Oliver Wendell Holmes Jr once remarked that
A man’s mind, once stretched, will never regain its original dimensions ever again.
On some occasions, the discovery is a flash of insight.
My two year old discovering how to open doors is one good example.
Now that she knows how to work the door handle, no matter how hard she tries in the future, she would never be able to unlearn that skill ever again.
On other occasions, the discovery takes place gradually over an extended period of time.
Some liken it to peeling an onion – as the layers come off one by one the insight becomes sharper and more defined.
For me, it was this slow osmosis of ideas over many years that shaped my thoughts on this particular matter we are about to discuss today.
The mind has been stretched indeed, and I am now unable to see things as they were before.
I clearly remembered the moment where it all took off.
In 2003, I came across Malcolm Gladwell’s article in The New Yorker magazine entitled Blowing Up: How Nassim Taleb turned the Inevitability of Disaster into an Investment Strategy. It was my first encounter with the Gladwell name despite his classic ‘The Tipping Point‘ hogging the bestsellers list for months.
It was also the first time I came across Nassim Taleb. In Blowing Up, Gladwell describes Taleb as this quantitative trader who runs his own trading firm. He is a rebel and a maverick, someone with a totally radical view of how investing should and should not be. He is also quite a character, a deep intellectual who never shies away from a confrontation of his ideas and on top of that, a very prolific human quote machine.
Over the years, Taleb himself has gone on to author many books that explains his unorthodox worldview. The Black Swan and Antifragility are top shelves classics that have already assured their place in history. And if you would like to get to know Taleb better without having to sit through his rambles and rants, The Bed of Procrustes: Philosophical and Practical Aphorisms (despite its title having more than one word that I cannot pronounce nor know the meaning to) is a short and sweet mindf&*k.
The ideas behind the man is predicated on a few core pillars.
If I had a dollar every time I come across someone misuse the term ‘black swan’ or ‘black swan event’, I would be shovelling money just to find a place to sit down.
From TV news anchors to opinion pieces in the papers to taxi drivers, everyone brandishes the term around because it makes them sound knowledgeable. It makes them sound knowledgeable because nobody else knows any better.
While using the term Black Swan to explain totally unexpected events traces its way back to an ancient Latin expression, Taleb bought forth and popularised the term once again in modern times. For an event, any event, to be called a Black Swan, the event itself has to exhibit three characteristics. Here is Taleb himself explaining
What we call here a Black Swan is an event with the following three attributes
First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.
If all that sounds too academic, work according to this heuristic – A Black Swan is an Unknown-Unknown. Brexit is not a black swan. The results of the vote might surprise some but at the end of the day, we all know that Britain will either stay or leave. It is a known-unknown.
Neither is the fact that Donald Trump is now President of the U.S. of A. Whether Trump wins or Hillary wins is an unknown. But this ‘unknown’ also happens to be most closely watched, commented on and predicted upon event by the entire free world. Fair enough if people were to label Trump’s victory as an unexpected outcome. But unexpected outcomes alone do not make Black Swans.
In other words, there has to be yet another additional element of unknown, the ’square’ of unknowns before it is truly a black swan. For example, if Aliens were to beamed Hillary Clinton away, now that would be a black swan event indeed. Anything else – Nope. Trump’s victory is hardly a black swan.
Mediocristan and Extremistan
To appreciate Nassim Taleb’s next idea, we first have to plug into his worlds of Mediocristan and Extremistan.
We start off with physical characteristics of human weight and height. Imagine a room full of people, all of whom has had their height measured before entering the room. The tallest adult is at most twice the height of the shortest, with the majority falling with a rather narrow band somewhere in the middle.
If we plot the height of all the people in the room, chances are it would end up looking like this.
If it does look somewhat familiar to you, well done for being able to recognise the Normal Distribution, more commonly known as the Bell Curve. Many phenomenons in nature fall into this pattern. They include height, weight, shoe size, intelligence, life expectancy amongst others.
Essentially, this is what the ‘orderly’ world looks like. It is highly measurable and behaves predictably. No individual player or single event will have a drastic effect on the distribution. Inviting the tallest person in the world into the room would not move the mean much. This is how things play out in Nassim Taleb’s imaginary world of Mediocristan.
On the other hand, instead of measuring height, we can measure the net worth of people we invite into the room. Since everyone lives around in the same neighbourhood around the room, a plot of their data ought to turn up a somewhat similar pattern.
Let us suppose then, that Warren Buffett, one of the richest persons in the world just happened to be wandering around the neighbourhood and decides to pop into the room for a look-see. At more than 70 Billion dollars, Buffett is worth many times more than all the individuals in the room combined. In fact, by making up more than 99% of our net worth aggregation, he has effectively reduced everyone else to a rounding error. (For the same thing to happen with human height, the tallest person would have to grow tall enough to reach the moon – a totally impossible feat).
And this is how things play out in the Extremistan that Taleb has created.
In Extremistan, a single observation can disrupt the entire dataset. There is little orderliness and extreme randomness and predictions are largely unreliable. In Extremistan, a winner takes all system is observed.
