The Black Swan: The Impact of the Highly Improbable

[Peter11216]

The Black Swan: The Impact of the Highly Improbable

Nassim Nicholas Taleb, Random House, 2007

I don't have too much to say about this one. I doubt I would have made it past chapter one, had it not been written by Taleb. Taleb, a successful derivatives trader, has written a couple of effective critiques of the so-called "Black-Scholes" option pricing "equation." When the Black-Scholes formula was first presented to me I thought it must be garbage, and certainly not deserving of even the fake "Nobel" prize, which Myron Scholes received (in 1997, I think).

It is pretty clear, even without understanding the math behind it, that Black-Scholes relies on false assumptions about how a derivatives market operates. One of the strangest assumptions is that traders know the future, yes that's right, the future probability distributions of the options they are trading. In addition, the model assumes that stock prices do not make large, sudden jumps. The formula is basically normative - it says "This is how you should price options." It didn't look to me like it gave any guidance to some who actually wanted to trade options. Worse, the formula for which these guys won the Nobel is clearly not theirs in any meaningful sense. It had been derived by other people, both for financial uses, and natural phenomena. All these guys did is say, "Hey, maybe the price movements in the stock market are analogous to the movement of a grain of pollen suspended in liquid. If so, we could use the same formula for pricing options as was used to describe pollen in liquid."

Nonetheless, who am I? I'm not great with the math, and don't really know anything about options trading. It was thus happily self-confirming to find that Taleb, a guy who actually is a trader, and knows something about the math - had quite effectively shown that Black-Scholes was utter bunk. Among other things, Taleb did the research to show that it wasn't an original idea, from direct experience reported that no one actually uses the formula for trading (because it doesn't work), and provided a more rigorous account of its stupidity than I could. Therefore, I felt obligated to finish his rather tiring book.

The vast majority of claims Taleb makes in Black Swan are ones I agree with. This is nice, but there is little in the book that was really new to me. So, having finished reading it, I don't have any better arguments or know of any references that help confirm or disconfirm what I already believe (I had already read one of his papers on Black-Scholes).

I think Taleb's main points are the following: (1) instead of trying to beat the market, try not to be a sucker; (2) guassian distributions do not accurately describe much phenomena of interest, instead improbable events happen more frequently than predicted by current statistical tools used by market participants, especially on Wall Street. He very briefly describes his investment strategy as a "barbell." Protect yourself from loss (that will occur much more frequently than you expect), while exposing yourself to high risk assets (that will pay off much more frequently than you expect). This implies putting, say, 85-90% of your portfolio in the safest assets possible, while putting the other 15-10% is highly risky assets, and not bothering with anything in between.

A large part of the book is devoted to arguing that the world is such a place that, in fact, it will yield better payoffs to those who follow this strategy rather than traditional strategies. The arguments along this line are extended by Taleb to all sorts of aspects outside of financial markets.

I think Black Swan would probably be of most interest to anyone interested in financial economics, and maybe even for practicing traders.

Best,

Pete

[While reading this one, I had a few Tatuaje Brown Label Reservas, of the petite panatela vitola. Quite nice smokes, with sensational (in the literal sense) wasabi bite. Thanks to a couple of forum members who recommended the Tatuaje brand to me.]

[Puros Y Vino]

Interesting!! I just read Malcom Gladwell's "What the Dog Saw" and one of the stories was on Taleb, his theories and this book. Thanks! I might have to add this to my "read on the beach while on vacation list"

[thechenman]

I've read this book as well as his other work "Fooled By Randomness." Being in the financial industry with experience trading equities, futures etc. I can honestly say that the faults he finds with Black and Sholes' work, are faults his on work falls into. Is Black -Scholes fullproof? No. But at the time it was the best model out there. Financial markets are not stable, and the equity/derivatives markets even less so. However, you cannot account for future events that are unknown. Therefore when evaluating trades you factor in the known variables (buy guesstimate) and you assume the other variable to be fairly constant. Often time we stumble across trading models that work, but they only work for a duration of time...eventually a ***** in the armor shows. Let's face it...if there was a fullproof method everyone would be using it. We do the best with what we have, same as anyone else. Taleb does not espouse anyting that is not common knowledge. The hedging of risk is nothing new, people have done that long before organized financial markets even existed. Risk is a given...and if you want alpha, you have to be willing to take on a lot of beta. No professional money manager will every question the wisdom or need to hedge, the question is how to effectively hedge a position at the lowest possible cost to minimize beta, but maximize alpha. Not an easy task.

[Peter11216]

• I've read this book as well as his other work "Fooled By Randomness." Being in the financial industry with experience trading equities, futures etc.
  
