Agora Financial’s Rude Awakening

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Laguna Beach, California

· Guest columnist Nassim Taleb explains the fraud that is “modern economics,”
· A closer look at what caused the current global economic crisis,
· Time is running out to apply for your $1,500 dividend check and more…

Eric Fry, reporting from Laguna Beach, California…

Nassim Taleb never received a Nobel Prize for his financial insights. But that’s not the ONLY reason we are one of his biggest fans. We also admire Nassim Taleb because he is everything Wall Street’s book-smart, quant-morons are not. He is street smart, intellectually honest…and also pretty darn funny.

“My major hobby,” says Taleb, “is teasing people who take themselves and the quality of their knowledge too seriously and those who don’t have the courage to sometimes say: ‘I don’t know.’ (You may not be able to change the world, but can at least get some entertainment and make a living out of the epistemic arrogance of the human race).”

Taleb calls himself a ’skeptical empiricist and, as Wikipedia explains, “believes that scientists, economists, historians, policymakers, businessmen, and financiers are victims of an illusion of pattern; they overestimate the value of rational explanations of past data, and underestimate the prevalence of unexplainable randomness in that data. He follows a long lineage of skeptical philosophers…in believing that we know much less than we think we do, and that the past should not be used naively to predict the future.”

In his two best-selling books, “Fooled by Randomness” and “The Black Swan,” as well as in dozens of subsequent speeches and interviews, Taleb argued that rare, catastrophic events are as certain as they are unpredictable.

Incredibly, the “pop science” that sired trillions of dollars worth of toxic credit derivatives ignored this inconvenient truth. Therefore, Taleb concluded (before the fact) that the quantitative models that inspired tens of trillions of dollars worth of investment decisions were tragically flawed.

“Six Nobel prizes were handed out to people whose work was nothing but BS,” he gripes. “They convinced the financial world that it had nothing to fear.”

But clearly, the financial world had very much to fear…as much to fear as any farm-raised turkey on the third Wednesday in November.

“Until today or tomorrow,” Taleb remarked during a recent pre-Thanksgiving speech, “the typical turkey enjoyed a fairly decent life.

“You can understand how fraudulent most economic analysis is,” he continued, “just by looking the life of the turkey. The animal is fed for 1000 days…and then it is killed. So, if you plotted out the turkey’s life on a chart, it would look great for 1,000 days…each day, the food arrived reliably, and each day, the turkey gained weight. The turkeys would look around and say they were enjoying growth and a bull market. Momentum investors would see it as an opportunity. The quants would run linear regressions on the data and prove that the risk was minimal.”

But the folly did not end there.

As our friend, colleague and employer, Bill Bonner, remarked in a recent edition of the Daily Reckoning, “Ben Bernanke would describe the turkey’s life – with no setbacks – as the product of a ‘Great Moderation.’ Turkey stockbrokers would assure their clients that nothing had ever gone wrong in the turkey’s life.

Turkey econometricians and theorists would come up with explanations for why the turkeys’ growth would continue forever and they’d pat each other on the back for having finally mastered the ‘turkey cycle.’ Turkey politicians would run for re-election on the grounds that they had helped create a better world. And turkey economists would project further weight gains…until the turkey was the size of a hippopotamus.

“Then, come Thanksgiving, and all of a sudden, something goes wrong,” Bonner concluded. “Alas, all the turkeys’ theories, models, and conceits were for the birds.”

“Rare events can’t be modeled,” Taleb explains. “Because these events are so rare, they are also completely unpredictable…and usually much worse than you can expect. Like Thanksgiving Day for the turkey.”

Taleb is no Monday morning quant-jock. He first aired his skeptical perspective in 2001, when he authored “Fooled by Randomness: The Hidden Role of Chance in the Markets and Life.” In the words of Fortune Magazine, this book examined “luck perceived and disguised as nonluck (that is, skills), and randomness perceived and disguised as non-randomness (that is, determinism)”

Taleb reiterated and expanded this message in his 2007 best seller, “The Black Swan: The Impact of the Highly Improbable.”

So now that America’s epic financial calamity has validated Taleb’s anxious auguries, is there anything left to say or do?