Many phenomenons occur in this regime. Taleb suggests book sales per author as an example. A Harry Potter launch would outsell every single title in the entire store. There is no orderliness in the way books and their authors rise to super-stardom. Yet, it is almost impossible to predict which book would be a hit and publishers just have to take their chances with many titles initially. JK Rowling had to face multiple rejections before finally getting her first book published. It is messy and unpredictable.
Other than book sales, the proliferation of a language, death rates of war, sizes of and damage caused by earthquakes; they all belong together in Extremistan. More than half the world’s population speak one of ten languages out of the hundreds, the two World Wars account for more than 70 million casualties while most other wars are resolved with much lesser damage to human life.
Earthquakes are measured using the logarithmic Richter Scale. What this means is that while an increase from 4 to 5 on the scale is a 25% increase in absolute number, the quake is in fact ten times stronger. (Fun Fact: A 9.0 quake is a million times stronger than a 3.0 shake and releases a billion times more energy. Try it yourself here).
Most important of all, the entire realm of finance remain firmly entrenched in this land of Extremistan. Geopolitical events such as wars and earthquakes are impossible to forecast. Yet they have every impact on global finance – they throw markets into turmoil.
Taleb’s biggest beef is how many people in finance (and we have very smart people at that) try to impose regular Mediocristan ideals into a wrapped Extremistan world. Economists often speak of multi-sigma events that are statistically almost impossible to happen during our lifetimes. Their projections and predictions about the future disregard these events due to the extreme low probability of them happening.
Such is the issue with LTCM.
Fat Tails and Long Term Capital Management
LTCM was founded in 1994 by ex Saloman Brothers fixed income trader John Meriwether. Amongst its principals included Myron Scholes (he of the Black-Scholes Model) and Robert Merton, both who went on to share the 1997 Nobel Prize for Economics and also David Mullins, once Vice Chairman of the Federal Reserve. Buffing up their ranks included many other lesser known scholars and PhD holders from Massachusetts Institute of Technology. #verysmartpeople
It started off spectacularly, with gains before fees of 28%, 59%, 57% and 25% in the first four years of operations. LTCM initially replicated Meriwether’s operations in Saloman and arbitraged bonds. Say a government bond, being the least risky of financial instrument, yields 3% per annum. A corporate bond in order to compensate investors for taking on more risk, pays a higher coupon of 5%.
By going long on the higher yielding instrument and shorting the other, LTCM has entered into a market neutral trade. No matter which way the interest rates (and consequently bond prices) go, both instruments will rise and fall in tandem. At redemption, assuming neither parties default (which during ‘regular’ market conditions almost 99% of the time), LTCM would have pocketed the 2% spread.
There are two issues with this strategy. Firstly, a arbitrage strategy does not generate huge returns. In fact, it generates very placid returns. The only way to produce the kind of returns LTCM initially did was to go on steroids and take on leverage. A 2% return on a capital of $100 brings in $2. With leverage and $900 of borrowed money, the same 2% will turn into $20 which represents a 20% return based on the initial capital of $100. Secondly, the strategy will only work when the markets behave exactly the way LTCM’s models predict they would behave. It was the lethal cocktail of both these factors that eventually bought LTCM on its knees.
In August 1997, Russia announced that it was ‘restructuring’ its bond payments, a nice way of saying that it was defaulting on its debt. Now, if you have a machine that prints money at home, you will never need to tell your creditors to go fly a kite. After all, if they do hound you for payment, just get the machine going and print some more. In the same vein, Russia’s default is a highly unlikely event. It was deemed so unlikely that it did not feature on LTCM’s computer models. LTCM suffered huge losses on Russian debt.
And so, just like that, LTCM blew up. Within the space of one month, LTCM lost up to four billion dollars of investors money. Many of their positions were so big that it was impossible to unravel them without affecting the entire market at large. Even more worrying is the fact that many big banks were LTCM’s creditors. Bear Sterns in particular would have collapsed and impacted the integrity of the entire financial system. The Federal Reserve had to step in to negotiate a buy out deal with a consortium.
By many’s reckoning, LTCM both defined and emboldened Nassim Taleb. The episode was a microcosm of everything he eventually stood for and against. His resentment against economists grew. He became convinced that they totally do not understand risk. He saw the fragility of the financial system and how dependent the entire ecosystem is on one another. He became disgusted when LTCM fund managers, despite the damage they have done, walked away from the fiasco relatively unscathed and went on to start more funds. He became the biggest advocate of having Skin in the Game.
Taleb, Universa and Trading Options
In the New Yorker article, Gladwell also describes how Taleb trades. To keep up with Taleb, we first have to understand options. To the retail investor more familiar with stocks and shares, options are complex, exotic and risky. Out of the three descriptions, only the complexity argument holds true.
Options may be exotic to the man in the street investor but they are a staple of the financial markets. The options and derivatives market is many times greater than the global equity market. Another general consensus among retail investors is that dabbling in options is risky. Many feel that unlike stocks, losses can become un-contained and the investor might lose more than the money he has put in.
