Taleb: Traders— Look Out

'Black Swan' Author Nassim Taleb Warns Traders To Look Out For The Improbable

By Joshua Boak | Tribune | 16 January 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 very 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" (the song): "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 such extreme 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. "But academics do not take him seriously because he does not cite previous academic literature in his theories, relegating him to a popularizer of ideas, making money selling books."

[ Normxxx Here:  Since when does a mathematical theory require references? It can be proved irrefutably to be true or false! And Taleb's contention that the stock market and many other such 'natural' phenomena do not follow Gauss' famous bell curve, has been well proved. It's not the 'real' world that's at fault, it's the mathematics!  ]

'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."

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Normxxx    
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