Ido Erev Nassim Taleb

8/14/2019 Ido Erev Nassim Taleb

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UPDATE: this was written before the subprime mess enough evidence on the irresponsibility of the viewthat only on Wall Street do people seem to give proper credencenot too much, not too littleto veryunlikely events.

Note: I was at a Boston workshop organized by Harvards School of Government in Nov 2007. A speaker

before me was the former Treasury Secretary Lawrence Summers (also former Harvard President). Aneconomist by training he announced that: out-of-the-money options are too expensive and need to besold. He made the statement afterthe debacle. Only an economist would have the intellectual arroganceto think that rare events are understood and priceable. Only an economist!

Brief Discussion of Empirical and Logical Mistakes in Tyler Cowens Review ofTheBlack Swan in Slate

Nassim Nicholas TalebSecond Draft, June 2007 I have been adding data & graphs (JPY, ES) etc.

Also note a mathematical appendix Note the appendix: www.fooledbyrandomness.com/options.pdf

Unlike the other, more technical critics, I do not think much of Cowens intellect, abilities, & understanding of probability& random payoffs, but that irresponsible fool was the first to advertise the contribution of prediction markets in high

moment applications, heavy-tailed environment. Prediction markets fail in fat-tailed domains because of a hugeestimation error. Also note abloggerwho got my point about predicting in Extremistan.

I -The Grass, not the Trees

First, the empirical & logical1 mistakes:

Oddly, Taleb's argument is weakest in the area heknows best, namely finance. Only on Wall Street dopeople seem to give proper credencenot too much,not too littleto very unlikely events (...) Stock andbond markets offer simple ways to bet on blackswans. (...)These investments pay off preciselywhen the rest of the market does not anticipate thescope for surprise. Yet "long-shot" strategies arewell-studied, and they do not yield extra profit.

A brief summary of what I will discuss next:

1) Selling long shots have yielded (monstrous)extra losses since those selling them (credit,options) go bust periodically. Saying "long-shot"strategies (...)do not yield extra profitrequires removing too many outliers from thedata and confining the studies to a narrow subsetof instruments. In my analysis in TBS I took a

1 This is extracted from my paper on prediction markets & whyderivatives cannot predict anything in the tails.

long history of all the businesses that dependedon a large move: derivatives, credit instruments,bank loans, reinsurance. Betting against largedeviations in type-2 randomness does not pay.

2) The market may be collectively able to guesstype-1 variables, like the number of beans in a jar,not price instruments that depend on a singleunpredictable large event.

The results Cowen refers to may hold solely in a verynarrow subset of index options (not stock options), whichrequiresexcluding the crash of 1987, and ignoring theimpact of the errors. Recall from TBS that I became

financially independent after the crash in 1987 optionswere cheapest before the event, and I stocked up on longshots not because of any forecast of a possible event, butbecause they were incredibly cheap. As figures 1 and 2show, the crash of 1987 represents between 95% and99.9% of the total variations in an option portfolio over thepast 20 years. Removing it from any analysis is dishonest.

Cowens discussion reveals a far more fundamental flawbut I can use it to rephrase my main arguments. I wrote anentire book on confirmation ( absence of evidence v/s


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Copyright 2007 by N. N. Taleb. 2

evidence of absence ) and the reviewer of the book fellfor the error of confirmation in his counterargument. Iexplained that statisticians and economists have tendencyto find quiet periods to confirm that the data is wellbehaved like someone having breakfast with O.J. Simpsonand using this as evidence that he is not a killer becausehe did not kill anyone during the episode. Killers do not kill

all the time, and wild randomness is very rarely volatile.

Figure 1 You miss 1987, and ... (To use the analogyfrom the great Benoit Mandebrot: they can see thegrass, not the trees).

Figure 2 It can get worse for far out-of the moneyoptions.

