|Nassim Nicholas Taleb, creator of Black Swan Theory.|
Nassim is called by many as the "Modern Nietzsche" or even "Modern Renaissance Man".This is a man who suffers fools impatiently, and his intellect makes his hauteur largely justified.
Nassim Taleb is a modern philosopher of randomness and a philosopher who praises erudition above all.Nassim is also a top Financial Math expert, philosopher, statistician and a Hedge fund manager,a guy who uses philosophy in decision making,model building and hedging the funds.
The new sage of Wall Street
The trader turned author has emerged as the guru of the global financial meltdown. Not only is he riding high in the bestseller lists, his theory of black swan events has become the most seductive guide to our uncertain times.
No wonder the Lebanese-born trader turned author feels like relaxing: his book, The Black Swan: The Impact of the Highly Improbable, has become a huge success. A book of economics and philosophy, it's found a vast audience, speaks to its time and has become something of a key text to help understand the crisis in market capitalism.Not only does the book sit high in the US bestseller lists, but as a mark of its impact, the term 'black swan' has joined 'tipping point' and 'long tail' by having a life of its own. The financial meltdown is now routinely referred to as a 'black swan event'. As influential financial website bloomberg.com noted earlier this month: 'One hears folks from New York to Ulaanbaatar buzzing about black swans.'Taleb's central thesis is that a small number of unexpected events - the black swans - explains much of import that goes on in the world. We need to understand just how much we will never understand is the line. 'The world we live in,' he likes to say, 'is vastly different from the world we think we live in.'
The title refers to the medieval belief that all swans were white, hence black swan was a metaphor for something that could not exist, a metaphor that shifted into a perceived impossibility that came to pass when black swans were discovered in the 17th century.Taleb does not think of himself as an ideological or even philosophical writer, though his book contains elements from both realms of thinking; he prefers the role of mischievous intellectual whose observations stretch effortlessly from reason to superstition. In the midst of the economic upheaval, Taleb's acerbic attitude to bankers and economists has won him a new following and provided a comfort to many puzzling over the apparent unpredictability of recent events.
We are, he believes, suckers. 'The tools we have to understand what's happening on Wall Street were developed over the last couple of centuries,' he told the audience at Kentucky's Idea Festival last week. 'We need new tools. We will have to finance the losses because of a huge misunderstanding.'That misunderstanding, he explains in his book, is partly based on our belief that bankers and financial analysts are somehow blessed with superior knowledge. While 'peasants know they can't predict the future', Wall Street bankers believe they can.'Banks hire dull people and train them to be even more dull.In his estimation of the scale of the disaster: 'The banking system, betting against black swans, has lost more than $1 trillion - more than was ever made in the history of banking.'When it comes to finance, collective wisdom has shown itself to be close to astrology - based on nothing. But according to Taleb, unpredictable events - 9/11, the dotcom bubble, the current financial implosion - are much more common than we think.In Taleb's coinages, most people live in 'Mediocristan,' a fake model of reality where no rare events occur, and not in 'Extremistan', the complex real world where unpredictable and devastating events can dictate the outcome.
One of Taleb's favourite allegorical tales is the story of the turkey and the butcher. As previously described by Bertrand Russell, a turkey may get used to the idea of being fed but when, the day before Christmas, it is slaughtered, it will incur 'a revision of belief'.No one, he believes, is more guilty of living like turkeys in the false security of Mediocristan than economists and financial risk management analysts who rely on computer models that don't account for rare devastating events.
Taleb's personal black swan event came when Lebanon was engulfed by civil war in 1975, and he spent several war years in the basement of the family home studying. The son of a wealthy, highly educated Greek Orthodox family, he received degrees at Wharton, Pennsylvania, and the University of Paris before becoming a Wall Street trader.Then came 19 October 1987 - Black Monday. The event reinforced his belief in chance events. It was a sizable black swan, he says, that 'had vastly more influence on my thought than any other event in history'. Shorting the market made him nearly $40m.
