Fine, it's the holidays, I'll post it the article. http://www.traderdaily.com/magazine/article/2165.html Postmodern Man Academic heavyweight Nassim Taleb is doing some serious thinking about randomness and risk. The Pentagon has picked his brain. Now, so do we. By: A.D. Barber Issue: February/March 2006 -------------------------------------------------------------------------------- In the eight years since his first book, Dynamic Hedging: Managing Vanilla and Exotic Options, crowned him a celebrity in the derivatives world, Nassim Taleb has been expanding the focus of his work beyond the confines of finance while delivering his ideas to ever-larger audiences. The 45-year-old has been cited in testimony before Congress, participated in Pentagon think tanks and lectured at the respected Courant Institute of Mathematics. He has seen his most recent book, Fooled by Randomness, become a bestseller, with editions in 17 languages. Taleb is the first to boast that everything he learned about risk, he learned on the trading desk. Born in Lebanon but forced to flee amid the onset of civil war in 1975, he flourished as a student, ultimately obtaining his MBA from the University of Pennsylvania's Wharton School and his Ph.D. in applied mathematics from the University of Paris. Throughout the '80s and '90s, he held senior positions at a slew of Wall Street's biggest derivatives desks, including UBS, Bankers Trust and CSFB. In the early '90s, he walked away from the Street to trade as a local for 18 months on the CME. He's currently the head of Empirica LLC, the investment company he established in 1999. For the most part, he has forsaken the day-to-day grind of trading to focus on research via an endowed professorship at the University of Massachusetts. He's also working on his next book, about randomness in society at large. It's called The Black Swan, named for a worldview he developed around the idea that most people tend to ignore, or live in denial of, the reality that large, random and unexpected events -- black swans -- can and likely will happen eventually. (Exhibit A: Hurricane Katrina.) True to his affinity for randomness, the entertaining conversationalist jumped from tangent to tangent during an extended chat with Trader Monthly. Would you describe yourself more as a writer or an academic? I refer to myself as an epistemologist of randomness. Do you miss trading? I've been a trader for 20 years, and I still hate trading as much as I did the first day. I have some form of addiction [laughs]. It's love-hate. Although you now have people who trade for you, can you share with us a little of your methodology? I specialize in way-out-of-the-money [fat] tails, but I don't like to buy volatility. A lot of people think I just buy volatility, but that's not true, and I laugh when I hear that said about me. I like to sell volatility and buy tails, which is the opposite of what a lot of people think I do. Please elaborate. Some of the products we used to offer customers (at Empirica) were strategies that were viewed as protection strategies -- buying puts, buying strangles or buying butterflies, for example -- but one thing about fat tails is that the farther you're out on them, the less you have to be right from a probability standpoint. I specialize in options that are between 10 and 20 sigma out of the money. Let me explain better: Let's say I consistently buy a one-month option that is 20 so-called sigma out of the money. How long can I bleed the cost of purchasing those options and still be made whole when a sigma-20 event finally occurs? Years, we suppose. You want to know how many years? (Laughs loudly) More than 5,000 years! You've been portrayed as a critic of Modern Portfolio Theory. It's a scam, all of it -- Markowitz, Sharpe, it's just like astrology. Take pension funds, for example. They want to show that they perform proper due diligence, so they say, "We use MPT developed by Nobel Prize winners" and hire consultants who generate fees by supplying them with variations on these models. That way, when they have a problem, they can always say, "Hey, look -- I'm using the industry's standard method of investing." They've made a science out of nothing. Everyone knows it's a joke. The practitioners know it's a joke, but it's a self-feeding mechanism, and nobody wants to abandon it now. This brings us to another big problem we have in finance -- fund managers whose objective function is not necessarily to deliver value. Let's say you make a dollar every day and lose a hundred once every hundred years. People are not going to wait 20 years to evaluate your strategy; they're going to review it every single year and then promote you or demote you based on that year's performance. So all you have to do is manufacture pseudo alpha and deliver it, and you can show consistent returns and a Sharpe ratio that's very high over a small time frame. Then you're going to be well-compensated. It's perception arbitrage: showing someone statistics that are meaningless. That sounds to us like something you wrote in your book Dynamic Hedging concerning how a lot of traders get compensated. You called it "accounting arbitrage," yes? Selling an option that's worth a dollar 100 times is not as attractive as selling a 50-cent option 500 times, because you care only about how many bonuses you get before it blows up on you. Does this mean you think that the compensation structure for hedge-fund managers is flawed? People think I'm cynical about hedge funds when, in fact, I'm extremely positive. I think they're a great mechanism. A hedge fund can be so much smarter than a bank or other financial institution in allocating its resources. The problem is I'm very cynical about these big hedge funds, or funds of funds, which are gaming the system. What was it like working with the Pentagon? People in the military understand very well that you cannot take things at face value, that you have to look at rare events. They understand hindsight bias very well, and they have a sense of mission. They pay attention to the process and not to results, which is exactly the opposite of Wall Street. I was very impressed; the thinkers I encountered in the Pentagon made me feel ashamed to be talking to them, because they are far more sophisticated than I will ever be. Were these military people receptive to your ideas? The people who like my message are those in the military, venture capitalists and pure traders -- people who are devoted to truth and less interested in appearances. Speaking of venture capital, what are your thoughts about hedge funds moving into more non-public investments? I'm glad that hedge funds are smart enough to invest in private-equity deals that have not yet reached that mature point. (Venture capitalists) look like idiots locally, but cumulatively it's a phenomenal business, a virtuous business. A virtuous business? We've never heard venture capital described that way. Any business that can "make big and lose small" -- that is, long the tail -- is a virtuous business. Economic loss always seems to come from "make small, lose big" (strategies) -- i.e., short options. So who is it, exactly, who doesn't get your message? Finance Ph.D.s. I don't really understand why anyone would want to pursue a finance doctorate. If you're interested in finance as such, just become a practitioner. If you have intellectual curiosity, you can study philosophy, biology or history, or something interesting.