Nassim Taleb vs Victor Niederhoffer

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Victor Niederhoffer was a hedge fund industry superstar until he blew up his account in the 1997 Asian Financial Crisis. He had to liquidate his fund and personal assets in order to pay back the losses. He is a very intelligent man and by reading his books, “The Education of a Speculator” and “Practical Speculation”, I can see his depth of thinking. A PhD holder, a chess expert and a national squash champion. There is no doubt in his ability. He views the market as having similarities to squash playing, chess moves, music and many other activities. Niederhoffer went on to manage George Soros’ fixed income and foreign exchange portfolio. They are good friends and often play tennis together. I have a speculation why Soros did so and will explain to you later in this article.

Nassim Taleb should be more familiar to you. He is the international bestselling author of “Fooled by Randomness” and “The Black Swan”. Based on the article written by Malcolm Gladwell, Niederhoffer invited Taleb to his home after the latter gained a pretty good reputation in Options trading. Taleb was awed by the wealth and knowledge of the host. As much as he respected Niederhoffer, the former did not agree with his trading concept.

Niederhoffer believes in empirical results as the truths. Being a brilliant statistician, he tested the methods and ideas in order to find something that ‘truly’ works, before he applies it with real money. He has a motto, “everything that can be tested must be tested.”  On the other hand, Taleb believes it is not possible to find empirical truths, and he would rather find empirical falsification. This means that testing a trading idea and trying to prove it works is dangerous, as you may be blinded by the good results that you get. You continue to believe that it works until an improbable event happens in the future and render your method false. What works consistently in the last 10 years does not guarantee it will be perfectly correct in the future. Nassim knows there are more things he does not understand and hence, he had devised his trading method to profit from improbable events, so that he does not blow up like Niederhoffer.

Taleb believes all the risk management models taught in schools are wrong. Risks cannot be quantified and completely known. No one will have perfect knowledge. The financial insitutions has been hiring quants to apply science and complex mathematics to the market. This does not work as the market involves human intervention. Unlike nature whereby the laws do not change. Quoted from Gladwell’s article,

“…when I drive home every night in the fall I see all these leaves scattered around the base of the trees,?” Spitznagel recounts [Spitznagel works in Taleb’s fund]. “There is a statistical distribution that governs the way they fall, and I can be pretty accurate in figuring out what that distribution is going to be. But one day I came home and the leaves were in little piles. Does that falsify my theory that there are statistical rules governing how leaves fall? No. It was a man-made event.””

The market can be disrupted by government interventions, scams, manipulations, etc. The financial and risk model will break down whenever this happens.

One of the highest probable way of making money in the market is to sell Options. Since most of the Options expire worthless, you would make money rather consistently by collecting the premiums. It was suggested in Gladwell’s article that Niederhoffer sells Options too. Taleb would think there are many hidden risks that he does not understand. His trading idea would be to buy Options as insurance and wait for an improbable event with great impact and simply profit from the occurrence. As a human, do you prefer to win most of the time or do you prefer to lose most of the time? The answer is obvious. Again, in Gladwell’s article,

“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.”

To lose money everyday is unnatural but that is what Taleb does. Gladwell recounted the experience,

“At 11:30 A.M., for instance, they [Empirica staff] had recovered just twenty-eight percent of the money they had spent that day on options. By 12:30, they had recovered forty per cent, meaning that the day was not yet half over and Empirica was already in the red to the tune of several hundred thousand dollars. The day before that, it had made back eighty-five per cent of its money; the day before that, forty-eight per cent; the day before that, sixty-five per cent; and the day before that also sixty-five per cent; and, in fact-with a few notable exceptions, like the few days when the market reopened after September 11th — Empirica has done nothing but lose money since last April. “We cannot blow up, we can only bleed to death,” Taleb says, and bleeding to death, absorbing the pain of steady losses, is precisely what human beings are hardwired to avoid.”

Gladwell went on to explain very well with regard to the psychology when applying such ‘losing’ method,

“”Say you’ve got a guy who is long on Russian bonds,” Savery says. “He’s making money every day. One day, lightning strikes and he loses five times what he made. Still, on three hundred and sixty-four out of three hundred and sixty-five days he was very happily making money. It’s much harder to be the other guy, the guy losing money three hundred and sixty-four days out of three hundred and sixty-five, because you start questioning yourself. Am I ever going to make it back? Am I really right? What if it takes ten years? Will I even be sane ten years from now?” What the normal trader gets from his daily winnings is feedback, the pleasing illusion of progress.”

Karl Popper has a great influence over Taleb. In fact, George Soros was a student of Popper. It is obvious how the two got the idea of empirical falsification from. Since Soros also does not believe in empirical truths, why did he allow Niederhoffer to manage part of his money? I think Soros is being consistent. He always adopt the notion that he can be wrong and hence, he has to find another person that would do the exact opposite to manage some of his money, and I believe he found it in Niederhoffer.

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Co-Founder. Believer of the Factor-based Investing approach. Running a Multi-Factor Portfolio that taps on the Value, Size, Profitability and Momentum Factors. Quant at heart. Believe the financial industry can treat their customers better. Wants to change the world.
  • Thanks for this. I also enjoyed reading the Gladwell’s article on the two men. While they have different strategies and underlying philosophies, both are men of integrity and honest to themselves.

    • Hey Fountain, totally agree with you – they are great men indeed despite their differences. Likewise for Gladwell 😀

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