A brush with throat cancer preceded the publication of his first book, Fooled by Randomness, that became a surprise hit in 2001. It established Taleb as a new thinker. The author even found his views adopted by strategic planners at the Pentagon. In February 2002, then Defence Secretary Donald Rumsfeld offered this hybrid of Taleb thought: 'There are known knowns. There are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don't know. But there are also unknown unknowns. There are things we do not know we don't know.'Taleb is full of inconsistencies - happily so. 'My problem is what my mother kept telling me I'm too messianic in my views,' he concedes. He claims not to read newspapers, yet his website is crammed with links to his press cuttings (he says he get news from people at parties). He's paid up to $60,000 for speaking to businessmen at conferences, yet he claims to distrust anyone who wears a tie (following the example of the Silicon Valley types he admires more, he sticks to black polo necks).And of course there is the ultimate contradiction: where he believes no one can predict black swan events, he's eager to cite instances where he alone has done so. 'One simply cannot predict history beyond a short time horizon,' he offered his audience in Louisville last week. 'It might be useful to be able to predict war. But tension does not necessarily lead to war, but often to peace and to denouement.'
To establish his credentials as sage of our current predicament, Taleb frequently refers to an August 2003 article in the New York Times in which he correctly predicted the quasi-governmental US insurance giant Fannie Mae had underestimated the risk of a rise in interest rates that would destroy the value of their portfolios. 'The fact that they have not blown up in the past doesn't mean that they're not going to blow up in the future,' he said. 'The math is bogus.' (The company was taken over by the US government last month.)The footnote on page 225 of The Black Swan reads: 'When I look at their risks, [Fannie Mae] seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry - their large staff of scientists deem these events "unlikely".'
Even globalisation, which was supposed to make the economic machine more resilient, may be having the opposite effect, he thinks. 'Things are way too efficient, so the smallest mistake blows up. Tomorrow, if there's a problem in Bangalore, we're toast for a long time, you see?'Economics is a tragedy for me. Because look at how the whole world now is designed according to some ideas that have not proved adequate. The whole financial system. We don't understand economic policy, do you realise that? When Alan Greenspan lowered interest rates thinking it would help the economy, all it did was push banks to take risks-hidden risks.'Taleb is not the only author competing to provide the intellectual weight to the current confusion. This autumn, Michael Lewis, author of Liar's Poker and Moneyball, seeks to describe the collision of market forces, human idiosyncrasies and greed in Panic: The Story of Modern Financial Insanity. His thinking: risky loans and easy money almost always lead to disaster - whether it's the crash of '87, the Asian currency crisis of 1999 or the sub-prime mortgage fallout.And one might feel that with hindsight it's not hard to predict that a banking industry that drops lending standards, securitises bad loans without transparency and sells them on to massively leveraged institutions and hedge funds will end in trouble.Perhaps Taleb's black swan theory promises to be more enduring because it does not, he argues, depend on hindsight. In any case, he has his own in-built defence mechanism. 'My major hobby,' he says, 'is teasing people who take themselves and the quality of their knowledge too seriously and those who don't have the courage to sometimes say, "I don't know..."'
|Taleb's Black Swan is the most Influential book since Adam Smith's Wealth of Nations|
Black Swan Theory
Taleb has made his living (and a small fortune, now transformed into a large fortune by the 2008 market) in an unusual way -- by financial speculation in contexts where he spots a small chance of making a very large gain. As with others who have had unusual careers (say, Neil Armstrong or Marcel Marceau) it is interesting to hear his experiences, but when such a person declares I am a philosopher of ideas one is wise to be cautious (italics denotes quotes from Taleb, boldface denotes my own emphasis).
