So that's it - now I understand. Investing is simple, just ignore all the mathematical trends and advice, just follow this man.
Nassim Nichloas Taleb
His last book 'The Black Swan: The Impact of the Highly Improbable' argues that almost all bankers are 'subhuman and very, very dangerous'. Powerful words that might confirm a few suspicions we all have - I mean, how come banks always feed in a frenzy in a boom and the bust hits them like a brick wall? What happened to management foresight, prudence, survival instinct or just plain common sense? Taleb gives us the answer - they live in a fantasy world in which sophisticated mathematical models and risk management systems can control the future. Well Gordon Brown might want to read this - after all he was the one that believed the UK economy could be controlled by fine tuning interest rates; suddenly there is a complete disconnect between the base interest rate and borrowing. While economists poo-poo'd Taleb's assertions that one random event can can disprove an entire theory, the world was hit by the credit crunch and the aftermath of the sub-prime revelations.
The article can be read in full but Taleb's interesting slant basically puts mathematics into an interesting position and he illustrates it saying if you toss a coin 40 times and each time it turns up heads, then statistical theory will say the chance of it turning up heads on the 41st toss is 50-50. Not so, argues Taleb (and this in some way augments some of the answers I gave in my statistics exams - at least the randomness aspect anyway), the chances of 41 straight heads are minimal, below 1%, unless cheating is involved. You see his logic? I think what Taleb is saying that there is a difference between theory and real world. So I shan't be buying any more lottery tickets for a while as I won £10 last time and the chances of that happening twice in two weeks are minimal by my standards.
His greatest vindication was seeing the joint winners of the 1997 Nobel Prize in Economics who had set up a hedge fund in 1994 go spectacularly bust 1998 with positions worth $1.25 trillion outstanding. So Taleb is saying is that we have created a world which we actually do not understand, where winners tend to take all, the rest nothing. Things like banking systems are over complicated and have no redundancy. Are you getting the picture? No? What it means is that the banking system doesn't have slack and in a normal situation banks would go bust regularly. 'But in the complex system of today there is a tendency to cluster around powerful units - so all banks become the same bank so they can all go bust together.' Tell that to Northern Rock and Bear Sterns, but I see where he's going.
He goes on to point out that banks really make money from two sources - interest on current accounts and charging for services. The risks they take on loans, mortgages, derivatives and other things, he argues, they have never, ever made a penny on as they rake in huge profits and then lose all of it in crashes. In the last few months, Merrills made $2bn loss in Q1 vs $2.1bn profit a year before and wrote off $24bn (and still paid the outgoing CEO millions) and shed 4,000 jobs, Credit Suisse made $2.1bn loss in Q1 vs $2.7bn profit a year earlier and wrote off $5.3bn, UBS wrote off a staggering $37bn, Citigroup made $5.1bn loss in Q1, $9.8bn loss the quarter before with $12bn write downs and over 13,000 job cuts, RBS wrote off £5.9bn, made a £12bn issue and will sell various arms also. The scale of loss is staggering - yet still the whizz kids got paid their massive bonuses.
Pascal Lamy, Director-General of the WTO, says it is all to do with deregulation. The WTO boss also said that workers hurt by globalisation should receive more help from their governments. Mr Lamy's remarks put him at odds with the so-called "Washington consensus" that liberalisation, privatisation, and open markets are the only way to bring about economic growth.
It makes you think
In these times of financial turmoil, restricted credit, potential recession, menacing inflation, potential downturn in corporate profitability, uneconomic large-scale wars, mixed with a sudden crisis of availability of food, shockingly high oil price, rapidly expanding budget deficits, mounting debt and potential job losses - do we really think this was all started by one of Taleb's Black Swans? Or did we plan our way into this mess? Does galloping greed in the financial system skew judgement or was it really the result of a complicated system not having a variable to cope with a spanner in the works like sub-prime?
But didn't we invent sub-prime and allow it to spread as the clamour to hand out more credit and sell off the debt secured against almost worthless assets fuelled by commission at the front end and massive bonuses at the back end? Did those who bought the debt not think about actually doing the necessary due diligence on the true worth of the assets? Or has the system got so incredibly complex that to stop and check would have been impossible?
