A World of Randomness

Skewed Bets: A World of Randomness
by Nassim Nicholas Taleb
The Daily Reckoning
London, England
Wednesday, November 03, 2004

Nassim Nicholas Taleb explains why he doesn't make "market calls," and why he prefers Skewed Bets when it comes to trading activity.

But what could they do? They had only two major candidates to choose from. Either one of them might be a decent choice to run a medium-sized supermarket; neither would you want at the helm of the "great ship of state."

In Europe, the reaction to the U.S. election is of such universal disgust; they are practically hanging black crepe paper from the balconies and lampposts. The Europeans hoped Americans would come to their senses and get rid of George Bush. Instead, voters stood by their man, such as he is.

Here at the Daily Reckoning, we're disappointed, too. We were hoping both candidates would lose.

But Americans are proud of their democracy. It gives them an opportunity to change leadership without bloodshed…by fraud, that is, rather than by force. The candidates stir up the mob of lumpenvoters however they can - dredging up from the bottom of the pot the most sordid and titillating sentiments: One offers short visions of apocalypse…and stands tall as the man who can protect them. The other says he will give voters more pills - at someone else's expense, of course…and a whole range of new bribes…while also cutting the federal deficit in half! No matter that the promises are implausible, impossible, oxymoronic, or merely stunningly counter-productive, the crowd takes to it like a shot of Jack Daniels after escaping from a dry-out center.

By the end of the election season, the voters are as excited as sports fans, desperately hoping their man will come through, and willing to wait in long lines to support the home team.

"Voting was extended by more than three hours in some precincts in Ohio," reports today's Times of London, "as people queued for five hours to vote in what was regarded by both sides as the most important election in a lifetime."

Pity the poor voters! Lined up for hours to cast a ballot that is unlikely to make any difference to anybody. Every vote is supposed to count. Very few actually do. Only residents in "swing" states could push the result one way or another. And any one of them could perfectly well step out of line and go have a drink with no effect on the outcome.

We have lived through Republican administrations and Democratic ones…through conservatives and liberals - and never have we noticed much change. Instead, what always mattered was what was going on in our private lives - not what was happening in Washington.

Besides, once elected politicians often do the exact opposite of what they promised to do anyway. George Bush was elected as a "conservative" with a "humble" foreign policy. What a disappointment when he turned out to be the most radical president since Franklin Roosevelt.

But the voters like him. And why shouldn't they? His neo-con advisors have given us a jolly good war. We are told we are kicking the enemy's butt…and, at the very same time, the enemy is said to be a bigger threat than ever before! Therefore, we must spend more money…and launch new campaigns…and kick his butt even more! Did you ever have such a splendid war, dear reader? The more we win, the less safe we are.

No one dares suggest that by kicking fewer butts, there might be fewer people who wanted to kick ours. That's the sort of reflection that would get a candidate branded as "weak," which is to say, the kind of comment that would take real strength to make.

Ohio was a key state. It is in America's "rust belt," part of the gritty chain of depressing places where people used to make things. Now, many of the things they used to make are made in Asia. And no matter who the poor voter selected, the globalization of the world economy was not about to stop. Nor is America's huge trade deficit going to disappear, nor America's $38 trillion debt…nor its $54 trillion "funding gap," (the present value of the difference between what the federal government is already committed to pay out and what it will receive in tax revenues).

It is already the day after tomorrow. George Bush has been reelected. And none of America's problems have gone away. You will recall, dear reader, that Alan Greenspan's EZ credit policies triggered two major booms - one in U.S. consumer spending, enabled by rising house prices…and the other in Asian (particularly Chinese) capital spending. Both booms are doomed. For they both rest on a lie - that the U.S. consumer has purchasing power beyond what he actually earns. We're waiting for both booms to go bust - as they must.

But the busts will not be the same. China's big bust will be like America's panics of the 19th century…or even its big crash of '29. China's bust will be a setback on its path to economic growth. With a little luck, the Chinese will be able to switch their over-built production facilities to meet rising demand from Asian consumers.

But America's coming bust is likely to be in line with the primary trend…a bust, not on the way up, but on the way down. It is a slump leading towards a lower standard of living, not a higher one. Why a lower standard of living? Because Americans did not save money…they did not build factories…they did not invest in the skills and enterprises that will help them increase real earnings. Instead, they spent more than they could afford on trinkets, geegaws, and luxurious McMansions. Few people in the world can afford to live in the manner to which Americans have become accustomed. Sadly, not even Americans themselves.

What can the President do? He can lie about it. He can distract the public. He may even be able to postpone the day of reckoning and make it worse; but he can't take it off the calendar forever.

The candidates fought until the bitter end, but the question remains: Who'd want the job of U.S. president?