To borrow an often used cliche in gun control debates – Guns do not kill people, it is people who do. Options (or for that matter, stocks, commodities, forex) can only be as risky as the investor welding them make them out to be. Run away losses might only occur when the investor sells options (and even that downside can be protected) and never when they buy options.
To understand options, we need to know three things about them.
1. Calls vs Puts
An option gives the holder the right (but not the obligation, we will come to this later) to either buy or sell something. If the option allows the owner to buy something, it is called a call option. If it gives the owner the right to sell something, it is called a put option.
Call option – Buy. Put option – Sell. Easy enough.
2. Strike Price
An option not only allows one to buy or sell. It allows one to buy a stock or a commodity (called the underlying) at a pre-determined price. This is known as the strike price.
3. Expiry date
To add yet another dimension to our discussion, all options expire. Like the milk in our fridge, there is an expiry date tagged to every option out there.
The following is the option chain for the SPY, the largest exchange traded fund in the world tracking the S&P500 index. Calls and puts, strike price and the expiration dates are all clearly labelled. (Note: Article completed 15 May 2017, published 14 June 2014)
Suppose you think that the US market is due for the correction soon. You could short the market outright, or you could look towards buying put options on the SPY. Let us examine the $238 Put in more detail.
The SPY last transacted at $240.41 while the 238 Put last changed hands at $0.55. One contract of the 238 put allows the owner the right but not the obligation to sell 10 shares of SPY at $238 each before expiry of the option on the 24th May 2017.
Two things can happen. From now till the 24th, the SPY can track and close above the strike price of $238. So even though you have the right to sell the SPY at $238, you would not want to do it because it could have fetched a better price in the open market out there. You would have allowed the option to expire worthless and in the process, lose $0.55.
On the other hand, if the SPY trades at around $235, you could easily have bought in via the open market and sold it to the option seller (who is obliged to purchase from you) at $238. You would have made $238 – $235 – $0.55 = $2.45, a 450% returns within a week.
I have vastly simplified the process. In principle though, that is exactly how Nassim Taleb operates in the financial markets.
Taleb never sells options, and only buys them. In not selling options, his maximum loss is limited to the amount he has paid for his options. There is no chance of blowing up. In buying options, Taleb has exposed himself to unlimited upside for a rather small amount of money. When a random, totally unexpected event descends on the markets and good sense goes out of the window, the options that he owns will allow him to sell (or buy) stocks at irrational prices.
To capture the essence that tail risks are undervalued, Taleb only buys far out of the money options. He buys them way out, at pennies a contract, and he buys them by the truckload. To give you some perspective, the $230 put with the same expiry currently trades at $0.10. Should an unexpected event cause the S&P500 to correct 5% and close at $228 before the 24th May, the option would have returned 2000%.
In a normal trading day, his strategy will lose him money. He will bleed, a little by little every day. It is extremely painful and devastating on the human psyche.
However, on a day where Mister Market goes into manic mode and every other investor is panicking and trying to cut loss, Nassim Taleb will be sitting back and watching his gains increase exponentially.
Such a strategy is the anti-thesis of the kind of regular, dividend investing we are all too familiar with. It is the strategy of a true market contrarian.
Taleb the Contrarian
Nassim Taleb is a contradiction in more ways than one. I have seen numerous videos of him in action defending his very unorthodox worldview. When he visited Singapore in 2014 and was to speak at the National Library, I made a huge effort to clear my calendar just to attend. Taleb speaks with conviction, is intolerant of any form of dissent and has no patience whatsoever. One would figure that such confidence can only come from a man who knows everything.
Yet in mind and matter, Taleb is the exact opposite.
Instead of claiming he knows everything, he stands proud with the insistence that he knows nothing. While many of his counterparts are churning out endless projections and predictions, while they are able to attribute market movements to policies, global events, other markets, Taleb stays clear of such claims. In fact, he abhors predictions.
Via his strategy, he makes no predictions. He does not know if the market will crash the next day. What he does know is that if a crash does happen, he will be in a good position to benefit from it. In doing so, he has constructed a trading system with black swans as the cornerstone, black swans which everyone else with their complex models, economic theories and their quest for regularity and world order, is willing to happily overlook.
With this ‘I know nothing’ claim alone, he takes on the entire financial industry.
Many have read Nassim Taleb’s books and examined his ideas and have gone on to deride him for being a nutcase and an insufferable fool.
I sit on the opposite end of the spectrum. Over the past decade, Taleb has more than influenced my outlook towards money and life and the state of affairs in the world of finance.
I can no longer look to an ‘expert’ and his ‘predictions’ about the direction of the economy with reverence and respect. I can truly fathom why people are willing to take on huge amounts of risk for the chance of a small profit on a daily basis. (and why I should never engage in such behaviour). I am cognisant of the destructive power of true black swans on the economy and one’s investment portfolio. I now see the need to not only insure my house, car, job and health. It is just as important to set up a policy to protect my wealth.
My mind has been stretched and it can no longer revert it back to its original shape. I wish the same for you as well.
Image Credits: rampages.us, ticketscript.com, time.com, libertyblitzkrieg.com, econcrisis.org, memegenerator.com, nlb,