London: On a freezing day in March 2007, Nassim Taleb walked into a conference room at Morgan Stanley’s Manhattan offices on 47th Street and Broadway to address a group of the firm’s risk managers. His message: your models don’t work.
Using a whiteboard to scribble out his calculations, Taleb, now 48, began one of his rants, this time against stress tests—Wall Street lingo for examining how a market rout will play out. Stress tests are inherently risky because they ignore rare but potentially devastating events, Taleb said.
Perfect timing: The Black Swan came out just months before the subprime fiasco led banks to announce at least $208 billion worth of write-downs
Only six months later, Morgan Stanley experienced its own rout. The world’s second biggest mergers adviser announced in December that it had written down its subprime-related holdings by $9.4 billion (Rs37,700 crore today) after the firm’s traders misjudged how fast and far prices of the debt would fall. Their risk management had failed.
The Lebanese-born Taleb, a balding man who labels himself a philosopher of randomness, has an eerie knack for timing things right. His most recent book, The Black Swan: The Impact of the Highly Improbable (Random House), came out last May, just months before the subprime fiasco rocked global markets and led banks to announce at least $208 billion worth of writedowns. The book’s message offered something of a preview of the crisis: that we’re all blind to rare events and routinely fool ourselves into believing we can predict risks and rewards.
Crisis, crash, collapse
Taleb argues that history is littered with high-impact rare events, known in quantspeak as “fat tails”, for their shape when plotted on a bell curve. He cites the Latin American debt crisis of 1982, the collapse of hedge fund firm Long Term Capital Management Lp in 1998 and the crash of the US stock market in October 1987, to name a few.
As the founder and manager of New York-based Empirica Llc., a hedge fund firm he ran for six years until he closed it in 2004, Taleb built an investment strategy based on options trading. It was designed to bulletproof investors against blow-ups while profiting from rare events. His 20-year trading career has been marked by jackpots (such as when he lucked out in trading options during the stock market crash of 1987) followed by long dry spells.
“If you lose money on a steady basis and then make money in a lumpy way, people think you’re crazy,” he says.
While Taleb has stepped back from everyday trading, he remains an adviser to Santa Monica, California-based hedge fund firm Universa Investments Lp. It opened its doors last year under the direction of Mark Spitznagel, 36, Taleb’s former trading partner at Empirica.
Universa has a so-called Black Swan Protection Protocol managed by Pallop Angsupun, a former Taleb student who’s hedging roughly $1 billion of client investments against certain events that can cause market declines. The firm has another $300 million pot betting on large positive jumps in individual stocks and is readying a similar, third fund several times that size, a person familiar with the funds says. “Nassim and I share this genetic flaw,” says Spitznagel, a one-time Chicago pit trader who was a student of Taleb’s at New York University. “We’re not interested in the small frequent payouts. We want the infrequent huge payouts.”
Taleb has gone from being a leading Wall Street heretic—he rails against economists and quantitative model makers—to a mini institution whose appeal reaches well beyond the realm of finance. More than 370,000 copies of The Black Swan are in print in the US and the UK. It spent 17 weeks on The New York Times best-seller list and is being translated into 27 languages. It even outranks Alan Greenspan’s memoirs, The Age of Turbulence: Adventures in a New World (Penguin, 2007), among 2007 best-sellers on Amazon.com.
The success of The Black Swan has led to a $4 million advance for the English-language rights to a follow-up book, according to a person familiar with the deal. It’s tentatively titled Tinkering, and will examine how to live in a world we don’t understand.
Taleb now charges more than $60,000 for some of his lectures, according to the London Speaker Bureau, a firm that places business, political and motivational speakers. He warns audiences against believing worst-case scenarios and making so-called naked, or unhedged, bets on the future that could lead to disastrous losses.
The message of The Black Swan—whose title describes a bird once thought not to exist, until it was found in Australia in the 17th century—has penetrated Wall Street trading rooms, says Aaron Brown, a risk manager at Greenwich, Connecticut-based AQR Capital Management Llc., which manages about $8.6 billion in hedge fund assets.
“You can’t say you haven’t read it or you read it but you’re not going to do anything in response in a trading or risk management role,” says Brown, a former Morgan Stanley risk manager who calls Taleb a friend while disagreeing with him that banks’ risk models are useless.
Now, everybody wants to talk about “black swans”, those highly improbable events that can cause havoc. The National Aeronautics and Space Administration’s Langley Research Center in Hampton, Virginia, has invited Taleb to talk about how to identify technology black swans as it prepares to send humans back to the moon and beyond.
The US Fire Administration, part of the Department of Homeland Security, wants him to address 200 executive fire officers to talk about the probability distribution of forest fires. He’s given talks about risk models for the US Department of Defense, where he’s a member of the Highlands Forum, a Pentagon-sponsored study group on risk.
Taleb is no security expert, nor does he claim any special knowledge of space technology. Instead, these groups want to hear him talk about how to apply his ideas on chance and decision making to their specific fields.
One day last December, Taleb stood before 30 top executives from Societe Generale SA, France’s second biggest bank. The executives, including chairman Daniel Bouton, had gathered at Prague’s five-star Hotel Aria, where each room is dedicated to a famous musician, for a conference organized by Paris-based business school ESCP-EAP.
The proliferation of bank mergers has resulted in fewer banks and a greater concentration of risks, Taleb warned, according to a person who attended. The probability of a devastating banking loss has increased rather than decreased, he said. The response was muted, and attendees walked out with copies of The Black Swan, the person said.
About six weeks later, SocGen revealed the biggest trading loss in banking history, announcing that it had lost €4.9 billion (Rs30,576 crore today) and blaming 31-year-old trader Jerome Kerviel.
