Will it all go wrong when you interview an expert on random catastrophes? My meeting with Nassim Nicholas Taleb, the options trader-turned-author of the bestseller Fooled By Randomness, starts without a hitch, but that’s no cause for complacency.

“You don’t know what’s going to hit you and where it’s coming from,” Dr Taleb says. “You may not be able to do much about the unknown unknowns, but at least you can be cautious and be aware.”

Business leaders should take notice, he says. His grand idea, in his new book, The Black Swan, is the damage done by very rare events. Their effect may be huge, but people habitually discount them, he writes, because the chance of any particular catastrophe is low and we are psychologically programmed to ignore it. When the blow comes, it is completely unexpected. In financial jargon, systemic risk is underpriced.

The Lebanese-born forty-something (he will not give his age) has practised what he preaches and it has made him rich. As a quantitative trader for New York banks and his own firm, Dr Taleb has constantly bet on disaster. Unlike other traders, he lost a little most days, but very occasionally — most notably, in the 1987 stock market crash — he would hit the jackpot while colleagues’ lifetime earnings turned to ash.

His experiences led to his 2001 book, Fooled By Randomness, a bombastic critique of all that the investment world holds dear. Human instinct tends to mean we ascribe meaning to mere noise, he argued. Most of what seems like talent among chief executives or fund managers is pure luck; randomness will always favour a few.

Worse, traders can appear to be doing far better than is justified, until they lose it all when one huge bet goes against them.

The risks people forget are of things that have not happened before and of share price movements considered impossible or absurd. Dr Taleb dubs these “black swans”, noting that until discovery of Australia’s Cygnus atratus, it was believed a proven fact that all swans were white. This is his new book’s theme.

“Our representation of the world is fundamentally flawed and self-serving, and is not that compatible with a modern environment,” he says. “People overestimate volatility and underestimate very large deviations. The odds of a 5 per cent move in the stock market are grossly overestimated. The odds of a 20 per cent move are vastly underestimated. It’s simple.”

Observers failed to predict both world wars, he says. Niall Ferguson, the historian, has demonstrated that the prices of imperial bonds in the run-up to 1914 show that war was unanticipated, despite the history books saying otherwise. In our era, the utter shock of September 11 is the “black swan” striking.

Dr Taleb dislikes being asked where the next unforeseen catastrophe will arise. Instead, he says his message is: “How not to be a sucker.” Seekers of stock tips are missing the point. But does he have any advice for investors? “Sell volatility and buy tails,” he says, although admitting that this trading tactic has proved painful over the years.

After many mergers, banks, Dr Taleb argues, are now “sitting on a pile of dynamite”. He says: “Banks are a lot more centralised than they were. You could buy credit derivatives 20 years ago, had they existed, without having some kind of ultimate risk on JPMorgan. Today buying a credit derivative is exactly like buying life insurance on the Titanicfrom the captain.”

Hedge funds are an ally against the unknown, Dr Taleb argues. Small, diverse and uncontrolled, they are far less likely to fall victim to the group mentality of the big players.

Dr Taleb also has warm words for the Bank of England, which last month said that credit transfer markets’ strength was breeding a dangerous complacency. “These guys,” he says, “know what they’re doing.”

Nassim Nicholas Taleb

— Born in Amioun, Lebanon
— Worked as a trader for Union Bank of Switzerland, Credit Suisse First Boston, Banque Indosuez, CIBC Wood Gundy, Bankers Trust and BNP Paribas
— Founder of Empirica, a hedging operation
— Dean’s Professor in the Sciences of Uncertainty, University of Massachusetts
— Books: Dynamic Hedging (1997), Fooled By Randomness (2001), The Black Swan (2007)
— Is setting up the Ecological and High Impact Uncertainty Project, a research institute in London looking at people’s responses to uncertainty

Source: fooledbyrandomness.com

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