A "Black Swan" is defined as an event characterized by rarity, extreme impact, and retrospective (though not prospective) predictability, and Taleb's thesis is that such events have much greater effect, in financial markets and the broader world of human affairs, than we usually suppose. The book is challenging to review because it requires considerable effort to separate the content from the style. The style is rambling and pugnacious -- well described by one reviewer as "with few exceptions, the writers and professionals Taleb describes are knaves or fools, mostly fools. His writing is full of irrelevances, asides and colloquialisms, reading like the conversation of a raconteur rather than a tightly argued thesis." And clearly this is perfectly deliberate. My own overall reaction is that Taleb is sensible (going on prescient) in his discussion of financial markets and in some of his general philosophical thought, but tends toward irrelevance or ridiculous exaggeration otherwise. Let me run through some discussion topics, first 6 where I broadly agree with Taleb, then 6 where I broadly disagree, then 4 final thoughts.
"Ask your local mathematician to define probability, he would most probably show you how to compute it, probability is not about the odds, but about the belief in the existence of an alternative outcome, cause, or motive. Recall that mathematics is a tool to meditate, not compute. Again, let us go back to the elders for more guidance – for probabilities were always considered by them as nothing beyond a subjective, and fluid, measure of beliefs".
Nassin Nicholas Taleb
Taleb Against Gaussian Curve
Nassim's most famous work and probably the most ground breaking work of modern Financial world.He states that Gaussian curve is not suitable curve or distribution for events in financial world as the randomness involved in modern financial world is quite massive than that follows Gaussian curve.Gaussian curve is meaningless in money and stocks but you may see it on German notes. Bell curve is used in risk management though in many banks by Black Suit wearing officer. Assume that average height of men has a mean of 1.5 m and standard deviation 0.22 m and they follow a Normal /Bell distribution. Note that 220 cm standard deviation(.220 m) is randomness here and a very high one for a computer programmer.Gaussian yields its properties rather rapidly (a way to get a solution rather accuracy ), standard deviation in Bell curve face a head wing where probabilities move rapidly as you move far away from mean. But my way of calculation thus not make probability change ,it stays remain same over a range(unlike Bell curve). If I tell you that combined height of 2 men is 14 feet then you will think of 7 feet for each not 11 and 3 feet for them. People like to think in an easiest way and avoid randomness as 7 feet as for frequent and mind see it easier to conceive. Bell curves used in extreme events may cause a lot of disaster.
Measures of uncertainty that are based on Bell curve disregard the impact the sharp jumps and inequalities and using them is like getting grass (grass disaster) and missing out the trees (Big Black Swans). This is why economics is based on Equilibrium , it allows you to treat economics as Gaussian . Assume you have a sample of 1000 people(giants and dwarfs) , your average will not be changed if you add another giant as your average will not be altered but if you add a mega giant it may be. So a single event will not change anything. So, while weight, height and calorie consumption are Gaussian, wealth is not. Nor are income, market returns, size of hedge funds, returns in the financial markets, number of deaths in wars or casualties in terrorist attacks. Almost all man-made variables are wild or carry massive randomness(Black Swans).
(1) The sterilized randomness of games does not resemble randomness in real life; thinking it does constitutes the Ludic Fallacy (his neologism). This is exactly right, and mathematicians should pay attention. In my own list of 100 instances of chance in the real world, exactly 1 item is "Explicit games of chance based on artifacts with physical symmetry -- exemplified by dice, roulette, lotteries, playing cards, etc".
(2) Taleb is dismissive of prediction and models (explicitly in finance and econometrics, and implicitly almost everywhere). For instance, Why on earth do we predict so much? Worse, even, and more interesting: why don't we talk about our record in predicting? Why don't we see how we (almost) always miss the big events? I call this the scandal of prediction. And In the absence of a feedback mechanism [not making decisions on the basis of data] you look at models and think they confirm reality. He's right; people want forecasts in economics, and so economists give forecasts, even knowing they're not particularly accurate. Also, the culture of academic research in numerous disciplines encourages theoretical modeling which is never seriously compared with data.
(3) Taleb is scathing about stock prediction models based on Brownian motion (Black-Scholes and variants) and of the whole idea of measuring risk by standard deviation:You cannot use one single measure for randomness called standard deviation (and call it "risk"); you cannot expect a simple answer to characterize uncertainty.
