Talebs "Black Swan" Hedge Fund posts up to 110% gains

[BSD]

"Taleb's `Black Swan' Investors Post Gains as Markets Take Dive

Oct. 14 (Bloomberg) -- Investors advised by ``Black Swan'' author Nassim Taleb have gained 50 percent or more this year as his strategies for navigating big swings in share prices paid off amid the worst stock market in seven decades.

Universa Investments LP, the Santa Monica, California-based firm where Taleb is an adviser, has about $1 billion in accounts managed to hedge clients against big moves in financial markets. Returns for the year through Oct. 10 ranged as high as 110 percent, according to investor documents. The Standard & Poor's 500 Index lost 39 percent in the same period.

``I am very sad to be vindicated,'' Taleb said today in an interview in London. ``I don't care about the money. We're proud we protected our investors.''

Taleb's book argues that history is littered with high- impact rare events known in quantitative finance as ``fat tails.'' As the founder of New York-based Empirica LLC, a hedge- fund firm he ran for six years before closing it in 2004, Taleb built a strategy based on options trading to bullet-proof investors from market blowups while profiting from big rallies.

Mark Spitznagel, Taleb's former trading partner, opened Universa last year using some of the same strategies they'd run since 1999. Pallop Angsupun manages the Black Swan Protection Protocol for clients and is overseen by Taleb and Spitznagel, Universa's chief investment officer.

``The Black Swan Protection Protocol is designed to break even 90 to 95 percent of the time,'' Spitznagel said. ``We happen to be in that other 5 to 10 percent environment.''

CONTINUED:
Bloomberg.com: Worldwide

 

[Splitlink]

I read his book, too. Very entertaining but there is a problem to which I thought that he had no solution.

Black Swans have been around since the beginning of time and they, always, come at unexpected moments and in never in the same form.

I don't think that anyone can forecast them with accuracy and the pessimist is likely to wait half a lifetime for it to happen. When they do, they are very visible--- with benefit of hindsight.

I viewed Socrates attempts to write naked options, which he expected to expire near to worthless. with misgivings. I guessed that he was likely to make money as long as the Black Swan did not appear. It did, however, in the form of this present slide in the indices, but there was no guarantee that it would come at all.

Nevertheless, both systems are dangerous, IMO.

 

[BSD]

Black Swans have been around since the beginning of time and they, always, come at unexpected moments and in never in the same form.

Absolutely true.

What drives his model is that they, as you say, come at unexpected moments and in never the same form, but that they are still far more frequent than previously thought, frequent enough to drive his model.

"The pseudo-science hurting markets

FINANCIAL TIMES

Last August, The Wall Street Journal published a statement by one Matthew Rothman, financial economist, expressing his surprise that financial markets experienced a string of events that “would happen once in 10,000 years”. A portrait of Mr Rothman accompanying the article reveals that he is consider ably younger than 10,000 years; it is therefore fair to assume he is not drawing his inference from his own empirical experience but from some theoretical model that produces the risk of rare events, or what he perceives to be rare events.

The theories Mr Rothman was using to produce his odds of these events were “Nobel-crowned” methods of the so-called modern portfolio theory designed to compute the risks of financial portfolios. MPT is the foundation of works in economics and finance that several times received the Sveriges Riksbank Prize in Econ omic Sciences in Memory of Alfred Nobel. The prize was created (and funded) by the Swedish central bank and has been progressively confused with the regular Nobel set up by Alfred Nobel; it is now mislabelled the “Nobel Prize for economics”.

MPT produces measures such as “sigmas”, “betas”, “Sharpe ratios”, “correlation”, “value at risk”, “optimal portfolios” and “capital asset pricing model” that are incompatible with the possibility of those consequential rare events I call “black swans” (owing to their rarity, as most swans are white). So my problem is that the prize is not just an insult to science; it has been putting the financial system at risk of blow-ups.

