'Black Swan' author Nassim Taleb warns traders to look out for the improbable
By Joshua Boak | Tribune staff reporter
January 14, 2008
Market meltdowns that scorch investors, 100-year floods that occur every 10 years and terrorist attacks such as 9/11.
Nassim Taleb, an author, lecturer and big thinker, calls such unforeseen events "black swans," borrowing from a tale about 17th Century European seafarers who landed on Australia and, much to their surprise, learned that not all swans were white.
Such shocks occur, Taleb says, because even experts fail to consider the likelihood of extreme scenarios. That's why his theory, outlined in his book, "The Black Swan: The Impact of the Highly Improbable," is so intriguing to Chicago's trading community, which seeks to lessen risk by exchanging futures and options. His ideas have earned him cachet with investment bankers as well as rock 'n' rollers.
Radiohead frontman Thom Yorke sings during "Black Swan": "This is your blind spot, blind spot. It should be obvious, but it's not."
Taleb considers investment to be an art form, not a mathematical science that can shield investors from disasters.
"It's better to do art than fraud," he told an audience of more than 200 at the Chicago Mercantile Exchange Friday.
As a former commodities trader at the Merc, his speech was a homecoming of sorts that meshed the lessons of the classroom with the realities of the trading pit. The University of Illinois at Chicago and the University of Chicago, sponsors of his lecture, noted that the combination has generated controversy.
Editors at The American Statistician, the profession's leading academic journal, said in August that if forecasting events is impossible, "then we might as well assume that the future will be populated with only beautiful white swans." They compared his theory with statements by former U.S. Secretary of Defense Donald Rumsfeld, who famously responded to prewar doubts about whether Iraq supplied weapons to terrorists as "unknown unknowns." His ideas even have riled the godfather of modern options trading, Myron Scholes.
Scholes shared the 1997 Nobel Memorial Prize in Economic Sciences for his work on the Black-Scholes formula, which the Chicago Board Options Exchange adopted more than 30 years ago to determine the value of options traded in quick bursts on its floor. Options provide the right to buy a stock at a prearranged price in the future, presumably helping to protect buyers from black swans.
"I don't want to glorify him by refuting what he says," said Scholes.
Scholes said academics do not take Taleb seriously because he does not cite previous academic literature in his theories, relegating him to a man who "popularizes ideas and is making money selling books."
'Doomed by the exceptions'
In "The Black Swan," Taleb considers Scholes' namesake flawed because it relies on a bell curve. A bell curve models risk geometrically by clustering averages at a bulbous middle while pushing the extremes downward, forming the shape of a bell. By pushing those extremes downward, that form of modeling an option's value underestimates the likelihood of black swans, Taleb wrote.
To prove his point at the lecture, he displayed a 10-Deutsche mark, the German bank note that disappeared with the euro's introduction. The bill has a portrait of Johann Carl Friedrich Gauss and his creation, the bell curve. Taleb noted that during Germany's economic crisis in the 1920s, the mark went from three per each American dollar to more than 4.2 trillion per dollar, a slope considered impossible by Gauss' mathematics.
"We're doomed by the exceptions," he said.
It is a concept that has baffled many. A reader summarized the fallout by sending Taleb a T-shirt that read: "The Absence of Evidence is not Evidence of Absence." Taleb wore it in the gym, confusing his neighbors on the treadmill.
While Taleb kindly considers the traders in Chicago "immune" to black swans attacks, members of the audience noted that his ideas are contrary to much of the conventional wisdom that built a multibillion-dollar futures and options industry in the Windy City.
"What he's saying is a threat to the way things are," said Chris Hart, a stock options trader for Okoboji Options. "It's had some impact, but the industry keeps going on."
Hitesh Patel, who works for Allegiant Asset Management Group, said opponents to Taleb's core notions are guilty of excessive pride.
"He's correct," Patel said. "It's hubris to try to predict extremes."
After his speech, fans gathered around as Taleb sipped a Corona. They asked about mutual friends or requested he participate in their morning workout the next day. Taleb politely begged off the exercise. He is a busy man who pleads guilty to two vices: He returns all e-mails and appears on time for everything on his calendar.
"I have a feeling of being more useful as a writer," Taleb said. "I did not write "The Black Swan" for the money, and that's why it sold."
The evening was a familiar scene for Taleb. Well before he achieved fame with "The Black Swan" and its 2001 predecessor, "Fooled By Randomness," which also features the rare bird, he entertained other financiers during lectures at New York University and drinking sessions afterward at the Odeon.
As a University of Paris PhD, a lover of the humanities and a survivor of Lebanon's civil war, Taleb thrived as a cult figure among quantitative analysts.
"In those days, before 1997, he was considered a fringe thinker," said Aaron Brown, who works at AQR Capital Management. "He was taken seriously for the money he made, but many professionals and academics considered him a troublemaker and poseur who delighted in making philosophical points without practical application."
Equations don't add up
At the time, most analysts aspired to outsmart risk. They relied primarily on complex equations. Then came the Asian financial crisis, the 1998 flameout of Long Term Capital Management, a hedge fund employing Scholes, and the punctured Internet bubble.
Math had insulated many from reality. With Taleb's books coincidentally released around such crises as the 9/11 attack and the subprime mortgage collapse, it became more respectable on Wall Street to embrace his skepticism.
"The funny thing is the ground had shifted so much that people who used to say his ideas were nonsense started saying they were obvious," Brown said.
Part of his credibility is the product of the popularity of "The Black Swan." On Amazon.com last year, it outsold Alan Greenspan's autobiography, Al Gore's "The Assault on Reason" and O.J. Simpson's mock homicide confession. In a market prone to marketing business titles as buzzwords, "The Black Swan" has migrated along the same path of cultural saturation as "Freakonomics" and "The Tipping Point."
The concept enthralled venture capitalist Matt McCall enough that he scrapped his intended presentation last month at a local technology business conference to instead explain the black swan phenomenon. As a co-founder of Draper Fisher Jurvetson Portage Partners, McCall noted that black swans can be positive, too, such as the discovery of penicillin or emergence of the Internet. Taleb provides a way to comprehend and possibly profit from disruptive forces as well, he said.
"I don't think it's changed our behavior at this point," McCall said. "It provides an effective framework for how entrepreneurs and investors think about their business." |