(4) Ask someone what happened in a movie they've just watched; their answer will not be just a list (this happened; then this happened; then this happened .....) but will also give reasons (he left town because he thought she didn't love him, .....). We habitually think about the past in this way -- events linked by causal explanations -- partly to make it easier to remember.
(5) Mediocristan and Extremistan for settings where (in technical statistics terms) outcomes do [do not] have finite variance. His writing is lively and memorable, and his examples are apposite, so that it would make a useful reading accompaniment to a technical statistics course (though as indicated below I disagree with his interpretation of the relative significance of the two categories).
(6) Given that Taleb's thesis is already well expressed by the bumpersticker "Expect the unexpected", what more is there to say? Well, actually he makes several memorable points, such as his summary of themes related to Black Swans:
(a) We focus on preselected segments of the seen and generalize from it to the unseen: the error of confirmation.
(b) We fool ourselves with stories that cater to our Platonic thirst for distinct patterns: the narrative fallacy.
(c) We behave as if the Black Swan does not exist; human nature is not programmed for Black Swans.
(d) What we see is not necessarily all that is there. History hides Black Swans from us [if they didn't happen] and gives a mistaken idea about the odds of these events: this is the distortion of silent evidence.
(e) We "tunnel": that is, we focus on a few well-defined sources of uncertainty, on too specific a list of Black Swans (at the expense of others that do not come so readily to mind).
And here is his investment strategy.
Half the time I am hyperconservative in the conduct of my own [financial] affairs; the other half I am hyperaggressive. This may not seem exceptional, except that my conservatism applies to what others call risk-taking, and my aggressiveness to areas where others recommend caution. I worry less about small failures, more about large, potentially terminal ones. I worry far more about the ``promising" stock market, particularly the "safe" blue chip stocks, than I do about speculative ventures -- the former present invisible risks, the latter offer no surprises since you know how volatile they are and can limit your downside by investing smaller amounts ....... In the end this is a trivial decision making rule: I am very aggressive when I can gain exposure to positive Black Swans -- when a failure would be of small moment -- and very conservative when I am under threat from a negative Black Swan. I am very aggressive when an error in a model can benefit me, and paranoid when an error can hurt. This may not be too interesting except that it is exactly what other people do not do. In finance, for instance, people use flimsy theories to manage their risks and put wild ideas under "rational" scrutiny.
Maybe not easy for you or me to emulate, but surely conceptually useful for us to keep in mind.
Taleb dismisses Mediocristan as uninteresting and basically attributes "Life, The Universe, and Everything" to Extremistan: it is easy to see that life is the cumulative effect of a handful of significant shocks. Now power laws (in the present context, distributions with power law tails, roughly what Extremistan is; pedantically, I am now talking about Gray Swans) have received much attention in popular science and popular economics over the last 20 years, and they really do arise in various aspects of the natural world, and (for different reasons) in various aspects of the human economic world. But my view is that
(a) the apparent prevalence of Extremistan is exaggerated by several cognitive biases
(b) outside rather narrow economic contexts, each example of Extremistan in the human world is surrounded by numerous equally significant examples of Mediocristan -- it's just a small part of a big picture.
In other words Taleb's assertion quoted above, like much of the popular literature, wildly overstates the significance of Extremistan. To argue this carefully would require a Chapter, but here's a brief version. A building might be damaged in a few seconds by an earthquake, in a few minutes by a fire, in a few hours by a flood, or in a few decades by termites. The first three are visually dramatic and may affect a large and unpredictable number of buildings at once; not so the fourth (Extremistan vs Mediocristan); the first three appear in the news as "natural disasters" but the fourth doesn't. But none of this is relevant to the quantitative impact of such events, which is an empirical matter (termites win). Similarly, ``number of deaths in different wars" is in Extremistan; childhood deaths from poor sanitation and consequent disesase is in Mediocristan. Guess which caused more deaths worldwide in the 20th century. That's an empirical matter (poor sanitation wins).
- Extremistan is sometimes dramatic; Mediocristan is never dramatic. But this has no necessary connection with quantitative impact.