"'Whoever wins, the next four years are going to be unusually challenging from the standpoint of America's economic stewardship,' said Stephen Roach on Monday. 'We can only hope that the victor is up to the task…'"

*** "Oh Daddy, I had such a good time when Momma and Aunt Maria were here. I am so lucky…"

We were walking along the Thames with our daughter, on our way to cross Blackfriar's Bridge. The sun was shining this morning. The leaves on a row of sycamores have turned a golden yellow, lit up by the morning sun. We had never seen a more promising morning.

"Sometimes I worry that I'm just too lucky," Maria continued, "I mean, I'm afraid there must be some bad times that come along to even things out…"

We did not say so, but the same unwelcome thought had lodged in our mind, like a squatter in an abandoned Post Office.

What a marvelous time to be alive. We live well. The cash machines work. There are good restaurants on nearly every street. The liquors stores are open.

"Well, Maria," said Dad, "bad things are sure to happen to you…as they are to everyone. Just recognize that these good times are not of your own making…and enjoy them."

The United States has probably begun a "major top," rolling over after more than 200 years of extraordinary gains. It enjoyed such great advantages: Because the industrial revolution took hold in England and New England…because oil was discovered in Pennsylvania, and later, Texas, and because it was cheap and abundant fuel for America's golden Machine Age…and because America was separated from European wars by a great ocean…and because America's dollar became the world's reserve currency…and because communism retarded the development of rival economies for more than half a century…what a great time it has been!

And it is a great time still…and will be for many years to come, even though, relative to, say, Asia…the Anglo-Saxon economies may be in a decline. The going is still almost unbelievably good. It is almost too wonderful.

It may not always be this way. The world's only super-power may not go gently into that good night. It might rage against the dying of the light that has shone so brightly on it for so long… …[Ed. Note: Bush Presidency, Act II: The Depression…if you thought 2004 was bad, wait until you see how you feel in 2005. Here are the conclusions…

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The Daily Reckoning PRESENTS: When looking at the markets, traders, more often than not, try to find patterns and theories to make a profit without any sort of risk-taking. Nassim Taleb is not one of those people…he thrives off of his "skewed bets…"

The general press floods us with concepts like "bullish" and "bearish," which refer to the effect of higher (bullish) or lower (bearish) prices in the financial markets. But also, we hear people saying, "I am bullish on Johnny" or "I am bearish on that guy Nassim in the back who seems incomprehensible to me," to denote the belief in the likelihood of someone's rise in life. I have to say that the notion of bullish or bearish are often hollow words with no application in a world of randomness - particularly if such a world, like ours, presents asymmetric outcomes.

When I was in the employment of the New York office of a large investment house, I was subjected on occasions to the harrying weekly "discussion meeting," which gathered most professionals of the New York trading room. I do not conceal that I was not fond of such gatherings, and not only because they cut into my gym time. While the meetings included traders, that is, people who are judged on their numerical performance, it was mostly a forum for salespeople (people capable of charming customers), and the category of entertainers called Wall Street "economists" or "strategists," who make pronouncements on the fate of the markets, but do not engage in any form of risk taking; thus having their success dependent on rhetoric, rather than actually testable facts. During the discussion, people were supposed to present their opinions on the state of the world.

To me, the meetings were pure intellectual pollution. Everyone had a story, a theory, and insights that they wanted others to share. I have to confess that my optimal strategy (to soothe my boredom and allergy to confident platitudes) was to speak as much as I could, while totally avoiding listening to other people's replies by trying to solve equations in my head. Speaking too much would help me clarify my mind, and, with a little bit of luck, I would not be "invited" back (i.e, forced to attend) the following week.

I was once asked in one of those meetings to express my views on the stock market. I stated, not without a modicum of pomp that I believed that the market would go slightly up over the next week with a high probability. How high? "About 70%." Clearly, that was a very strong opinion. But then someone interjected, "But, Nassim, you just boasted being short a very large quantity of SP500 futures, making a bet that the market would go down. What made you change your mind?" I answered, "I did not change my mind! I have a lot of faith in my bet! As a matter of fact, I now feel like selling even more!"

The other employees in the room seemed utterly confused. "Are you bullish, or are you bearish?" the strategist asked me. I replied that I could not understand the words "bullish" and "bearish" outside of their purely zoological consideration. My opinion was that the market was more likely to go up ("I would be bullish"), but that it was preferable to short it ("I would be bearish"), because, in the event of its going down, it could go down a lot. Suddenly, the few traders in the room understood my opinion and started voicing similar opinions. And I was not forced to come back to the following discussion.

Let us assume that the reader shared my opinion, that the market over the next week had a 70% probability of going up and 30% probability of going down. However, let us say that it would go up by 1% on average, while it could go down by an average of 10%. What would the reader do? Is the reader bullish or bearish?