• I can honestly say that the faults he finds with Black and Sholes' work, are faults his on work falls into. Is Black -Scholes fullproof? No. But at the time it was the best model out there.
  
• No professional money manager will every question the wisdom or need to hedge, the question is how to effectively hedge a position at the lowest possible cost to minimize beta, but maximize alpha. Not an easy task.
  

One of the points he makes, though, is that no one ever used Black-Scholes. I haven't read Fooled By Randomness, but he goes into it in some more detail with Haug in their paper, "Why we have never used B-S . . ."

He says no one really uses B-S, they all fudge the formula in crucial ways to make it work - which amounts to not using the formula at all. I think Taleb claims that even traders who say they are using B-S, only do so out of convention, since they've never bothered to look at the equation in detail - given that it is unnecessary.

I'm not sure if his strategies fail in the same way he claims B-S does. Because he claims, for example, stock prices behave closer to fractal patterns, I think he calls it Mandelbrotian. This is an empirical claim. The B-S implicitly claims stock prices are gaussian in distribution. So, he might fail, but not exactly in the same way.

But yeah, I agree, I think. The book is not exactly helpful in a practical way, and it doesn't say much that is novel.

It is funny, though, he says Scholes wrote him a threatening letter, or called him (I don't remember), and didn't seem to know the actual procedure for trading options.

Best,

Pete

[Torontonian]

You seem to have a real flair, Pete, for political philosophy and economics. (The latter seems especially popular on the forum generally.) I confess I've no aptitude for either. Both are very important, of course, and eminently practical, yet they have a soporific effect on me. Philosophy is one of my passions, but I usually find myself yawning through politically-driven stuff. And as for economics, well, I'm practically innumerate. Still, it's nice to know that we have some politico-economic savants about.

[Peter11216]

Yeah, I have definitely been reading a lot of economics stuff, and some political philosophy, too. I have now gone several years without reading any fiction, and haven't touched any philosophy for quite a while. (Though, Black Swan is classified as philosophy.)

The philosophy I used to enjoy was, I think, usually stuff called analytic philosophy. So I was interested that you mention you are reading an intro to modal logic. I liked Jerry Fodor's work, John Searle's, Austin's, and stuff along those lines. I have Quine's textbook on logic, but have never thought to look at it. Apparently, it is an excellent text book.

I'm not sure if I would call Ill Fares the Land or Empire of Illusion political philosophy. These strike me as commentary, without too much analysis. The value of these books, I think, is more in their descriptions of the world, than in any kind of enlightening arguments.

But re: political philosophy, I wonder: Have you tried reading John Rawls? Though, I've only looked at parts of it, A Theory of Justice is an amazing book.

I'm also looking forward to reading A Theory of Moral Sentiments. I really need to set aside sometime for this one.

For the time being, I'm still slowly, and happily, plugging away at Imerpial.

Best,

pete

You seem to have a real flair, Pete, for political philosophy and economics. (The latter seems especially popular on the forum generally.) I confess I've no aptitude for either. Both are very important, of course, and eminently practical, yet they have a soporific effect on me. Philosophy is one of my passions, but I usually find myself yawning through politically-driven stuff. And as for economics, well, I'm practically innumerate. Still, it's nice to know that we have some politico-economic savants about.

[Torontonian]

I have now gone several years without reading any fiction

That's much too long for me. (Does 'fiction' include poetry?) An abstemious month or two at most and then I need to breathe the rarefied air of a good novel or epic poem or something.

The philosophy I used to enjoy was, I think, usually stuff called analytic philosophy. So I was interested that you mention you are reading an intro to modal logic. I liked Jerry Fodor's work, John Searle's, Austin's, and stuff along those lines. I have Quine's textbook on logic, but have never thought to look at it. Apparently, it is an excellent text book.

Yes, Quine's text is quite famous. My readings in philosophy are fairly broad but only deep here and there. I have a penchant for the ancient Greeks, certain scholastics, several romantics, the existentialists generally, and a handful of contemporary thinkers. But, again, give me aesthetics, metaphysics, logic, or epistemology; not political or social philosophy, for all their merits.

[Peter11216]

Yes, that includes poetry. It's too long for me, too. But I still find there is always something that takes precedence, be it the paper, or a paper . . . I need to snap out of it.

Imperial is my attempt to get me closer to fiction, again.

That's much too long for me. (Does 'fiction' include poetry?) An abstemious month or two at most and then I need to breathe the rarefied air of a good novel or epic poem or something.

Yes, Quine's text is quite famous. My readings in philosophy are fairly broad but only deep here and there. I have a penchant for the ancient Greeks, certain scholastics, several romantics, the existentialists generally, and a handful of contemporary thinkers. But, again, give me aesthetics, metaphysics, logic, or epistemology; not political or social philosophy, for all their merits.