Taleb states that “My major hobby is teasing people who take themselves & the quality of their knowledge too seriously & those who don’t have the guts to sometimes say: I don’t know” Well, he’s livin’ the dream. In his latest thin-skinned screed against an insufficiently flattering review (Tyler Cowen, who basically gave The Black Swan a thumbs up, though from Cowen that's like getting a 'B' in business school), Taleb tries to lay out a point by point rebuttal. In the process, he highlights his many intellectual errors.

For instance, he thinks Frank Knight’s concept of uncertainty is nothing like his concept of uncertainty, seemingly confusing Knightian uncertainty with subjective probability. Unfortunately for Taleb, Knight had a pretty similar concept back in 1919 and the lack of success with this insight is instructive (after 90 years, not much has been generated despite much effort). Taleb also notes that he is not so much an expert on finance, but rather “French literature, ancient & medieval Mediterranean history & languages, probability theory, medieval Judeo-Arabic philosophy”, all from a guy who likes to take down arrogant ‘stuffed shirts’. But most importantly, he takes issue with Cowen’s jab that his main idea doesn’t work well in his area of ‘minor expertise’, finance. Cowen notes that unlikely events are well researched in finance, and these are not generally underpriced.

What Cowen did not expand upon, is that there’s a thing called a volatility smile, whereby out-of-the-money options have higher implied volatilities, especially on the downside. For example, in May 2006 when rumors of GM's woes were large and its stock price was around 32, GM options had a one-year at-the-money implied volatility of 60, but down at strike price of 15 its volatility is a much higher 140. The fact that Black-Scholes assumes lognormal returns does not imply market participants think likewise. You can't profit from the idea that market returns have fat tails because that's priced into the market via the volatility smile, and this volatility smile shows up in 'disaster' insurance of all types: people pay a lot to sleep easy. Many people have looked at option prices, and they all find that out-of-the-money puts are the most overpriced of all options—people are expecting ‘Black Swans’ too much.

Taleb responds by noting that the 1987 stock market crash changes everything, because if you bought puts then you would have made enough money to make up for decades of otherwise weak performance. While Shumway and Coval do not include 1987 in their academic study, Bonderanko does, and gets the same results. Taleb points out several anecdotes of financial market crises as further evidence, such as the 1998 crisis related to Long Term Capital Management (implied vols, libor spreads, skyrocked), or the emerging markets blow up of 1997. I agree these events made money for people long volatility, and the more extreme the bet the more the profits, but the plural of anecdote is not data, so he should cite an empirical paper showing the positive abnormal returns to taking on fat-tailed or asymmetric risk (or as a now famous and wealthy benefactor, direct some young quant to do the dirty work in an empirical paper). Though it is easy to recall big blowups, stasis is a fact of markets too, and as Stephen Jay Gould used to say, stasis is data. The volatility smile, and large bid ask spreads in the extremes as a function of price, mean you can’t make extranormal profits by going long ‘Black Swans’—at least in the markets were Taleb has the most experience (though not, according to him, expertise).

Clearly his experience as an options broker give him credibility here, but let us look at this experience. Before he became a regular on the talking-head circuit and expert on Judeo-Arabic philosophy he was primarily a broker. Brokers spend most of their time looking at a model such as Black-Scholes that tells them what price to buy and sell based on some underlying parameters. These models are pretty standard, and so the main thing the market maker has to do is keep his model inputs fresh, post prices to potential buyers and sellers, fill market orders, and pick off stale limit orders. Customers generally have access to older prices, and in a situation where the current price moves every second, this clearly puts a broker at an informational advantage, which is why it was such a lucrative field, especially in the days before the internet became big (ie, Taleb's time). The broker makes money irrespective of movements in the underlying model price, as in general he keeps his exposure to first-order (eg, delta) and second order (eg, vega) risks as close to zero as possible.

But the brokering skill is quite distinct from what a speculator or investor does, which involves a directional bet on the first or second order risks that brokers normally try to erase. Brokers know as much about what makes prices move as plankton knows about what makes the tides move. Much of being a broker is encouraging trading activity, and so many brokers are quite adept at presenting themselves as more than middle men, but also men with an angle, a story. A good broker is probably truly delusional about his prognostic abilities because this allows him to appear sincere in his sales pitch for the latest trade idea, those who don't believe their own stories make weak sales pitches (see Robert Trivers, who Taleb mentions favorably in The Black Swan). Most brokers are certain they could make money without their customer flow, because the same self-deception that serves them well chatting up customers generates delusions of strategic grandeur. Supreme self-assurance, even if undeserved, makes for a good broker just as much as knowing your greeks. Thus Taleb’s ‘narrative fallacy’ argument plays right into his own biases, that is, he has fooled himself into thinking he knows 'the big picture' because that delusion was helpful in his own career.

Rich investor vs rich broker: who is more fooled about his alpha? Notice the relation to the theme of Fooled by Randomness? Taleb is consistently amusing because his criticisms of others apply so neatly to himself: he claims he is an empiricist yet supports his points with anecdotes; the Black Swan makes fun of ‘experts’ with their credentials, but he states he does not deign to engage with anyone not sufficiently expertly credentialed (he applies a ‘name recognition’ filter to criticisms—argument by popularity?); he derides forecasters who don't give a full accounting of their prior forecasting history, yet delinks old remarks about Value-at-Risk, and recategorized his extinct Hedge Fund as a hedge; etc..

His career as a talking head started in 1996 when, as the author of a niche derivatives text, he made the outrageous claim in Derivatives Strategy magazine that the new Value-at-Risk phenomenon was dangerous, worse than useless, which made for great debate in risk management circles. His criticisms then of VAR are similar to his criticisms now: that a metric is not flawless, and those who believe it is flawless are fools. In a sense he is quite right, but in both the case of VAR, and specific parametric statistics, there are many users who understand that tools need to be supplemented by judgment. This is a cliché on the risk management lecture circuit, mainly, by senior executives who don’t want to do anymore homework. And of course he was dead wrong on VAR, in that in spite of his criticisms it became ubiquitous as a framework for amalgamating risks from different instruments into a single metric.

Of course, Taleb will say he just warned against naive usage of VAR, but his absurdly strong statement that VAR was for charlatans was what got him the Derivatives Strategy article that propelled him into public discourse (conveniently removed from his website, but you can read it online here). Then, as now, he points to anecdotes of imperfection to prove his points. Today, he argues the Gaussian distribution is a ‘fraud’, but I am sure as time goes on his view on this will soften. He says enough contradictory things that he does, in the end, say everything.

In the end he promises to teach us how to take advantage of these Black Swans, and his strategy is pretty lame. Along with notes about going to cocktail parties and other 'unconventional' channels, he argues for a barbell strategy of much safety, and a dollop of 'wild risks'. Though he considers his risky ventures vastly different than lottery tickets because they have unlimited upside and aren't quantifiable, I would argue they have worse payout rates than lottery tickets (further if the $100mm upside of a lottery ticket is insufficient, you are really chasing rainbows). But again, if you look at the broad empirical data as opposed to anecdotes, there is no evidence that 'uncertain' strategies have greater returns that more quantified ones. So in the end he suggests a risk-free focus with some money allocated to a bunch of Airport Holiday Inn real estate seminars or Llama farms, waiting for the next Black Swan. These lottery tickets amenable to the 'narrative fallacy'--and depite having 'wild uncertainty' they are lottery tickets--make great anecdotes, but lousy investments. Typical broker advice.