I would love to hear people's views on this and perhaps some suggestions on how we can plan to avoid it again. Or indeed should we just sit back and allow the financial gurus to regroup, lick their wounds, and find another way to earn those fabulous bonuses as they risk our money?
Taleb asserts that we should learn by trial and error and the best innovation comes from it like computers, the internet and lasers because trial and error reveals hidden black swans. If that is the case, have we not learnt a massive lesson about our fragile financial system? By the way, his investment tip is to put 90% of your money into government securities and about 10% into a large number of very high risk ventures.
And here is a final thought-provoking point from Taleb. In the Information Age, not only does he argue that the best information comes from real-life social interaction at parties or restaurants but also be mistrustful of knowledge - it's a bad thing. Afterall, if you give a bookie 10 pieces of information he will pick his horses - give him 50 pieces of information and he will do no better but fatally he will be more confident.
Heck, this about argues in the face of everything I have ever been taught. What do you think?
Tuesday, 3 June 2008
Investing, The world of Finance and Black Swans
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In my own experience the individuals that accept the risks are both not qualified to understand the risk or the risk does not effect them personally, where accepting it does (big bonus).
I work in IT risk but financial risk would be the same.
The risk will be calculated using complex algorithms developed by specialists, these are presented to the business that then are suppose to evaluate them and use these to make decisions. As the business do not have the knowledge to understand the algorithms that are used to calculate the risk they have no comprehension of what the different levels of risk mean. Also if they have to conflicting point of views from different reports, again they do not have the knowledge to determine which one to action, so choose which ever one is favourable to their point of view (big bonus).
Another issue is that the 90 page report that I developed, is turned in to a 4 page power point for upper management and then turned in to a 1 dashboard for senior management. A one page dashboard, is what the business strategy is based on *shakes head*
Thing is, as long as they act in line with the rest of the industry, the thinking is "we are accepting no more risk than our competitors", therefore senior management can not be ripped to shreds by the board as they are only acting in accordance to current thinking....... regardless of any mathematical model that might prove otherwise.
In the UK the blame has to fall with the FSA for not enforcing good risk policies or Basel II and protecting the banks from themselves.
I would like to comment on Taleb's example of the coin being tossed 40 times and landing heads and the chance that the next toss landing heads is 50/50.
At the point you have tossed 40 heads, the previous 40 times do not count (previous performance is not a guarantor of future investments) and the chances of the next toss coming up heads is still 50/50. Taleb's example is not predicting the next toss of the coin but trying to predict all 41 tosses of the coin upfront, which he correctly calculates to be less than 1%. The true thinking of a banker is not that the next toss is 50/50 but the fact that He/She has been correct 40 times already and that they will be able to call the next toss correctly with a considerably greater chance than 50/50, in their own mind the probability of the coin coming up heads is more likely 99%.
Thanks
Chris
“As the others have said there are no new ideas or unexpected situations here. The Black Swan, the Butterfly effect .... A market is a complex non-linear system and everything you learn about in Chaos101 applies. Sensitive dependence on initial conditions being a biggie. THe sub-prime situation is just another bubble. We've seen 'em before and we'll see 'em again. I lived thru the dotcom bubble. Fortunately I'm not so old I can personally recall the Dutch Tulip Bubble but...well it's all about timing. Like any bubble on the whole people will lose out when it bursts. But some will have made a lot and gotten out in time and some will make good money in the fallout. Wise heads will have been warning for ages and fools will have kept investing. THat's how these things work. I've never understood why anyone would think banks are different from Tulip Entrepreneurs or e-commerce gurus in believing they can predict the unpredictable. You will notice that ALL explanations of the sub-prime fiasco are post event rationalisations. Easy peasy that is. But prediction...can't be done on the whole.”
I reread my answer and I am not making the point I want to I suspect.
I'm saying that Taleb is right about Black Swans. One for example unpredictably large or rare event can completely screw the predictions of careful mathematicians and economists who live in Talebs Mediocristan.
I'm also saying that I think that the level of complexity in something like the financial markets is such that the Butterfly effect also has a huge impact. So the models may be successful in the short run because of a period of order in a random world. But overall only a (lucky not clever) few succeed and many many lose.