Let us go through the following exercise. Assume that youare some finance academic who wants to show that longshot strategies do not yield extra profit. You would

have to remove a lot of large deviations and do a lot ofconfirmation2:

2 I used more mathematical arguments in my Poisson busterseewww.fooledbyrandomness.com/blackswandebates.htmand mycomplexity paper. For the collective to converge in reasonable timerequires mild randomness the rate of convergence of an unbiasedestimator (how to get the average when n increases) with anexponent $240 billion.) Also, lendersblew up again in the S&L crisis, losing >100% ofcumulative profits the RTC needed funding ofbetween $500 Bil and a trillion. So banks haveonly been OK for a brief period (since 1992) and... I cant wait for the next episode. It shouldnot take long to cancel all previous profits.

To prove the Cowen point, do not includethe stock market crash of 1987 (for downsideputs on SP), do not use far out of the moneyoptions4, and do not use calls on single stocks.Further, US indices represent


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spreads and emerging market instruments havenot predicted anything.

Do not include G7 currencies for any period up to1998.

Figure 4-USD-JPY -The mildest of currencies. Forentertainment, look for fatter tails with the BRL.

DEM-ITL, or...the Russian ruble.

Do not include reinsurance products anytime in history. Reinsurers has been losingmoney even withouta large event.

Worse, assume that the system allowsoption traders to take long shots. A traderwho does not make steady money is rapidly fired.The trading strategies depend on a short windowwhich favors selling options.

Forget that markets never correctly predicted asingle war and have overreacted to rumors ofwars when peace prevailed.

Now the point of TBS is that even if we never saw a crash,absence of evidence is not evidence of absence if aninstrument leaves you exposed to downside all you needis a simple possibility of a large deviation.

I can understand that (some) economists may want toshow the virtues of prediction markets. But to showthat markets can predict collectively, you need to cheat a

lot not just with data, but by changing the mathematics.My point is that rare events are, by their nature,unpriceable, because the smaller the probability, the largerthe impact, and the greater the estimation error of therectangle probability times consequence. We may becollectively smart, but not smart enough to predict rareevents or get their properties right.

Furthermore, out of the money options do not reflectprediction, but inventory. And the bias comes from thefrequency of the bonus period: traders and hedge fundsget a yearly bonus when the properties take a long time toreveal themselves so their pricing is severely impacted bysuch structural constraint.

I discussed the point with James Surowiecki an insightfuland open-minded reviewer: type 2 randomness has toohigh a sampling error; derivatives have another subtlety:they depend on squares or cubes of the random variables,therefore will have at least four to nine times the samplingerror you can expect (in the rosiest of circumstances).

IINow the more minor factual mistakes. There are two kingof readers: those who read a idea fresh, and others whotry to fit it into what they already know squeeze it intotheir pre-packaged categories. This may work withsomething written by some economist or academic prisonerof a well-defined discipline. Invariably, with me, they missthe point.

Cowen writes:Taleb does insist on the originality ofhis workregarding it as a black swan, of course

I wonder whether Cowen read my book with any care. The

Taleb en questiondoes not insist on the originality of hiswork since he explains that he had to spend 20 years inlibraries and microfiches de la Bibliotheque Nationaleferreting out such a long list of predecessors: Menodotus,Sextus Empiricus, Antiochus of Laodicea, Pyrrho of Ellis,Theodas, Herodotus of Tarsus, Sextus Empiricus andSaturninus, Algazel, Pascal, Huet, Foucher, Bayle,Brochard, Favier, etc. (in philosophy, not counting thebetter known Hume, Popper, Mill, Goodman and somemodern academic philistines), Pareto, Yule, Richardson,Levy, Zipf, Tsallis, Simon, the great Mandelbrot, etc. (instatistics, among some 25 names), Makridakis (ineconometrics), Sornette, Bouchaud, (statistical physics),Hadamard, Poincar, DArcy Thompson, Polya (in

mathematics among many), Slovic, Kahneman, Tversky,Gigerenzer, Fishhoff, Erev, Barron, Tetlock, etc. (inpsychology, among 76 names), Shackle, Hayek, etc. (in theso-called economic sciences but no other name), etc.

