:00:

mistakes

This is wrong. Nassim told me that he says that tails are not priceable.
But there is somethig strange here. Nassim has full academic posititon, tenure offer from a prominent university, and 10 refereed publications in the last 2 years with revisions in Science, Complexity. How many did HedgeGuy publish? More critically how many of those did GARDNER publish?