Accordingly, bullish or bearish are terms used by people who do not engage in practicing uncertainty, like the television commentators, or those who have no knowledge in handling risk. Alas, investors and businesses are not paid in probabilities, they are paid in dollars. Accordingly, it is not how likely an event is to happen that matters, it is how much is made when it happens that should be the consideration. How frequent the profit is irrelevant; it is the magnitude of the outcome that counts. It is a pure accounting fact that, aside from the commentators, very few people take home a check linked to how often they are right or wrong. What they get is a profit or loss. As to the commentators, their success is linked to how often they are right or wrong. This category includes the "chief strategists" of major investment banks the public can see on T.V., who are nothing better than entertainers. They are famous, seem reasoned in their speech, plow you with numbers, but, functionally, they are there to entertain - for their predictions to have any validity they would need a statistical testing framework. Their fame is not the result of some elaborate test, but rather the result of their presentation skills.

Outside of the need for entertainment in these shallow meetings I have resisted voicing a "market call" as a trader, which caused some personal strain with some of my friends and relatives. One day a friend of my father - of the rich and confident variety - called me during his New York visit. He wanted to pick my brain on the state of a collection of financial markets. I truly had no opinion, nor had made the effort to formulate any, nor was I remotely interested in markets. The gentleman kept plowing me with questions on the state of economies, on the European central banks; these were precise questions no doubt aiming to compare my opinion to that of some other "expert" handling his account at one of the large New York investment firms. I neither concealed that I had no clue, nor did I seem sorry about it. I was not interested in markets ("Yes, I am a trader") and did not make predictions, period. I went on to explain to him some of my ideas on the structure of randomness and the verifiability of market calls, but he wanted a more precise statement of what the European bond markets would do by the Christmas season.

He came away under the impression that I was pulling his leg; it almost damaged the relationship between my father and his rich and confident friend. For the gentleman called him with the following grievance: "When I ask a lawyer a legal question, he answers me with courtesy and precision. When I ask a doctor a medical question, he gives me his opinion. No specialist ever gives me disrespect. Your insolent and conceited 29-year-old son is playing prima donna and refuses to answer me about the direction of the market!"

The best description of my lifelong business in the market is "skewed bets," that is, I try to benefit from rare events, events that do not tend to repeat themselves frequently, but, accordingly, present a large payoff when they occur. I try to make money infrequently, as infrequently as possible, simply because I believe that rare events are not fairly valued, and that the rarer the event, the more undervalued it will be in price. In addition to my own empiricism, I think that the counterintuitive aspect of the trade (and the fact that our emotional wiring does not accommodate it) gives me some form of advantage.

Why are these events poorly valued? Because of a psychological bias; people who surrounded me in my career were too focused on memorizing Section 2 of the Wall Street Journal during their train ride to reflect properly on the attributes of random events. Or perhaps they watched too many gurus on television. Or perhaps they spent too much time upgrading their PalmPilot. Even some experienced trading veterans do not seem to get the point that frequencies do not matter. Jim Rogers, a "legendary" investor, made the following statement:

"I don't buy options. Buying options is another way to go to the poorhouse. Someone did a study for the SEC and discovered that 90 percent of all options expire as losses. Well, I figured out that if 90 percent of all long option positions lost money, that meant that 90 percent of all short option positions make money. If I want to use options to be bearish, I sell calls."

Visibly, the statistic that 90% of all option positions lost money is meaningless, (i.e., the frequency) if we do not take into account how much money is made on average during the remaining 10%. If we make 50 times our bet on average when the option is in the money, then I can safely make the statement that buying options is another way to go to the palazzo rather than the poorhouse. Mr Jim Rogers seems to have gone very far in life for someone who does not distinguish between probability and expectation (strangely, he was the partner of George Soros, a complex man who thrived on rare events - more on him later).

One such rare event is the stock market crash of 1987, which made me as a trader and allowed me the luxury of becoming involved in all manner of scholarship. Many traders aim to get out of harm's way by avoiding exposure to rare events - a mostly defensive approach. I am far more aggressive than those traders and go one step further; I have organized my career and business in such a way as to be able to benefit from them. In other words, I aim at profiting from the rare event, with my asymmetric bets.

Editor's Note: Nassim Nicholas Taleb is an essayist principally concerned with the problems of uncertainty and knowledge. Taleb's interests lie at the intersection of philosophy, mathematics, finance, literature and cognitive science, but he has stayed extremely close to the ground, thanks to an uninterrupted two-decade career as a mathematical trader. Specializing in the risks of unpredicted rare events ("black swans"), he held senior trading positions in New York and London, before founding Empirica LLC, a trading firm and risk research laboratory. Fooled by Randomness has been published in 14 languages, and the author's ideas on skeptical empiricism have been covered by hundreds of articles around the world.

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