I was a trader and risk manager for almost 20 years (before experiencing battle fatigue). There is no way my and my colleagues’ accumulated knowledge of market risks can be passed on to the next generation. Business schools block the transmission of our practical know-how and empirical tricks and the knowledge dies with us. We learn from crisis to crisis that MPT has the empirical and scientific validity of astrology (without the aesthetics), yet the lessons are ignored in what is taught to 150,000 business school students worldwide.

Academic economists are no more self-serving than other professions. You should blame those in the real world who give them the means to be taken seriously: those awarding that “Nobel” prize.

In 1990 William Sharpe and Harry Markowitz won the prize three years after the stock market crash of 1987, an event that, if anything, completely demolished the laureates’ ideas on portfolio construction. Further, the crash of 1987 was no exception: the great mathematical scientist Benoît Mandelbrot showed in the 1960s that these wild variations play a cumulative role in markets – they are “unexpected” only by the fools of econ omic theories.

Then, in 1997, the Royal Swedish Academy of Sciences awarded the prize to Robert Merton and Myron Scholes for their option pricing formula. I (and many traders) find the prize offensive: many, such as the mathematician and trader Ed Thorp, used a more realistic approach to the formula years before. What Mr Merton and Mr Scholes did was to make it compatible with financial economic theory, by “re-deriving” it assuming “dynamic hedging”, a method of continuous adjustment of portfolios by buying and selling securities in response to price variations.

Dynamic hedging assumes no jumps – it fails miserably in all markets and did so catastrophically in 1987 (failures textbooks do not like to mention).

Later, Robert Engle received the prize for “Arch”, a complicated method of prediction of volatility that does not predict better than simple rules – it was “successful” academically, even though it underperformed simple volat ility forecasts that my colleagues and I used to make a living.

The environment in financial econ omics is reminiscent of medieval medicine, which refused to incorporate the ob servations and experiences of the ple beian barbers and surgeons. Medicine used to kill more patients than it saved – just as financial economics endangers the system by creating, not reducing, risk. But how did financial econ omics take on the appearance of a science? Not by experiments (perhaps the only true scientist who got the prize was Daniel Kahneman, who happens to be a psychologist, not an econ omist). It did so by drowning us in mathematics with abstract “theorems”. Prof Merton’s book Continuous Time Finance contains 339 mentions of the word “theorem” (or equivalent). An average physics book of the same length has 25 such mentions. Yet while economic models, it has been shown, work hardly better than random guesses or the intuition of cab drivers, physics can predict a wide range of phe nomena with a tenth decimal precision.

Every time I have questioned these methods I have been abruptly countered with: “they have the Nobel”, which I have found impossible to argue with. There are even practitioner associations such as the International Association of Financial Engineers partaking of the cover-up and promoting this pseudo-science among financial in stitutions. The knowledge and risk awareness we are accumulating from the current subprime crisis and its aftermath will most certainly not make it to business schools. The previous dozen crises and experiences did not do so. It will be dying with us, unless we discredit that absurd Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel commonly called the “Nobel Prize”."

LINK:
FT.com / Comment & analysis / Comment - The pseudo-science hurting markets

 

[BSD]

Long, but an excellent read, what many may not realize is that Taleb has a decades long career as a very successful trader, having started out as a floor member on the CME, moving on to a bank prop job, before starting his own hedge fund:

Some excerpts from the article that is absolutely worth a read in it's entirety:

"Blowing Up

NEW YORKER

DEPARTMENT OF FINANCE

How Nassim Taleb turned the inevitability of disaster into an investment strategy

...Wall Street was dedicated to the principle that when it came to playing the markets there was such a thing as expertise, that skill and insight mattered in investing just as skill and insight mattered in surgery and golf and flying fighter jets. Those who had the foresight to grasp the role that software would play in the modern world bought Microsoft in 1985, and made a fortune. Those who understood the psychology of investment bubbles sold their tech stocks at the end of 1999 and escaped the Nasdaq crash. Warren Buffett was known as the "sage of Omaha" because it seemed incontrovertible that if you started with nothing and ended up with billions then you had to be smarter than everyone else: Buffett was successful for a reason. Yet how could you know, Taleb wondered, whether that reason was responsible for someone's success, or simply a rationalization invented after the fact?

