Taleb + 3.5 years

I recently had the occasion to reread my review of The Black Swan, from April 2007.

It was fun reading my review (and also this pre-review; “nothing useful escapes from a blackbody,” indeed). It was like a greatest hits of all my pet ideas that I’ve never published.

Looking back, I realize that Taleb really was right about a lot of things. Now that the financial crisis has happened, we tend to forget that the experts who Taleb bashes were not always reasonable at all. Here’s what I wrote in my review, three and a half years ago:

On page 19, Taleb refers to the usual investment strategy (which I suppose I actually use myself) as “picking pennies in front of a steamroller.” That’s a cute phrase; did he come up with it? I’m also reminded of the famous Martingale betting system. Several years ago in a university library I came across a charming book by Maxim (of gun fame) where he went through chapter after chapter demolishing the Martingale system. (For those who don’t know, the Martingale system is to bet $1, then if you lose, bet $2, then if you lose, bet $4, etc. You’re then guaranteed to win exactly $1–or lose your entire fortune. A sort of lottery in reverse, but an eternally popular “system.”)

Throughout, Taleb talks about forecasters who aren’t so good at forecasting, picking pennies in front of steamrollers, etc. I imagine much of this can be explained by incentives. For example, those Long-Term Capital guys made tons of money, then when their system failed, I assume they didn’t actually go broke. They have an incentive to ignore those black swans, since others will pick up the tab when they fail (sort of like FEMA pays for those beachfront houses in Florida). It reminds me of the saying that I heard once (referring to Donald Trump, I believe) that what matters is not your net worth (assets minus liabilities), but the absolute value of your net worth. Being in debt for $10 million and thus being “too big to fail” is (almost) equivalent to having $10 million in the bank.

So, yeah, “too big to fail” is not a new concept. But as late as 2007, it was still a bit of an underground theory. People such as Taleb screamed about, but the authorities weren’t listening.

And then there are parts of the review that make me really uncomfortable. As noted in the above quote, I was using the much-derided “picking pennies in front of a steamroller” investment strategy myself–and I knew it! Here’s some more, again from 2007:

I’m only a statistician from 9 to 5

I try (and mostly succeed, I think) to have some unity in my professional life, developing theory that is relevant to my applied work. I have to admit, however, that after hours I’m like every other citizen. I trust my doctor and dentist completely, and I’ll invest my money wherever the conventional wisdom tells me to (just like the people whom Taleb disparages on page 290 of his book).

Not long after, there was a stock market crash and I lost half my money. OK, maybe it was only 40%. Still, what was I thinking–I read Taleb’s book and still didn’t get the point!

Actually, there was a day in 2007 or 2008 when I had the plan to shift my money to a safer place. I recall going on the computer to access my investment account but I couldn’t remember the password, was too busy to call and get it, and then forgot about it. A few weeks later the market crashed.

If only I’d followed through that day. Oooohhh, I’d be so smug right now. I’d be going around saying, yeah, I’m a statistician, I read Taleb’s book and I thought it through, blah blah blah. All in all, it was probably better for me to just lose the money and maintain a healthy humility about my investment expertise.

But the part of the review that I really want everyone to read is this:

On page 16, Taleb asks “why those who favor allowing the elimination of a fetus in the mother’s womb also oppose capital punishment” and “why those who accept abortion are supposed to be favorable to high taxation but against a strong military,” etc. First off, let me chide Taleb for deterministic thinking. From the General Social Survey cumulative file, here’s the crosstab of the responses to “Abortion if woman wants for any reason” and “Favor or oppose death penalty for murder”:

40% supported abortion for any reason. Of these, 76% supported the death penalty.

60% did not support abortion under all conditions. Of these, 74% supported the death penalty.

This was the cumulative file, and I’m sure things have changed in recent years, and maybe I even made some mistake in the tabulation, but, in any case, the relation between views on these two issues is far from deterministic!

Finally, a lot of people bash Taleb, partly for his idosyncratic writing style, but I have fond memories of both his books, for their own sake and because they inspired me to write down some of my pet ideas. Also, he deserves full credit for getting things right several years ago, back when the Larry Summerses of the world were still floating on air, buoyed by the heads-I-win, tails-you-lose system that kept the bubble inflated for so long.

16 thoughts on “Taleb + 3.5 years

  1. I was taught this in MBA school in the 1980's and a colleague actually heard an oil company president use it at a critical meeting with the bankers in the early 1980's …

    And I am sure its pre-historical

    It's why it apparently keeps getting forgot that might be more interesting…

    K?

  2. On a related note, I just reread Mandelbrots "The (mis)behavior of financial markets". It didn't occur to me at the first reading, but there is a surprisingly egocentrical tone to the book with an infinite repetition of "I invented…".

    I also found his dismissal of GARCH in favour of his multifractal model a bit strange, since both models seem to work in a similar way (taking a brownian motion for the innovation and generating a time-varying volatility from them, with GARCH as an arma-process of the squared residuals, and with Mandelbrot by twisting the "trading time" itself).

  3. In an updated version, Nassim Taleb lists
    '10 principles for a black-swan free world'and
    notes: "In the United Sates in the 2000s, the banks took over the governemnt.This is surreal."

  4. Forgot to paste "the too big to fail"

    The actual quote was "When you owe the bank a million or so and can't pay your in trouble. If you owe them 50 million – they are in trouble!"

    K?

  5. I tend to disagree with Taleb and partially with your review of him.

    My father has invested "conventionally-agressively" for a long time now. With "conventionally-agressively" I mean a diversified portfolio heavily tilted towards stocks and some room for commodities. Now I am a phd student in my twenties and given the recent events I decided to investigate the performance of my father portfolio which was given his primitive but very clear system (write everything down in a small booklet) not that difficult.