In August, The American Statistician, the quarterly journal of the American Statistical Association, came out with a special Black Swan issue that published a series of critical reviews alongside an article by Taleb. “He characterizes statisticians as people who blindly assume things, and nothing could be further from the truth,” says Peter Westfall, the journal’s editor and a professor of information systems and quantitative sciences at Texas Tech University in Lubbock.
Even his one-time colleagues disagree with him. Robert Engle, a Nobel laureate in economics who teaches at New York University’s Stern School of Business in Manhattan, says Taleb’s book ignores a mass of literature on rare events called extreme value theory, which is often used to assess risks in insurance as well as finance.
One day last June, Taleb gets up in front of about 40 people at Miller’s Academy, a West London lecture society, to talk about black swans. Surrounded by antiques and a fish tank stuffed with dead owls, he begins his trademark attack on Gaussian statistics, named after 19th century German mathematician Carl Friedrich Gauss, who charted probabilities on a bell-shaped curve.
In a bell curve, high-frequency events are represented at the top, or middle, and infrequent episodes are charted on the edge, or tail, of the curve. The tail is usually thin, reflecting rare, low-impact events. Gaussian statistics might work in casinos, but it can’t accurately help calculate stock market valuations, Taleb argues. “With stocks, we don’t know if we’re overpaying,” he tells the audience.
“No self-respecting statistician in finance is using Gaussian statistics,” interjects Lord John Eatwell, an economist and president of Queens’ College at Cambridge University, who’s sitting in the back. “All models are Bayesian,” he says, referring to the theory derived from 18th century British mathematician Thomas Bayes that allows for data to be constantly added to calculate probabilities. Taleb shoots back: “Bayesian is necessary but not sufficient.”
Guarantee to investors
When Taleb set up Empirica in Greenwich, Connecticut in 1999 after years on Wall Street, the goal was to protect investors against market crashes. Knowing how much they would pay for options, the two guaranteed investors they wouldn’t lose more than 13% a year. “Our aim was not to make money,” Taleb says. “I make no claims of being able to beat markets.”
Empirica did outperform the market. In 2000, its returns rose by about 60% on the back of high volatility and the bursting of the dot-com bubble, Taleb says. The next year, after the 11 September terrorist attacks, nervous investors came flocking. Then, volatility dropped as the stock market slowly drifted down, removing the opportunities to profit from wide market swings.
In 2002, Empirica posted its worst year as returns fell about 12%, Taleb says, while the Dow Jones Industrial Average dropped 17%. “I knew he was likely to lose money most of the time because it was kind of an insurance,” says Jean Karoubi, an Empirica investor and chief executive officer of LongChamp Group Inc., the New York-based hedge fund unit of Silvercrest Asset Management Group Llc., which manages about $10 billion.
Taleb and Spitznagel moved Empirica to midtown Manhattan in 2003 and changed tack for some clients. To profit from low volatility, they began selling at-the-money options—those close to the market price of the underlying security. In 2003 and 2004, Empirica posted small positive returns, Taleb says. Eager to focus on writing The Black Swan, Taleb shuttered Empirica in 2004 and returned about $380 million to investors.
“I was fed up,” he says. “I just wanted to write, and I had writer’s block.” The Black Swan was itself a black swan—an unexpected hit.
Taleb has a foot in academia. He’s now a visiting professor at the London Business School, where he’s conducting experiments with Dan Goldstein, an assistant professor of marketing, on the psychology of risk and decision making. Taleb wants hard proof that people misjudge risks.
In one pilot experiment, they posed the following question to participants: “You’re on vacation in a foreign country and are considering flying the national airline to see a special island you have always wondered about. Safety statistics in this country show that if you flew this airline once a year, there would be one crash every 1,000 years on average. If you don’t take the trip, it is extremely unlikely you’ll revisit this part of the world again. Would you take the flight?”
Everyone answered yes, assuming that one crash every 1,000 years was a minimal risk.
Finding the extremes
Another group was given the same problem except they were told that an average of one in 1,000 flights on this airline crashes. Although it’s the same risk mathematically, 30% refused to fly when presented with this wording.
“This one-in-every-X-years framing is something you hear concerning market crashes in financial reports on TV,” says Goldstein, 38, who holds a doctorate in psychology.
Extremes are more likely in finance than in the real world, Taleb says. At a conference for risk managers in London last June, he used the following illustration: “Say I sample from the world population and find two people cumulatively 14 feet tall. What’s the most likely allocation for Gaussian? One and 13? No, it’s seven and seven.” In wealth, it’s the opposite. “If we sample from the world population and get two people whose net worth totals £14 million (Rs112.7 crore), what’s the most likely combination?” he asked. “Seven and seven? No, it’s £5,000 and £14 million minus £5,000.”
He gives these two domains different names. The first he calls Mediocristan, where, if you have a large sample, the average of an independent, identical, random set of variables will converge in the middle. In Taleb’s other domain, Extremistan, average outcomes have little meaning. If financial markets are governed by extreme movements and unexpected events, we shouldn’t be fooled into believing worst-case scenarios, he says.
“We need more chutzpah,” he says. “If someone tried to do stress testing before the stock market crash in 1987, they would not have tested for 20% down.”
Taleb likens modern-day financial markets to medicine in the 1800s, when going to a hospital in London or Paris multiplied your risk of death by four times, he says. Similarly, quants increase risk by deploying flawed financial tools designed to reduce it, he adds.
For Taleb, the ills besetting financial markets are a vindication of his ideas. Like medicine, though, he isn’t offering easy cures.