I just described how the idea came to me hiding inbasements then how I became committed to it after thestock market crash. It does not mean claiming originality.As a matter of fact I show in the process how the ideas weattribute to Popper & Hume are not theirs.


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[Taleb] refers to opposing views as the "GIF: GreatIntellectual Fraud."

What your Taleb fellow calls GIF is the use a probabilitydistribution outside of its natural domain, i.e. the Gaussianoutside Mediocristan.

why you should become a speculator rather than aprostitute

He gets it backwards. I explain that it is better to NOT be aspeculator because there is a lot of randomness in scalableprofessions. I recommend becoming a dentist becausepayoff is more directly linked to skill.

Same error of mistaking my purpose:

Incremental progress is a hard enoughachievement, and it is to be applauded with vigor.

Tell me something I dont know. I want this to happen.But we cant change the world. The Soviet have tried; theFrench have tried a libertarian should know what

previous attempts resulted in.

More:

Why venture capitalists make more than inventors(inventors pursue black swans, but they often dietoo soon to see the biggest payoffs)

Maybe right, but not my point. In The Black SwanI wrotethat writers, researchers, inventors and artists living in theantechamber of hope are less diversified than investors(publishers, venture capitalists, etc.) hence weaker at thebargaining table. (I studied it with De Vany but we neverpublished it.)

The Black Swan also encounters some problems

when it attempts to map out a metaphysicalphilosophy. (...) Virtually by definition, the bulk ofwhat goes on is ordinary events determined byordinary processesmixed in, of course, with someextraordinary influences.

That is not the point of TBS it frowns on the metaphysicsthe review claims that I am mapping. TBS is about theunpredictable that we can do something about. It is abouthow not to be a sucker. And it is about the class of randomvariables that is dominated by the tails i.e., Black-Swanprone.

In 1921, economist Frank Knight drew a distinctionbetween unquantifiable and radical uncertainty andthe risk of flipping a coin or playing a roulettewheel.

Knight, I explain in Chapter 16 and in the notes, is NOT theoriginator of the difference. And I reject the difference:probability for me is (as I wrote 4 times) epistemic. Suchobjectively computable RISK does not exist in a subjectivemetaprobability framework.

If these ideas have not always been part of themainstream, it is because they can quickly proveintractable, not because they have been suppressedby an arrogant scientific community.

Yes, they have been suppressed by anarrogantscientific community albeit only by economists --

because most academic economists like to tell you whatthey know, not what they dont know. Like quack doctors,they do not accept that NO remedy can be better than thebest available one and that NO measure of uncertaintycan be better than a wrong one if it prevents you fromtaking a certain class of unbounded risks.

This explains why I am an academic libertarian.

The late G.L.S. Shackle, a Scottish economist

Sorry to nitpick (though my erudite father taught me thatsmall mistakes reveal shallowness in someones culture),but the Shackle I talk about was born in Cambridge,England, in 1903 and worked in England all his life(London, Liverpool).

the area he knows best, namely finance. This is nota big deal but I am irritated when people equate me withfinance, trading etc. It was (is) only a day job. Finance issomething for philistines. I just know finance data andfinancial payoffs (like most derivative professionals) but itis not my principal interest, as I state in the book. The areaI know best is French literature, ancient & medievalMediterranean history & languages, probability theory,medieval Judeo-Arabic philosophy, &... the theconfirmation bias& its consequences.


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III

To conclude, Cowen is a prominent economist (whichdoes not mean much), so his review provided me with theopportunity to deliver a broader response and rephrase thepoints of the book that (unlike almost all other reviewers),he missed.

Let me explain what my idea is about (I repeat that thereview completely missed the central point): it is not aboutwholesale skepticism or angst. It is not aboutmetaphysics. It is about fine-tuning your behavior to beless skeptical in some domains and more in others. It is avery simple map based on the boundaries betweenMediocristan & Extremistan and how to navigate in aworld that we do not understand. And to enjoy everyminute of it.

Note the appendix:

www.fooledbyrandomness.com/options.pdf

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Ido Erev Nassim Taleb