George Soros seemed to be successful for a reason, too. He used to say that he followed something called "the theory of reflexivity." But then, later, Soros wrote that in most situations his theory "is so feeble that it can be safely ignored." An old trading partner of Taleb's, a man named Jean-Manuel Rozan, once spent an entire afternoon arguing about the stock market with Soros. Soros was vehemently bearish, and he had an elaborate theory to explain why, which turned out to be entirely wrong. The stock market boomed. Two years later, Rozan ran into Soros at a tennis tournament. "Do you remember our conversation?" Rozan asked. "I recall it very well," Soros replied. "I changed my mind, and made an absolute fortune." He changed his mind! The truest thing about Soros seemed to be what his son Robert had once said:

"My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking, Jesus Christ, at least half of this is bull****. I mean, you know the reason he changes his position on the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it?s this early warning sign."

Niederhoffer was a staunch empiricist, who turned to Taleb that day in Connecticut and said to him sternly, "Everything that can be tested must be tested," and so when Taleb started his own hedge fund, a few years later, he called it Empirica. But that is where it stopped. Nassim Taleb decided that he could not pursue an investment strategy that had any chance of blowing up.

Nassim Taleb and his team at Empirica are quants. But they reject the quant orthodoxy, because they don't believe that things like the stock market behave in the way that physical phenomena like mortality statistics do. Physical events, whether death rates or poker games, are the predictable function of a limited and stable set of factors, and tend to follow what statisticians call a "normal distribution," a bell curve. But do the ups and downs of the market follow a bell curve? The economist Eugene Fama once studied stock prices and pointed out that if they followed a normal distribution you'd expect a really big jump, what he specified as a movement five standard deviations from the mean, once every seven thousand years. In fact, jumps of that magnitude happen in the stock market every three or four years, because investors don't behave with any kind of statistical orderliness. They change their mind. They do stupid things. They copy each other. They panic. Fama concluded that if you charted the ups and downs of the stock market the graph would have a "fat tail,"meaning that at the upper and lower ends of the distribution there would be many more outlying events than statisticians used to modelling the physical world would have imagined.

In the summer of 1997, Taleb predicted that hedge funds like Long Term Capital Management were headed for trouble, because they did not understand this notion of fat tails. Just a year later, L.T.C.M. sold an extraordinary number of options, because its computer models told it that the markets ought to be calming down. And what happened? The Russian government defaulted on its bonds; the markets went crazy; and in a matter of weeks L.T.C.M. was finished.

Taleb likes to quote David Hume: "No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion." Because L.T.C.M. had never seen a black swan in Russia, it thought no Russian black swans existed. Taleb, by contrast, has constructed a trading philosophy predicated entirely on the existence of black swans. on the possibility of some random, unexpected event sweeping the markets. He never sells options, then. He only buys them. He's never the one who can lose a great deal of money if G.M. stock suddenly plunges. Nor does he ever bet on the market moving in one direction or another. That would require Taleb to assume that he understands the market, and he doesn't.

And he doesn't bet on minor fluctuations in the market. Why bother? If everyone else is vastly underestimating the possibility of rare events, then an option on G.M. at, say, forty dollars is going to be undervalued.

What Empirica has done is to invert the traditional psychology of investing. You and I, if we invest conventionally in the market, have a fairly large chance of making a small amount of money in a given day from dividends or interest or the general upward trend of the market. We have almost no chance of making a large amount of money in one day, and there is a very small, but real, possibility that if the market collapses we could blow up. We accept that distribution of risks because, for fundamental reasons, it feels right. In the book that Pallop was reading by Kahneman and Tversky, for example, there is a description of a simple experiment, where a group of people were told to imagine that they had three hundred dollars. They were then given a choice between (a) receiving another hundred dollars or (b) tossing a coin, where if they won they got two hundred dollars and if they lost they got nothing. Most of us, it turns out, prefer (a) to (b). But then Kahneman and Tversky did a second experiment. They told people to imagine that they had five hundred dollars, and then asked them if they would rather (c) give up a hundred dollars or (d) toss a coin and pay two hundred dollars if they lost and nothing at all if they won. Most of us now prefer (d) to (c). What is interesting about those four choices is that, from a probabilistic standpoint, they are identical. They all yield an expected outcome of four hundred dollars. Nonetheless, we have strong preferences among them. Why? Because we're more willing to gamble when it comes to losses, but are risk averse when it comes to our gains. That's why we like small daily winnings in the stock market, even if that requires that we risk losing everything in a crash.

