Fat tails + nonlinear feedback means that the majority of successful traders were successful due to luck, not skill. It's painful to live in the shadow of such competitors.What other fields are dominated by noisy feedback loops? See Success vs Ability , Nonlinearity and noisy outcomes , The illusion of skill and Fake alpha.
Why It is No Longer a Good Idea to Be in The Investment Industry
Nassim N. Taleb
Abstract: A spurious tail is the performance of a certain number of operators that is entirely caused by luck, what is called the “lucky fool” in Taleb (2001). Because of winner-take-all-effects (from globalization), spurious performance increases with time and explodes under fat tails in alarming proportions. An operator starting today, no matter his skill level, and ability to predict prices, will be outcompeted by the spurious tail. This paper shows the effect of powerlaw distributions on such spurious tail. The paradox is that increase in sample size magnifies the role of luck.
... The “spurious tail” is therefore the number of persons who rise to the top for no reasons other than mere luck, with subsequent rationalizations, analyses, explanations, and attributions. The performance in the “spurious tail” is only a matter of number of participants, the base population of those who tried. Assuming a symmetric market, if one has for base population 1 million persons with zero skills and ability to predict starting Year 1, there should be 500K spurious winners Year 2, 250K Year 3, 125K Year 4, etc. One can easily see that the size of the winning population in, say, Year 10 depends on the size of the base population Year 1; doubling the initial population would double the straight winners. Injecting skills in the form of better-than-random abilities to predict does not change the story by much.
Because of scalability, the top, say 300, managers get the bulk of the allocations, with the lion’s share going to the top 30. So it is obvious that the winner-take-all effect causes distortions ...
Conclusions: The “fooled by randomness” effect grows under connectivity where everything on the planet flows to the “top x”, where x is becoming a smaller and smaller share of the top participants. Today, it is vastly more acute than in 2001, at the time of publication of (Taleb 2001). But what makes the problem more severe than anticipated, and causes it to grow even faster, is the effect of fat tails. For a population composed of 1 million track records, fat tails multiply the threshold of spurious returns by between 15 and 30 times.
Generalization: This condition affects any business in which prevail (1) some degree of fat-tailed randomness, and (2) winner-take-all effects in allocation.
To conclude, if you are starting a career, move away from investment management and performance related lotteries as you will be competing with a swelling future spurious tail. Pick a less commoditized business or a niche where there is a small number of direct competitors. Or, if you stay in trading, become a market-maker.
Bonus question: what are the ramifications for tax and economic policies (i.e., meant to ensure efficiency and just outcomes) of the observation that a particular industry is noise dominated?
19 comments:
What does smart mean? There is a very huge difference between being smart and knowing how to do something. My family is loaded with “smart” people- but if I were drowning I would never ever call on most of them.
In Jay McInerney's novel "Brightness Falls," there's a manic-depressive billionaire investor whose up and down cycles have happened to precede the stock market's by three months.
"if you are starting a career, move away from investment management and performance related lotteries"
If you are starting a career and don't know anything, why not move toward this career where you can get very rich through sheer luck?
The bonus question appears rhetorical. But can anyone do what everyone knows to be right?
I think Taleb is writing for people of above average ability (i.e., himself). In Fooled By Randomness he expresses bitterness at the "lucky fools" who made more money than he did. BTW, most practitioners I know think Taleb was a failure as a trader.
Do those practitioners have any thoughts about what Taleb's ability level is? It seems clear that Taleb is of above average ability in some areas, but what about other areas that matter to traders? It can be hard to separate chance from insufficiently understood/appreciated skills. As an (perhaps the best) example I would argue that "knowing the right people" has a significant element of skill.
"What other fields are dominated by noisy feedback loops?"
I suppose those fields don't include software start ups or academic physics?
Taleb claimed he fought with his bosses, because he followed the same strategy he does now, that is buying a small amount of mispriced options and therefore usually losing the premia and at best breaking even with the bulk in risk free.
Operationally, for the purpose of meaning something, it means a high IQ.
Answer to bonus:
Hedge fund managers and traders are job-creators and Atlases. They shouldn't pay more than 15%.
