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Why Nassim Taleb’s Black Swan idea won’t catch on

http://www.nakedcapitalis…black-swan.html

While not quite a book review, Yves Smith of nakedcapitalism.com discusses Nassim Nicholas Taleb’s The Black Swan from the perspective of how likely the ideas in the book are to spreading and being widely understood and internalized.

It’s an interesting post. Even in these times where we are increasingly observing the effects of long tails and fundamental unpredictability/randomness, people still cling to the idea that the world will unfold as planned even though it’s rarely ever this way.

NNT discusses this problem within the book. In particular, the problem of hindsight bias causes us to overstate our own control over event outcomes that are fundamentally more random — particularly when it is a positive outcome. On the flipside, we acknowledge how uncontrollable things are when the event has a negative outcome. This sinister bias inflates our belief in our own predictive power. Sort of silly, right?

I particularly like Yves’ conclusion (see bolded bit). You have to love that the success of a book about unpredictability and luck is, itself, a sort of black swan. Mind, this is Taleb’s second book on randomness and unpredictability; however, Taleb’s success as a stock trader, making massive sums and achieving widespread acclaim for his correct trading of the 1987 stock market crash, is arguably a black swan event — right? Or does expecting a black swan cause the expected event to cease being a black swan?

Further still, is Taleb’s success anecdotal proof that awareness of black swans and exposing yourself to upside potential from random events, planning for the unplannable, is not only possible, but could be a wildly profitable pursuit? I tend to think this may be the case, but maybe my human control bias is creeping in.

Fundamentally, I just don’t know.

Here is Yves:

I sincerely doubt [Nassim Taleb’s ideas] will be internalized. . . . The very fact that his construct has been reduced to the soundbite “black swan” when it is more complicated and richer is telling.

What are some of the reasons? Let me speculate.

First, Taleb goes to some length to establish that he is not the first to go down this line of thinking; he has quite a few intellectual ancestors. Yet these observations never took hold.

Of course, one reason is that the implications are pretty uncomfortable for a lot of professions . . .

But second, and perhaps as important, people do not want to see the world as subject to chance to the degree that Taleb says it is. This is hugely unsettling if you really do come to terms with the implications of his argument. We like to believe we have some measure of control over our lives. . . .

Third, if our mental construct of how the world works is off in some fundamental respects, it also calls into question our ability to make good decisions. And apart from Taleb, there are reasons to question our abilities here. It has been pretty well documented in brain research that humans can only hold so many variables in their consciousness at once. Our decision-making capabilities are more limited than we’d like to believe. And confronting every situation as if it were new would be simply exhausting, That is why we rely heavily on rules of thumb (more fancily called heuristics). Now we also have certain types of analytic processes, what I like to think of as pattern recognition, that can serve us well (this was the topic of Malcolm Gladwell’s Blink). The problem is that this quick pattern recognition can work very well, or be absolutely wrong, and we have no easy way of telling which.

Essentially, Taleb paints a picture of the world and human behavior that is unflattering. So as much as his work makes a fundamentally important set of observations, its success may be largely a function of luck. It came out just when the credit markets were starting to unravel and well established practices, both among traders and the broader financial community, were being shown to have serious flaws. Had his book come out at another juncture, it probably would not have been as well received.

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How bank bonuses let us all down

http://www.ft.com/cms/s/0…0077b07658.html

More from Nassim Nicholas Taleb (See prior at tag nassim-taleb) on our current system that fosters the “free option,” which is most easily summed up as, “Heads I win, tails you lose.”

NNT has previously argued that our banking system is built to blow up, and how can you argue with the reality that banks steadily earn profits for years only to suddenly blow up, losing all past profits and more?

Why does this happen? I think there are two reasons, only one of which gets press generally. The other is at the root of Taleb’s discussion on a broken incentive structure (free options).

The widely accepted and discussed reason for our current mess is leverage — a.k.a. credit. By way of a simple example of the power of leverage, in a booming housing market, leverage enables a homeowner to turn little-to-no-equity into a hefty profit ($10k down, $90k loan to buy a house; sell in two years for $150k and you made 500%!). However, when that housing market goes bust (or even just stops booming), the levered homeowner suddenly can’t cash out or see his minimal equity position wiped out. Since he has little skin in the game, he lets the loss go fully to the bank. We are now seeing this happen en masse.

Heads I win. Tails you lose.

It is the same with banks, except in a monstrous, centralized, global, and ridiculously more complicated (thanks to derivatives) way.

So it is becoming widely understood how credit and leverage can muck things up.

The less (or not-at-all) acknowledged problem is our corporatist legal system whereby businesses can incorporate and separate personal loss from business loss. By default, creating a corporation is essentially creating a public negative externality. How so? Well, a corporation can only bear the cost of its failures to the extent of the capital invested. So even without any leverage, the corporation is incentivized to take on more risk than it has capital to cover in order to maximize profits. When times are good, this is incredibly profitable. When times are bad, corporations go bankrupt even as the CEOs and risk-taking managers who messed up get off with their wages and bonuses!