At Empirica, by contrast, every day brings a small but real possibility that they'll make a huge amount of money in a day; no chance that they'll blow up; and a very large possibility that they'll lose a small amount of money."...

FULL ARTICLE:
gladwell dot com - blowing up

 

[trendie]

reading these excerpts makes me go "wow", as these ideas on hum-drum trading seem to spill over into philosophy.
brilliant choices, BSD.

liked this from the first article:
``We refused to touch credit default swaps,'' Taleb said. ``It would be like buying insurance on the Titanic from someone on the Titanic.''

classic.

 

[Adamus]

I have read both Fooled by Randomness and Black Swan and while I think they're both great, I have problems seeing how Taleb's theory affects me as a futures trader.

Even at one point Taleb ridicules users of Omega Tradestation - which I happen to be.

In any futures market admittedly I do have unlimited risk, but if ever see a Black Swan, it will only be flying overhead on its way to take someone else out, and I will be unlucky if I get so much as shat on.

Tell me I'm wrong, Taleb! I can take on unlimited risk in the futures markets and I can liquidate my positions and walk away when I see any black birds swimming up the Swanny (if the market happens to be going against me that is).

 

[arabianights]

Tell me I'm wrong, Taleb! I can take on unlimited risk in the futures markets and I can liquidate my positions and walk away when I see any black birds swimming up the Swanny (if the market happens to be going against me that is).

Imagine if someone nukes LIFFE or the CME (conicidentally destroying London or Chicago) and you're long indexes. Try to liquidate your positions then!

 

[Splitlink]

I have an idea that that would be the least of my problems. Besides I might be short.

 

[porph]

Interesting books, found him to be a little too up his own ****..

 

[arabianights]

A more serious problem - when you need to liquidate the most the liquidity disappears. That was what really finished LTCM off...

Alright for smaller locals like me but if you intend to have thousand lot positions on as a matter of course some day then this really is something to worry about.

 

[Adamus]

A more serious problem - when you need to liquidate the most the liquidity disappears. That was what really finished LTCM off...

Imagine if someone nukes LIFFE or the CME (conicidentally destroying London or Chicago) and you're long indexes. Try to liquidate your positions then!

Well, there's exchange for physicals, but I figured it wouldn't be so easy.

Also speculated what might happen if i woke up in hospital after being in a coma for 10 days with a big position on..........

 

[gooseman]

i have nightmares like that.

 

[arabianights]

me too, I dream about trading at least once a week.

And they're never good dreams.

 

[gooseman]

i always wake up in a panic wondering where the market is or what vol is doing.....!!

 

[jm99]

YouTube - The REAL Maverick: Present Economy worse than Depression

 

[porph]

Well, there's exchange for physicals, but I figured it wouldn't be so easy.

Also speculated what might happen if i woke up in hospital after being in a coma for 10 days with a big position on..........

I guess that's what an automated stop is for.

 

[Quenkish]

I read his book, too. Very entertaining but there is a problem to which I thought that he had no solution.

Black Swans have been around since the beginning of time and they, always, come at unexpected moments and in never in the same form.

I don't think that anyone can forecast them with accuracy and the pessimist is likely to wait half a lifetime for it to happen. When they do, they are very visible--- with benefit of hindsight.

I viewed Socrates attempts to write naked options, which he expected to expire near to worthless. with misgivings. I guessed that he was likely to make money as long as the Black Swan did not appear. It did, however, in the form of this present slide in the indices, but there was no guarantee that it would come at all.

Nevertheless, both systems are dangerous, IMO.

Socrates is the best trader on the forum, I am led to beleive.