My last thought on the subject. It was the coin toss that reminded me.
My friend John Schonegevel, a smart man, said to me once in a boozy conversation that running a big business is not unlike riding a bronco in the Rodeo. You WILL be thrown. The trick is to stay on longer than the others.
My last thought on the subject. It was the coin toss that reminded me.
My friend John Schonegevel, a smart man, said to me once in a boozy conversation that running a big business is not unlike riding a bronco in the Rodeo. You WILL be thrown. The trick is to stay on longer than the others.
This was so not a "Black Swan" event. This was a visible and even talked about series of events --the housing crisis here in California by various think tanks at various universities (UCLA for one) who predicted for the last 2 years that the money was too easy and the crunch was coming.
While the actual value or correction is painful right now-- and long overdue, since traditionally real estate values double every 10 years or so, the speculation and dependency on that continual rise in value was really turning a blind eye to the other factors in the global and national economy that are markers that this situation could not continue.
The oil crisis -- and speculators who are involved in driving up the prices of oil and other products like rice (!!)-- was to be expected and quite frankly, I am both surprised and not surprised that the Bush Administration has not been more pro-active about working on this globally with other countries to create a more balanced economy. Other presidents were more involved in reaching out on economic conferences globally.
While the US is leading in exports, our dollar is not doing well and the signs have been there all along-- it's not just the sub-prime debacle but a great many things tied into this situation in the global financial world that are causing this situation to steam roll .
Ah! I see Chaos theory came into the discussion. I seem to recall John Reid, while at Citibank, engaging the boffins at the Santa Fe Institute to look for patterns of predictability in the third-world loans debacle. I might have said "John, save yourself the fees; if you make bad loans, you likely will lose your shirt (well, actually your shareholders shirts, you''ll still get a fat bonus". Seems oddly familiar.
Taleb is getting a lot of prominence and I have just read both his books which are really excellent..... But let's not go crazy about "Black Swans" which seem to have been discovered in the financial markets only yesterday..... Taleb's (correct) notion is that the world is subject to a higher degree of randomness than most of us think or that (perhaps) our brains allow us to think. So he asks us to get better at understanding the probability of an event. Now the so-called Black Swan or unexpected event is based on the (also correct) ideas of David Hume through to Karl Popper (writing in the 1930 and 40s) about logical positivism and scientific method. So not Taleb's invention and certainly not a new idea - i.e. that you can never prove something is true, you can only prove it is false. Another idea used by Taleb is that of Solon in Ancient Greece, i.e. "it ain't over till the fat lady sings" which is how Yogi Berra explained the same thing....... Overall, the point is that complex systems are inherently unpredictable, so those who think they are and base their decisions on assumed predictability are in for a shock...... But this has indeed always been the case - just that financial managers aren't well -educated enough to know it.”
I think that we tend to misunderstand the mind of the financial people involved here. They are not STUPID but they are human.
It's here where Taleb's arguments come to the fore - and yes I appreciate they are not new, no does he claim them to be.
IMHO what happens is even intelligent well educated people see patterns and trends where they do not exist and mistake islands of stability for long term stability.
And then you have those who see what's happening but believe they can get out before it all goes pear shaped. And the point is some do.
Our miscomprehension of probability is also a big part of that.
In some ways it's like people who do the lottery. People see the numbers - in the case of the British National Lottery it's something like 14m to 1. And they logically 'get' the fact they are not going to win but...Yet they've no idea how fantasitcally unlikely that makes a win. So they live in hope.
The Black Swan, Sensitive Dependence, basic probability, human nature all militate against the possibility of totally rational decision making. But the system rolls on because it's actually large enough for the *whole* to survive the cock ups of the few.
The words of Cicero echoed by Santayana & re-echoed by Toynbee have always rung true: They who fail to learn the lessons of history are doomed to repeat them. Moreso, those who learn the wrong lessons of history can even commit worse mistakes.
"The fault lies not in our stars ..." or black swans "... but in ourselves if we are underlings ..." of others paradigms & not the truth, with all due apologies & no disrespect intended to the Great Bard.
from Joffre
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