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Taleb makes some valid points but it's a little ridiculous to blithely assume that everyone always underestimates the probability of rare events and thus all ma

by ctkrohn 18y ago

Taleb makes some valid points but it's a little ridiculous to blithely assume that everyone always underestimates the probability of rare events and thus all mathematical finance is useless. There's a whole field of study -- behavioral finance -- dedicated to discovering and understanding the facets of human nature that cause us to over and underestimate probabilities. Financial models often make simplifying assumptions that can make users complacent -- e.g. log-normal distribution of prices -- but they can also lead to a good number of useful facts and methods if you're aware of the dangers of the assumptions. I think Taleb is taking the easy way out. Rather than doing the hard work of modeling fat-tailed probability distributions, or studying how people mismanage risk, or building new financial models with more realistic assumptions, he throws up his hands and says that the future cannot be modeled. To his credit, he did once run a hedge fund based on his principles (called Empirica), but it was forced to close. Whether this was due to a lack of rare events or to mismanagement, no one can really know.

1gor 18y ago
>Rather than doing the hard work of modeling fat-tailed probability distributions.... or building new financial models with more realistic assumptions... Unfortunately, you are wrong and Taleb is right. The future of a dynamical system such as market cannot be predicted any better than a weather can be predicted one month from now. You could try to 'model' the temporal structure of the market (trying to find and describe its 'strange attractor'), but this is pointless because this market system has too many dimensions and your measurements of the system are too noisy and incomplete. The best you can do is to run some 'local' predictor. Like simply build a black box model based on the system's past and predict tomorrow based on what you've seen in the past. This works quite well but only for the very short term horizon. And it is not the 'model' you are thinking about. You should dispose of the traditional statistics altogether. It simply does not work in real life and all of the kludges developed to save it (like ARMA models etc) are pointless. As far as his fund is concerned, I would think he has done right by stopping trading in times when his strategy did not work. His strategy was to buy out of money options. Well, we had almost ten years of falling volatility and he would bleed to death in such an environment. A log of smart traders also went out of the market (Soros etc), some are coming back now. Taleb is not even such an innovative thinker. All of the stuff he is talking about has been an active field of scientific study, but he is valuable for being a popularizer of these ideas.
- ctkrohn 18y ago
  I'm not saying that you should try to predict the future of the market. I would agree with you that in many cases, this is a fool's errand. Mathematical finance is about a lot more than prediction, however. Risk management is even more important, since there are so many market participants who find themselves exposed to risks that they must hedge. Even your neighborhood mortgage banker is exposed to interest rate risk -- both the level of rates and the volatility of rates. Any multinational corporation is exposed to foreign exchange risk. An option trading desk will often find itself exposed to volatility and correlation risks. It would be foolish to leave these unhedged, and without some sort of a model you're forced to. The right way to approach this isn't to treat markets as some inscrutable thing, but to propose the best method you can and be aware of the risks you remain exposed to.
  - eugenejen 18y ago
    I don't think Taleb disagrees with this part. What he found annoyed is the modelers frequently forget what we have is a model! While in physics, any elegant theory or model will be "disapproved" by experiments. Financial modelers may just stubbornly refuse to consider the model is wrong! Unfortunately whether string theory is right or wrong may not affect out daily life. But a blow up in millions people's retirement money is in fact a tangible disaster that affect many people's life. What I get after reading NNT's books is "being humble, prepare to be humiliated" I think it also the same like what PG said for startups, "get users feedback asap, and iterate it fast" An arrogant developer or hedge fund manager is just a disaster waiting to happen.
  - 1gor 18y ago
    The only true hedging is - you got an asset - you sell it forward. You are hedged. What passes for hedging and 'risk management' today in the financial industry is something different. You measure how one instrument has correlated with another instrument (or a basket) in the past build an offsetting portfolio based on these correlation matrices -- and voila! But your assumptions that those correlations between assets will stay the same in the future (including volatility etc) are baseless. As you see, it is also predicting the future. And it is wrong.
eugenejen 18y ago
I remembered a WSJ interview of NNT last year about Empirica after subprime blowout. According to Taleb, Empirica is not forced to closed by lacking of rare events and they did not lose their raised fund, but he felt bored. Because Empirica built its position in taking small loses everyday, and Taleb said that is really frustrating for people operate it psychologically. Just like what Taleb said (not verbatim): human being needs once in a while endorphin kicks in brain to live. And knowing your are losing money everyday to wait the payoff is really not that exciting. Don't you think it is the same feeling when you run a start up, living cheaply and waiting for the pay day? Unless a man with superhuman will power, it is too hard for most human being. But after subprime, he said he was interested in coming back to market because he thought it would have fun because the volatility of market may come back. Since he has "fuck off" money now, for him the fun is more important.
- msg 18y ago
  Taleb saved it on his website, as a pdf, ads and all. http://www.fooledbyrandomness.com/wsj-patterson.pdf http://www.fooledbyrandomness.com/wsj-patterson.pdf For what it's worth, the same article has him still in as of October last year with a new fund called Universa, doing basically the same thing.