- Our minds focus on variability. Extremistan is, by definition, more variable than Mediocristan, so it attracts relatively more of our attention. But this has no necessary connection with quantitative impact.
Turning to (b), take any example, even a standard "economic" one such as financial success of different movies. Most movies lose money; a few make enormous profits. So this aspect of the movie sector of the economy is indeed in Extremistan. But how much, and to whom, does this matter? The size of the sector (number of employed actors and technicians, number of cinemas) isn't affected in any obvious way by this variability, just by our taste for watching movies as opposed to other entertainment. Of the movies I (and you too?) enjoy, some were commercial successes and some were flops -- how would my experience be different if the successes and failures were less extreme? Even an investor diversified across the movie business isn't much affected. It's hard to think of any very substantial consequences -- for instance, logic suggests that in Extremistan one should "take risks" by making unconventional movies, but Hollywood is generally criticized for exactly the opposite, for making formulaic movies.
In other words the whole Extremistan metaphor, suggesting a country in which everything is ruled by power laws, is misleading. A better metaphor is an agora, a marketplace, which is a useful component of a city but is surrounded by other components with different roles. This provides a segue to a quotable proclamation of my own.
- Financial markets differ from casinos in many ways, but they are almost equally unrepresentative of the operation of chance in other aspects of the real world. Thinking otherwise is the Agoran fallacy.
(a) Money is "simply additive"; your career investment profit is the sum of your profits and losses each day, or the sum of profits and losses on each investment. The rest of life doesn't work that way -- your happiness today isn't a sum of incremental happiness and unhappiness of previous days.
(b) Imagine you have woken from a 25-year sleep and want to catch up on what's happened. Taleb and I agree that looking at the roughly nine thousand daily headlines you missed would not be helpful -- these are "just noise" from a long-term perspective. Taleb views Black Swans as the only alternative. But he ignores the cumulative effect of slow trends (which are uninteresting to speculators, hence represent a cognitive blindspot). One can think of an endless list of slow changes in the U.S. over the last generation: (increase in childhood obesity, increased consumption of espresso, increased proportion of occupations requiring a College education, increased visibility of pornography) as well as the more prominent ones (acceptability of a black President, increase in health care sector to 16% of GDP). Consider a 55 year old thinking about changes in the U.S. over the last 30 years - how is the experience of being 25 in 2009 different from the experience of being 25 in 1979? Perhaps most obvious is the Internet (more precisely, the things we now do using the Internet) and the prevalence of laptop computers. This is a change that our 55 year old experienced as an individual -- we remember the first time we used a browser or a search engine. We have a natural cognitive bias towards changes such as the Internet that we experienced as an individual, rather than those such as "increase in childhood obesity" that we didn't.
The word prediction has a range of meaning. Stating "Microsoft stock will rise about 20% next year" is a deterministic prediction, whereas stating your opinion about the stock's performance as a probability distribution is a statistical prediction. Any attempt by a reader to make more precise sense of Taleb's rhetoric about prediction requires the reader to keep firmly in mind which meaning is under discussion, since Taleb isn't careful to do so. For instance, Taleb discusses [p. 150] data that security analysts predictions are useless, as if this were a novel insight of his. But in this setting he is talking about deterministic prediction, and he is just repeating a central tenet of 30 years of academic theory (the efficient market hypothesis and all that), not to mention the classic best-seller "A Random Walk Down Wall Street". On the other hand, the standard mathematical theory of finance starts with some statistical assumption -- that prices will move like Brownian motion or some variant. Taleb's criticisms of this theory -- that it ignores Black Swans, and that future probabilities are intrinsically impossible to assess well -- have considerable validity but he doesn't make sufficiently clear the distinction between this and traditional stockbroker advice.
