Veteran options trader (and indefatigable skeptic intellectual) Nassim Taleb has ended 2007 as the top bestselling author in the non-fiction book category according to Amazon.com. Taleb´s charts-topping “The Black Swan” glowfully crowns his outrageously successful transition from market player to popular muser. As is well known by now, the book deals with unexpected, rare events that have a profound effect when they do eventually take place. Taleb´s main assertion is that we tend to misunderstand such events, and stubbornly assign very small (even negligible) probabilities to them happening. In real life, “black swans” happen much more often than generally assumed either by conventional perception or by standard statistical methods. This is, of course, particularly true in financial land, where events that are assigned probabilities of one in a million years make a semi-regular appearance every half-decade or so.
As was to be expected, Taleb´s musings have not been too well received within finance theory circles. He goes hard at the very foundations of financial economics, a discipline that has experienced what seems like an unstoppable process of quantitatification in the past decades. By discrediting the use of the Normal distribution (and associated statistical measures, such as standard deviation) in the markets, Taleb strikes a blow to modern portfolio theory and the Black-Scholes option pricing model, most likely the two key pillars (and crowning achievements) of theoretical finance, both Nobel winners. By negating the possibility that we may be able to forecast when it comes to social sciences, Taleb takes away any practical relevance that financial econometrics (another Nobel-endowed building block) may have. In Taleb´s view, financial theory would not just be essentially useless, but actually quite dangerous, as it provides a very faulty guide and forces people to take actions that may result in enhanced, not reduced, market turmoil.
But, bothered as the most dogmatic of academics surely are, perhaps it is with (many) practitioners that the true displeasure with Taleb´s message lies. This might seem like an odd assertion at first. After all, Taleb has been one of them, and a very prominent one at that. Why would real-world financial players be annoyed by what a twenty-year derivatives veteran has to say? Because, bluntly stated, Taleb´s ruminations threaten to disrupt what has traditionally been a very welcome and cherished resource at the disposal of bankers and market punters. After Taleb, it could become more difficult to use the “unforseeable once-in-a-lifetime rare event” as an excuse for blow-up losses, just as it could become less feasible to peddle products which are heavily (negatively) exposed to the black swan taking place.
Financial dealers make a lot of money by selling and arranging sophisticated devices that can deliver very nice returns for end-users as long as markets don´t turn awry. CDOs are of course the most recent shining example of this, but one can find many other cases, including plain-vanilla interest rate swaps where clients would face huge losses if Libor were to move drastically. Now, for these dealers it is absolutely essential that the probability of the nasty scenario remains somewhat downplayed. After all, not many customers (not even the most recklessly cowboysh) would enter into a transaction where they face large odds of suffering a bloodbath. So, while (honest) bankers would tend to warn as to the potential risks, it certainly helps if no one loudly proclaims that the chances of those risks materializing are far larger than negligible. By doing just that from his highly-visible Black Swan parapet, Taleb could be damaging many a salesman´s prospects.
The same logic would apply to hedge funds. Many of these high-profile players enjoy nothing more than taking positions that bet on the negative black swan (the crash, the meltdown, the defaults) not taking place. For instance, many punters seem to have traditionally been avid option sellers, a great way to generate very tasty returns (in real-income form, to boot) for what could be many years, but of course also a window to a potential devastating blow-up down the road. Here it is again crucial to downplay the possibility of disaster, as not many investors would wire money to an outlet that is perceived to face a non-insignificant chance of going down the toilet. The black swan must be presented and marketed as irrefutably unlikely, perhaps by relentlessly asserting that markets behave normally (fund managers could present tons of academic “scientific backing” in this regard). These days, however, such presentations become less irrefutable, courtesy of Taleb´s incesant contrarian rooftop chatting.
Equally likely to lose credibility becomes financiers´ traditional “unpredictable freaky rarity” excuse when faced with outlandish setbacks due to abnormal market movements.
So, it turns out that Taleb has achieved not just worldwide notoriety and fortune by transforming himself into a crack intellectual, but may actually influence the way market participants interact with each other. This could be a good thing. By acting as “probabilistic cop” Taleb could force pros to be more honest with others, and, crucially, with themselves. This would apply particularly to customers and investors. The subprime mortgage crisis has allowed us to once more witness disgruntled members of those two factions claim their ignorance as to the actual risks of the stuff they took exposures to, in an scenario reminiscent of the mid-1990s corporate derivatives debacles or the early-2000s dot.com massacres. This could change after Taleb. When a book that unremittlingly states that nasty “unexpected” surprises do happen quite often becomes an unmissable bestseller, it becomes much harder not to take a very close look at the rarities lurking in the fat tails of the distribution, and to accept and condone claims of naive ignorance after the fact.