    The results were stunning. Looking at the cumulative performance he performed slightly better than the market index. Start date october 1985 – end august 2010 (when I did the exercise). If this is picking up pennies then I'd love to pick up pennies.

    My father isn't a financial genius nor a stunning investor. Everytime he had some mount of savings he just bought some stocks of companies he *trusted* (was more or less familiar with their activities). He had read a small book on investing in the stock market (with a strong emphasis on things like diversification).

    I am sure there are many stories like these but these tend to get crowded out when times get a bit rough. If you keep a well diversified portfolio for a sufficient amount of time, you get a nice return (cfr. the equity premium). If you can't invest in your own business it isn't a bad idea at all.

    Note: I am an economics phd student, so I may be a bit biased in my judgement, but looking at the past 50 years, it is hard to find a period ( with an investment horizon of reasonable length) in which you would have lost vis-a-vis safe investments, even when you would have timed the market extremely bad.

  6. 1. Market timing's a tricky business. It's always easy to see what you should've done in retrospect.

    2. There's a very clear moral hazard to playing with other people's money on a percentage-of-profits basis.

    When you're running a hedge fund on a standard "2 and 20" scheme (2% of your investor's capital as a fee plus 20% of any profits), you're rewarded far too much for pure volatility if you can line it up by year.

    For instance, consider investing $100 with a hedge fund charging the standard "2 and 20" (2% of capital, 20% of profits). Contrast the following two investment profiles:

    year[1]:+50%, year[2]:-33%
    after year 1: $150 – $12 expenses = $138
    after year 2: $91 – $2 expenses = $89

    year[1]:+10% and year[2]:+10%
    after year 1: $110 – $4 expenses = $106
    after year 2: $116 – $4 expenses = $112

    In the first scenario, the hedge fund makes $14 and the investor loses $11, even though the investment itself is flat, not counting fees. In the second scenario, the hedge fund makes $8 and the investor makes $12, with the investment itself up a bit more than 20%, again not counting fees.

    Of course, one could argue that after the -33% year 2, the first strategy would lose clients. Still, I don't like the way the game's stacked. It encourages volatility in addition to the pure moral hazard of having no real downside to the hedge fund (2% of capital is the minimum payment to the fund).

  7. Louis: if I remember correctly Taleb's advice on investing was being aggressive with a "small" percentage of your money — such as 20%. This way if a black swan event occurs you dont lose all your money, and if you are smart (lucky?) about the agressive part, you can make whole lota money.

  8. An interesting companion piece to Taleb's books is Didier Sornette's "Critical Phenomena in Natural Sciences". Taleb never wades too deeply into the math and he often refers to Sornette as someone willing to do some exploration on these concepts.

  9. I've also been re-examining Taleb's ideas recently. There certainly are points where he has been proven correct. I'm interested to see what kind of content will be in his new book, coming out this month, supposedly.

  10. Koala: yes, that's the "barbell" strategy. Invest the majority of the portfolio (~70-90%) in "ultra-safe" investments like T-bills, then put the rest into aggressive bets like out-of-the-money options, very-small-cap stocks, etc. I'd be interested to see an academic study on such a strategy.

    Louis: interesting comment. My concern is what occurs if stocks do not provide a 5-8% annual return for the next 30 years. Everyone's banking on it, but what if it doesn't happen? That's where I buy into Taleb's idea of being robust to black swan events. Still not sure what a proper investment strategy based on that idea would entail, though. Perhaps the barbell strategy.

  11. One may wonder whether the equity premium is there to stay. I am not claiming that it will, I am pretty skeptical about that too.

    But what about Taleb's strategy? Are T-bills going to remain super safe? Without expressing any thought on whether QE/QE2 are good ideas, surely it may pose a danger in the long run for US debt. Inflating away your problems is nice and it has been a great thing to alleviate the fiscal burden for the government in the past, but is this sustainable in the long run. Are the large debtholders going to keep buying US debt … ?

    Betting on the Black Swan is a great strategy. That is one thing on which I take Taleb's word (although not doing it myself). But putting the money in these "safe" investments, hmmf
    I am recently looking to invest in some emerging countries (or even pre-emerging) with major upwards potential. Think about the amazing boom in Brazil, some African countries, …

    Getting a bit off topic and sorry for that. Great discussion though.

  12. "I recall going on the computer to access my investment account but I couldn't remember the password, was too busy to call and get it, and then forgot about it."

    That happens to me all the time.

    Of course, when I do remember to switch I usually make the wrong call. Like a few months ago, the Dow dropped to 9900, and I figured we wouldn't see 10,000 again for years, so I switched my kid's college fun from stocks to cash.

  13. It still really boggles my mind how you can have so much respect for Taleb. He plays so loose and fast with some of the basic tenets of statistics (iid, anyone?), and mixes conclusions from different distributions on a regular basis.

  14. Gabe:

    I found his books thought-provoking, as you can see from the long articles I wrote after reading them. I'm not so interested in evaluating Taleb as good or bad; rather, I appreciated that reading his books gave me a chance to reflect upon a wide range of issues.

  15. Andrew,
    I have given this chart another look (I have looked at it a few times) and one thing bothers me a bit: the choice of colours.

    The green-red scale suggests that pink is bad, because it goes to red. Now, if you are close to the pink threshold, you have made near 3%, annually! (and we are talking about real returns). That is not so bad I guess. At an average of 2% a year you have a real return of nearly 50%. That seems great to me. If you look at the chart you see that the median real return after 20 years is 4.1% which implies a whopping real return of more than 120%!
    Compare this with the "safe investment" (T-Bill or something like that). Inflation eats there too.

    Note: The numbers are pretty rough. They are based on reinvesting the investment gains at te median rate…

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