Software start up success has a big noise component; maybe even borderline noise dominated. Academic physics less so but even there luck is important.
Taleb has a good understanding of how things are broken, but that's quite different from having the practical skills to make money in the broken system. Yes, it's nice to be able to identify things that are likely to blow up within the next 20 years, but even after you've won the corresponding bets you'll still be behind many of the traders who are able to exploit limited liability to be on the right side of the "Taleb distribution" (lol), have a sufficiently strong technical understanding of the market to win at HFT, and/or have the superior social skills you allude to.
Which is okay for him (and us), since he's found a different, more socially useful niche.
The proposals suggesting that bonuses be paid out on a timescale longer than 1 year seem like the best solution. Without sitting down and crunching some numbers, we can't be sure what the optimal number of years is. This solution avoids pushing skilled individuals away from finance, but prevents the lucky from making too much undeserved profit.
This assumes of course that finance is a net good for society and that you believe the returns to luck should be zero. I agree with the former, but I'm not quite sure about the latter.
I'll venture an answer at the bonus:
Policy 1: Do not let fiduciaries for the public invest in management schemes like these. So, no union pension trustees (think Calpers) investing in "alternative investments", no picking individual mutual funds, etc... Only permit public stewards to invest in Malkiel-esque broad index funds, ideally using robot type blends tailored to the needs of the group.
Policy 2: Encourage the rich to play this pick-'em game as much as possible (for example, government should avoid prohibitive taxation and regulation) since all this churning simply generates extra tax revenue (cap gains and w-2's of hedge fund types) for the government even at a light tax rate - and it does nothing to enrich "the rich" as a whole. Sloshing money around among the rich should not disturb us as long as the government takes its "rake" out of the system.
One indicator of who is unjustly rich is a rich individual's decision to play this game on the investor side ... so let's see the government rake some of that away in the churn ...
Thanks for the thoughts (I like your last sentence ;-). I'm not sure "it's nice to be able to identify things that are likely to blow up within the next 20 years" necessarily even correlates positively with being a good trader (disclaimer: I am not in the financial industry and would be interested in opinions from those more knowledgeable). I think timing is the important skill and sometimes that requires "suspension of disbelief" to get the best out of a short term trade (say deciding whether to buy or sell internet stocks in 1999 with a 1 year time horizon). Identifying blow-ups is a more useful skill for an investor with a longer time horizon and the deep pockets/reputation to maintain a position that moves adversely for a time (say Warren Buffet in 1999).
A lot of software solves an invented problem.
I don't think the returns to luck should be zero, but I do believe they should be accounted for more fully (i.e. both positive and negative outcomes have corresponding "rewards"). Another way of saying that would be that the expected value of the returns to luck should be (closer to) zero (for the entities taking the risks). One of the trends in American society that most disturbs me is the privatization of gains and the socialization of losses (bankruptcy used "properly" can be an efficient engine for this, bailouts are another, taking unacknowledged tail risk and raking in bonuses for a period but walking away when things blow up seems to be a popular financial industry version)..
There's an economic modeling constraint that agents should be acting in a 'Individually Rational' way. While it can be taken too far, it does force one to at least make clear the specific cognitive error people are making which is often the key to their argument (eg, make people rational in their mind, but ignoring or overweighting extreme events). Those investors chasing returns here seem to be highly irrational, taking on extra risk for zero expected return. I do think investors are drawn to excess volatility, but his point seems to simply be it's all randomness, and so his main twist is actually simply an assertion about the ubiquity of chance, not that it exists. Taleb takes a reasonable, but rather common observation--luck matters--and then extrapolates that it's all luck, or more so now than before.
Interestingly, the alternative is that one listen more to the manager's theory than his data, but then in other writings Taleb ridicules theorists for fitting the real world into the Procrustean bed of an elegant but irrelevant worldview.
Effort, skill, and chance are all important, and I think increased factor mobility and travel has made effort and skill more important than it was in prior centuries, where one was much more substantially constrained by the accidental inheritance of family and place.
And Warren Buffet, if I've interpreted him correctly, thinks that innate talent itself should be regarded by the talented as lucky. 'Pay your taxes and don't complain', he says.
It would be much less of an issue if the poor were prevented from having children.
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