Tack onto this corporatist system the aforementioned system of leverage you key a system built to blow-up.

Despite all of the free option discussion, I’m not sure NNT understands the bald-faced simplicity of the problem of severing risk from loss. However, Taleb hints at a clearcut understanding when he makes mention of Roman soldiers. Soldiers have skin in the game – their lives. If they screw up, they risk their own life. When a CEO of a corporation screws up, they risk the wealth of their investors and that of general stakeholders in the event that their screw-up pushes waste onto society.

In fact, the incentive scheme commonly in place does the exact opposite of what an “incentive” system should be about: it encourages a certain class of risk-hiding and deferred blow-up. It is the reason banks have never made money in the history of banking, losing the equivalent of all their past profits periodically – while bankers strike it rich. Furthermore, it is thatincentive scheme that got us in the current mess. . . .

If capitalism is about incentives, it should be about true incentives, those resistant to blow-ups. And there should be disincentives to remove the asymmetry of the free option. Entrepreneurs are rewarded for their gains; they are also penalised for their losses. . . .

However, when it comes to banks and other “too big to fail” entities, the problem is severe: we taxpayers in our respective countries are funding these global monsters and are coughing up money for mistakes made by bankers who retain their bonuses and are hijacking us because, as we are discovering (a little late), banking is a utility and we need them to clean up their mess. We, in fact, are the seller of that free option. We should claim it back. . . .

Indeed, the incentive system put in place by financial companies has produced the worst possible economic system mankind can imagine: capitalism for the profits and socialism for the losses.

Finally, I was involved in trading for 21 years and I can testify that traders consciously play the free option game. On the other hand, I worked (in my other job as risk adviser) with various military organisations and people watching over our safety. We trust military and homeland security people with our lives, yet they do not get a bonus. They get promotions, the honour of a job well done and the disincentive of shame if they fail. Roman soldiers signed a sacramentum accepting punishment in the event of failure. This is prompting me to call for the nationalisation of the utility part of banking as the only solution in which society does not grant individuals free options to look after its risks.

No incentive without disincentive. And never trust with your money anyone making a potential bonus.

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Nassim Nicholas Taleb: “Bankers Designed Banks to Blow Up”

http://www.bloomberg.com/…mMd4PSxEKeE.asf

Just watched a fifteen minute interview by Bloomberg of Nassim Nicholas Taleb (The Black Swan). In the interview Taleb discusses the current crisis, robust systems, nationalizing the banks and the fallacy of using narratives of history to guide present-day policy/response.

Below are some quotes from NNT, which I’ve organized into like-nuggets of wisdom:

  • Looking at biology, things that survive have redundancy . . . we have spare parts, which is the exact opposite of leverage. . . . We have diversity and nothing is too big. Things fail early. . . . Banking is organized in a completely opposite way. . . . Complex systems have properties that banks don’t have. And biological systems have survived.
  • [We have an] Illusion of stability and then blow-ups are larger. Imagine if half-country was fed by one restaurant it’d be okay except one day people would starve.
  • Bad news travels immediately . . . This environment won’t tolerate the smallest mistake . . . I don’t know the system can allow for too much leverage.
  • People can invest in real things – they don’t have to invest in paper. . . .
  • What we have is a system of deposit where people buy a company, they borrow against it, and buy another company. . . . If that disappears we have less growth but it would be a more robust economic system.
  • The government is neither nationalizing the banks nor letting them break.
  • [With regard to banking,] separate the payment system from the risk taking system.
  • It looks like we have no control. The government has no control over what the banks are doing. The banks aren’t in control of what they are doing.
  • The press reports everything except the important stuff. September 18th . . . we had the run on money market funds and the government had to step in.
  • The situation is not comparable to the Great Depression. The situation is very different.
  • This crisis is not so much a Black Swan to me. It’s like saying you’ve got a pilot who doesn’t know about storms. . . . The Black Swan for me would be to emerge out unscathed and go back to normalcy.
  • We should be very careful when we make a historical analogy like the Great Depression because the world is not like it was in the Great Depression.
  • Capitalism is you let what’s breakable break fast.

Bloomberg also ran an article on the interview with Taleb, but it is spartan as far as quotes or insights from the actual interview.

From what I can tell, it seems Taleb views bank nationalization as similar to taking out plane hijackers. It’s an interesting, more palatable way to look at nationalization in that it frames the situation as one where the public will be harmed unless someone (in this case the government) steps in and takes drastic action.

Having said that, I don’t get the impression that Taleb is a proponent of long-term nationalization. NNT would prefer banking be structured similarly to a biological system where there are redundancies and fragile things “break early.” This system wouldn’t foster as much leverage and therefore would slow growth, but it would be considerably more robust.

This is more or less what I believe, as well. A free market is an organic, naturally forming system that is decentralized and redundant. It’s robust because market actions failing apart at any micro level will not break the entire system.

How do we get there from here? Good question.

(H/T to Jesse)