by ctkrohn 18y ago

1gor 18y ago

>Rather than doing the hard work of modeling fat-tailed probability distributions.... or building new financial models with more realistic assumptions... Unfortunately, you are wrong and Taleb is right. The future of a dynamical system such as market cannot be predicted any better than a weather can be predicted one month from now. You could try to 'model' the temporal structure of the market (trying to find and describe its 'strange attractor'), but this is pointless because this market system has too many dimensions and your measurements of the system are too noisy and incomplete. The best you can do is to run some 'local' predictor. Like simply build a black box model based on the system's past and predict tomorrow based on what you've seen in the past. This works quite well but only for the very short term horizon. And it is not the 'model' you are thinking about. You should dispose of the traditional statistics altogether. It simply does not work in real life and all of the kludges developed to save it (like ARMA models etc) are pointless. As far as his fund is concerned, I would think he has done right by stopping trading in times when his strategy did not work. His strategy was to buy out of money options. Well, we had almost ten years of falling volatility and he would bleed to death in such an environment. A log of smart traders also went out of the market (Soros etc), some are coming back now. Taleb is not even such an innovative thinker. All of the stuff he is talking about has been an active field of scientific study, but he is valuable for being a popularizer of these ideas.

ctkrohn 18y ago
I'm not saying that you should try to predict the future of the market. I would agree with you that in many cases, this is a fool's errand. Mathematical finance is about a lot more than prediction, however. Risk management is even more important, since there are so many market participants who find themselves exposed to risks that they must hedge. Even your neighborhood mortgage banker is exposed to interest rate risk -- both the level of rates and the volatility of rates. Any multinational corporation is exposed to foreign exchange risk. An option trading desk will often find itself exposed to volatility and correlation risks. It would be foolish to leave these unhedged, and without some sort of a model you're forced to. The right way to approach this isn't to treat markets as some inscrutable thing, but to propose the best method you can and be aware of the risks you remain exposed to.
- eugenejen 18y ago
  I don't think Taleb disagrees with this part. What he found annoyed is the modelers frequently forget what we have is a model! While in physics, any elegant theory or model will be "disapproved" by experiments. Financial modelers may just stubbornly refuse to consider the model is wrong! Unfortunately whether string theory is right or wrong may not affect out daily life. But a blow up in millions people's retirement money is in fact a tangible disaster that affect many people's life. What I get after reading NNT's books is "being humble, prepare to be humiliated" I think it also the same like what PG said for startups, "get users feedback asap, and iterate it fast" An arrogant developer or hedge fund manager is just a disaster waiting to happen.
- 1gor 18y ago
  The only true hedging is - you got an asset - you sell it forward. You are hedged. What passes for hedging and 'risk management' today in the financial industry is something different. You measure how one instrument has correlated with another instrument (or a basket) in the past build an offsetting portfolio based on these correlation matrices -- and voila! But your assumptions that those correlations between assets will stay the same in the future (including volatility etc) are baseless. As you see, it is also predicting the future. And it is wrong.

eugenejen 18y ago

I remembered a WSJ interview of NNT last year about Empirica after subprime blowout. According to Taleb, Empirica is not forced to closed by lacking of rare events and they did not lose their raised fund, but he felt bored. Because Empirica built its position in taking small loses everyday, and Taleb said that is really frustrating for people operate it psychologically. Just like what Taleb said (not verbatim): human being needs once in a while endorphin kicks in brain to live. And knowing your are losing money everyday to wait the payoff is really not that exciting. Don't you think it is the same feeling when you run a start up, living cheaply and waiting for the pay day? Unless a man with superhuman will power, it is too hard for most human being. But after subprime, he said he was interested in coming back to market because he thought it would have fun because the volatility of market may come back. Since he has "fuck off" money now, for him the fun is more important.

msg 18y ago
Taleb saved it on his website, as a pdf, ads and all. http://www.fooledbyrandomness.com/wsj-patterson.pdf http://www.fooledbyrandomness.com/wsj-patterson.pdf For what it's worth, the same article has him still in as of October last year with a new fund called Universa, doing basically the same thing.