Must read paper on risk, nerds and the unexpected tails. Great insights by BOE’s Andrew Haldane.
For almost a century, the world of economics and finance has been dominated by randomness. Much of modern economic theory describes behaviour by a random walk, whether financial behaviour such as asset prices (Cochrane (2001)) or economic behaviour such as consumption (Hall (1978)). Much of modern econometric theory is likewise underpinned by the assumption of randomness in variables and estimated error terms (Hayashi (2000)). But as Nassim Taleb reminded us, it is possible to be Fooled by Randomness (Taleb (2001)). For Taleb, the origin of this mistake was the ubiquity in economics and finance of a particular way of describing the distribution of possible real world outcomes. For non-nerds, this distribution is often called the bell-curve. For nerds, it is the normal distribution. For nerds who like to show-off, the distribution is Gaussian. The normal distribution provides a beguilingly simple description of the world. Outcomes lie symmetrically around the mean, with a probability that steadily decays. It is well-known that repeated games of chance deliver random outcomes in line with this distribution: tosses of a fair coin, sampling of coloured balls from a jam-jar, bets on a lottery number, games of paper/scissors/stone. Or have you been fooled by randomness? Continue reading
Must see video from the Black Swan Master.
While at the Black Swan subject, Taleb on his next Black Swan scenario. From CNBC.
A black swan is an event outside the realm of regular expectations. no mother person personifies the concept like telev. he has not appeared on cnbcsince 2010 to break his silence about what he fears will be ablack swan event. thanks for inviting me after all these months.we made it sound like you’ve crawled into a hole. clearly you’ve been writing, speaking. mostly finishing my new work. but, you know, i came out of this — i watched the election and something wrong is going on. only one candidate ron paul seems to have grasped the issues and is offering the right remedies for the central problems we facing. so i came out just to support – i’m not involved in politics. i’m a risk based person. but from my risk base vantage point i think one candidate represents the right policies when it comes to the big four, and that candidate is ron paul.
Full video here.
Guest Post by John Aziz of Azizonomics.
I have mentioned, in passing, the possibility of transforming debt into equity as a solution for many of the troubles in the global financial system.
I borrowed the idea from Nassim Taleb and Mark Spitznagel, who floated it in 2009. It is unfortunate that the idea has not yet been taken very seriously. There are probably two reasons for this: firstly Taleb and Spitznagel never fully fleshed it out, and secondly because the political and media punditry don’t really recognise the graveness of the present situation. Largely it is hoped that we can muddle through; radical solutions tend to get left on the shelf.
It is my view that it is much better to fix the system in a fundamental way, rather than clobber together solutions piecemeal. The latter approach has been the norm — from the bailouts of Greece and euro austerity, to the bailout of AIG and the wider financial system, to quantitative easing and LTRO, to Obama’s stimulus package — the focus has been on keeping a system that is falling apart at the seams from crumbling completely into dust.
So what is the problem that governments fear so hugely?
As the market has been rising over the past weeks, it is easy to get “fooled” into the long trade, and justifying the position by “everybody is long”. Whatever the positions you are running, spend a few minutes reviewing a couple of thoughts on risk. By Taleb;
Nature is the master statistician and probabilist. It follows a certain logic based on layers of redundancies, as a central risk-management approach. Nature builds with extra spare parts (two kidneys), and extra capacity in many, many things (say lungs, neural system, arterial apparatus, etc.), while design by humans tend to be spare, overoptimized, and have the opposite attribute of redundancy, that is, leverage—we have a historical track record of engaging in debt, which is the reverse of redundancy (fifty thousand in extra cash in the bank or, better, under the mattress, is redundancy; owing the bank an equivalent amount is debt).
Now, remarkably, the mechanism called hormesis is a form of redundancy and statistically sophisticated in ways human science (so far) has failed us.
Full article here.
Every now and then it makes sense going back to basics. Look at charts in the most simple way, and you might actually see the big picture without the noise. Vix has collapsed, while the markets have been grinding higher, led primarily by HFT no volume “stress the shorts” action. Are we reaching the inflection point, where the opposite is about to happen?
“Buy options when you can, not when you need them” (Taleb)
Simple charts below.
While majority of Investors lost huge sums in August, and some lost it all, there are the “free thinkers” out there producing extraordinary returns for their clients. Bloomberg reports on Taleb and his crew:
Mark Spitznagel pushes the throttles on his new twin-engine Chris-Craft Corsair 28, slicing through Grand Traverse Bay in northernMichigan on a warm day in late July. As the speedboat reaches more than 50 miles per hour, Spitznagel’s blond hair flying in the wind, he churns up a big wake.
Turbulence is where Spitznagel, the founder of hedge fund Universa Investments LP, thrives. On Aug. 4, while Spitznagel is still at his lake house, the Standard & Poor’s 500 Index begins to plunge as weak economic data prompt predictions of a double- dip recession. By noon, Spitznagel, a so-called black swan investor, has spoken with his Santa Monica, California-based firm 15 times by phone to capitalize on its positions to make money while other investors lose it, Bloomberg Markets magazine reports in its November issue.
At Universa’s office, between conversations with Spitznagel, two traders frantically buy and sell derivatives, including options on theS&P 500. The index’s 4.8 percent dive on that day is producing a windfall for Universa, says Brandon Yarckin, a Universa associate who handles investor relations. He points to a Japanese print on the wall — one of Spitznagel’s favorites — depicting a giant wave about to crash onto a group of hapless fishermen.
“Days like today are what we are here for,” he says.
Full article here.