A book on (say) the impact of Empires on human history might be expected to contain an explicit list of entities the author considered as Empires; that way, a reader could analyze any asserted generality about empires by pondering whether it applied to at least most empires on the list. Similarly, one might expect this book to contain some explicit list of past events the author considered Black Swans (here I am thinking of unique Black Swans, not Gray Swans). But it doesn't; various instances are certainly mentioned, but mostly via asides and anecdotes. If you read the book and extracted the mentioned instances, and then read it again to see how much of the material was directly relevant to most of the listed Black Swans, then it would be a very small proportion. In other words, the summary (6) of Taleb's views is interesting, but instead of expanding the summary to more concrete and detailed analysis, the book rambles around scattered philosophical thoughts.
The style of Taleb's philosophizing can been seen in the table "Skeptical Empiricism vs Platonism", where he writes a column of ideas that he explicitly identifies with, and contrasts with another column that no-one would explicitly identify with. This is straw man rhetoric. Indeed much of the book is rhetoric about empiricism, with a remarkable lack of actual empiricism, i.e. rational argument from data.
This love of rhetoric causes Taleb to largely ignore what I would consider interesting philosophical questions related to Black Swans. Here are two such. There are a gazillion things we might think about during a day, but (unlike a computer rebooting) we don't wake up, run through the gazillion, and consciously choose which to actually think about. For obvious reasons, in everyday life this issue
- what comes to one's conscious attention as matters one might want to think about?
Nassim has stated that his major hobby is "teasing people who take themselves and the quality of their knowledge too seriously and those who don't have the guts to sometimes say: 'I don’t know ...'
If you haven't read The Black Swan, Taleb's online essay THE FOURTH QUADRANT: A MAP OF THE LIMITS OF STATISTICS is a shorter and more cohesive account of some of his ideas. (14) Taleb often seems to imagine that the views he disagrees with come from some hypothetical FINANCIAL MATH 101 course, though in one case it was an actual course: It seemed better to teach [MBA students at Wharton] a theory based on the Gaussian than to teach them no theory at all. It is easy to criticise introductory courses in any subject as concentrating on some oversimplified but easy-to-explain theory which is not so relevant to reality (e.g. many introductory statistics courses exaggerate the relevance and scope of tests of significance; physics courses say more about gravity than about friction). It is much harder to rewrite such a course to make it more realistic without degenerating into vague qualitative assertions or scattered facts.
Writers on financial mathematics (Taleb included) tend to ignore what strikes me as the most important insight that mathematics provides. Common sense and standard advice correctly emphasize a trade-off between short term risk and long term reward, but implicitly suggest this spectrum goes on forever. But it doesn't. At least, if one could predict probabilities accurately, there is a "Kelly strategy" which optimizes long-term return while carrying a very specific (high but not infinite) level of short term risk, given by the remarkable formula
- with chance 50% [or 25% or 10%] your portfolio value will sometime drop below 50% [or 25% or 10%] of its initial value.
- As a default, assume the future will be statistically similar to the past. Not because this is true in any Platonic sense, but because anyone who says different is trying to sell you something.
The Taleb Lowdown
Born: In 1960 into an influential Greek Orthodox Levantine family from Amioun, Lebanon. Son of oncologist Dr Najib Taleb and Minerva Ghosn, daughter and granddaughter of former Deputy Prime Mrld we live in,' he likes toluence reduced during the Lebanese civil war.
Education: An MBA from the Wharton Business School,University of Pennsylvania, PhD from Paris University(Dauphine).
Best of times: The current market crash vindicated Taleb's economic predictions, making him, according to the Times, 'the hottest thinker in the world' with a $4m advance on his next book and worldwide speaking engagements ($60,000 a pop).
Worst of times: The frosty reception for The Black Swan. The American Statistician dedicated an entire issue to criticising Taleb's black swan theory.
What he says 'I am interested in how to live in a world we don't understand very well - in other words, while most human thought [particularly since the Enlightenment] has focused us on how to turn knowledge into decisions, I am interested in how to turn lack of information, lack of understanding, and lack of "knowledge" into decisions - how not to be a "turkey".'
What they say: 'Beneath Mr Taleb's blustery rhetoric lives a surprisingly humble soul who has chosen to follow a demanding and somewhat lonely path.' The Wall Street Journal.