Saturday, March 01, 2008

Taleb or not Taleb?

Nassim Taleb, love him or hate him, has appeared quite a few times on this blog. Personally I find him quite amusing. I like his irreverence for "expert" opinion (especially that of economists) and his skepticism toward finance theory (in particular, towards Black Scholes and assumptions about perfect hedging and normally distributed risks). His earlier book Fooled By Randomness is largely devoted to making the simple point (amazingly, not appreciated by many otherwise very smart people) that it is quite difficult to tell whether success is due to ability or plain luck. In Wall Street terms, when is there enough data to be confident about someone's alpha?

I recently found this interesting essay by Eric Falkenstein, which is quite critical of Taleb and his book The Black Swan. Many of Falkenstein's points are well taken, although one should evaluate his arguments carefully -- his background (worked on VAR, an economics PhD) might predispose him to dislike Taleb. He criticises Taleb's hero Mandelbrot and the use of fractal ideas in finance, but these criticisms point to the fact that the ideas do not lead to easily implementable models, not that they are wrong as a fundamental description of the underlying phenomena. See, e.g., here and here for more discussion. Eventually, he cuts to the chase and notes that Taleb's earlier hedge fund was probably a loser, and that if he had had any success as a trader he wouldn't be out there hawking books and giving lectures on the rubber chicken circuit :-)

Taleb's trading strategy, based on the idea that others in the market are insufficiently aware of fat tailed distributions, was to buy out of the money puts in hopes of a profiting from a catastrophe. Under this strategy his fund constantly lost small amounts of money in hopes of making a big killing. Sadly for Taleb, he never hit the jackpot, although (see the Fooled By Randomness comment above) that doesn't necessarily undermine the validity of the strategy. More damaging, however, is the fact that insurance companies are basically on the other side of Taleb's trade all the time, and they seem capable of generating steady profits for long periods of time. My guess is that any trader who sold a put to Taleb's fund would pad out the price so much that even if their probability distribution were off at the tails, they would still exact a premium over the real value of the option. The deeper out of the money you go, the more careful and suspicious your counterparty is likely to be.

Finally, here's a recent paper by Taleb which is harshly critical of Black-Scholes-Merton.

Falkenstein: ...Taleb argues that the unpredictability of important events implies we should basically forget about all that is predictable, because that’s not where the real money or importance is. So from a risk management perspective, we should ignore Value at Risk, which measures anticipated fluctuations. Further, we should ‘go long’ on these unanticipated events by engaging in quirky activities on the off-chance that we randomly find something, or someone, really valuable.

Success in markets, like life, is a combination of ability, effort, and chance. Much of intelligent thought is distinguishing between what is predictable v. what is unpredictable; it is to any organism's advantage to find out what we can figure out and change, and what is forever mysterious and unalterable (eg, the Serenity Prayer). The brain is constantly predicting the environment, trying to figure out cause and effect so it can better understand the world. Most of what humans process is predictable, but because we take predictable things for granted, they are uninteresting. We can't predict some things, but instead of resorting to nihilism, we merely buy insurance or manage our portfolios--in the broad sense of the term--to have an appropriate robustness. Discovering certain things are basically unpredictable does not diminish our constant focus on trying to predict more and more things. People will disagree on which risks at the margin are predictable, but that's to be expected, and we all hope to be making the right choices that optimize our serenity at the margin of our predictable prowess.

Of course, in the face of being totally wrong in his evaluation of the usefulness of VAR as a tool — it’s ubiquitous in practical management of diverse trading books — Taleb now says he merely warned against naive usage of VAR. However, it was only his absurdly strong statement that VAR was for charlatans that got him mentioned in 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.

From Taleb's Wikipedia entry circa July 2006, we see where 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).

In fact, Mandelbrot also argues for this strategy. Taleb co-authored a paper arguing that most people systematically underestimate volatility. Furthermore, he argues there exists not only a lack of appreciation 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, which a Popperian like Taleb should embrace. Specifically, buying out-of-the-money options, especially puts (because of negative skew), should, on average, make money. But insurance companies, which basically are selling out-of-the-money options, tend to do as 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. Of all the option strategies, selling, not buying, out-of-the-money puts has been the best performer historically.

Famed New Yorker writer Malcom Gladwell in a 2002 New Yorker article contrasts the thoughtful, pensive Taleb versus the brash cowboy Victor Neiderhoffer: Taleb buys out-of-the-money puts, Neiderhoffer sells them. Taleb is betting on the big blow up, Niederhoffer on the idea that people overpay for insurance. Who was right? Well, Neiderhoffer still ran his flagship fund until September 2007 from a chalet-style mansion in Weston Connecticut . Taleb shut down his Empirica Kurtosis fund at the end of 2004, and the only public data on it suggest a rather anemic Sharpe ratio, below that of the S&P500 (60% in 2000, about zero for the next 4 years, see here), which is consistent with shutting it down, and trying to redescribe it as a hedge or laboratory, and then move into the more profitable business of teaching how to invest. While neither strategy was great, Niederhoffer's was better, if you just look at their lifetimes (management, in this case Taleb, always likes to say that people left positions of power due to desires to be with family or other opportunities, but the bottom line is, selling puts remained immune to family considerations longer than buying puts).

Taleb's big problem is that he misinterprets the mode-mean trade. A mode-mean trade is where a trader finds a strategy with a positive mode, but zero or negative mean. He then uses someone else’s capital to make money off several years of good returns, making good money for creating or managing the strategy, then, when the strategy gives it all back, the investor bears all the loss. That’s a bad strategy for the investor, and the trader who manages it is either na├»ve or duplicitous. That is, selling extreme options or writing insurance on extreme events at any prices generates a good mode return, but if it underestimates the probability or severity of the bad times, it may generate a zero or negative average return. Buying High Yield debt is a good example. However, just because selling puts is a bad strategy, it doesn't mean buying puts is a good strategy. A Sharpe of 0.2 is a bad long position, but a worse short (because a - 0.2 Sharpe is worse than a 0.2).


Anonymous said...

Taleb makes for a fun read, but it is not enlightening. He offers us a visit with Hume, whom many of us visited long ago as young turks. I remember well my first visit with Hume. He showed the folly of induction and universals as foundations of true knowledge. Many while surprised and sympathetic to Hume's observations stopped visiting when we realized that life proceeded forward with or without accepting his points. What is missing from Taleb is a position that advances the conversation. I encourage him to show he has something new to offer us beyond Hume's thoughts packaged for the WS-centric.

Anonymous said...

How's this looking in 2009?

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