The short answer is, “yes.” The longer answer is that he who fails to learn from history is doomed to repeat it.

“I am interested in how to live in a world we don’t understand very well,” Taleb explains, “While most human thought (particularly since the enlightenment) has focused us on how to turn knowledge into decisions, I am interested in how to turn lack of information, lack of understanding, and lack of ‘knowledge’ into decisions…My last book The Black Swan drew a map of what we don’t understand; my current work focuses on how to domesticate the unknown.”

With this message in mind, we appreciated reading the column below when it first appeared in the Financial Times of London on December 7. In fact, we found the column to be so worthwhile that we requested permission from Mr. Taleb, his co-author, Pablo Triana and the Financial Times, to re-publish it in the Rude Awakening.

Permission granted. Please enjoy.

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Guilty Bystanders
By Nassim Nicholas Taleb and Pablo Triana

On March 13 1964, Catherine Genovese was murdered in the Queens borough of New York City. She was about to enter her apartment building at about 3am when she was stabbed and later raped by Winston Moseley. Moseley stole $50 from Genovese’s wallet and left her to die in the hallway.

Shocking as these details surely are, the lasting impact of the story may lie elsewhere. For plenty of people reportedly witnessed the attack, yet no one did much about it. Not one of the almost 40 neighbours who were said to have been aware of the incident left their apartments to go to Genovese’s rescue.

Not surprisingly, the Genovese case earned the interest of social psychologists, who developed the theory of the “bystander effect”. This claimed to show how the apathy of the masses can prevent the salvation of a victim. Psychologists concluded that, for a variety of reasons, the larger the number of observing bystanders, the lower the chances that the crime may be averted.

We have just witnessed a similar phenomenon in the financial markets. A crime has been committed. Yes, we insist, a crime. There is a victim (the helpless retirees, taxpayers funding losses, perhaps even capitalism and free society). There were plenty of bystanders. And there was a robbery (overcompensated bankers who got fat bonuses hiding risks; overpaid quantitative risk managers selling patently bogus methods).

Let us start with the bystander. Almost everyone in risk management knew that quantitative methods – like those used to measure and forecast exposures, value complex derivatives and assign credit ratings – did not work and could provide undue comfort by hiding risks. Few people would agree that the illusion of knowledge is a good thing. Almost everyone would accept that the failure in 1998 of Long Term Capital Management discredited the quantitative methods of the Nobel economists involved with it (Robert Merton and Myron Scholes) and their school of thought called “modern finance”. LTCM was just one in hundreds of such episodes.

Yet a method heavily grounded on those same quantitative and theoretical principles, called Value at Risk, continued to be widely used. It was this that was to blame for the crisis. Listening to us, risk management practitioners would often agree on every point. But they elected to take part in the system and to play bystanders. They tried to explain away their decision to partake in the vast diffusion of responsibility: “Lehman Brothers and Morgan Stanley use the model” or “it is on the CFA exam” or, the most potent argument, “modern finance and portfolio theory got Nobels”. Indeed, the same Nobel economists who helped blow up the system at least once, Professors Scholes and Merton, could be seen lecturing us on risk management, to the ire of one of the authors of this article. Most poignantly, the police itself may have participated in the murder. The regulators were using the same arguments. They, too, were responsible.

So how can we displace a fraud? Not by preaching nor by rational argument (believe us, we tried). Not by evidence. Risk methods that failed dramatically in the real world continue to be taught to students in business schools, where professors never lose tenure for the misapplications of those methods. As we are writing these lines, close to 100,000 MBAs are still learning portfolio theory – it is uniformly on the programme for next semester. An airline company would ground the aircraft and investigate after the crash – universities would put more aircraft in the skies, crash after crash. The fraud can be displaced only by shaming people, by boycotting the orthodox financial economics establishment and the institutions that allowed this to happen.

Bystanders are not harmless. They cause others to be bystanders. So when you see a quantitative “expert”, shout for help, call for his disgrace, make him accountable. Do not let him hide behind the diffusion of responsibility. Ask for the drastic overhaul of business schools (and stop giving funding). Ask for the Nobel prize in economics to be withdrawn from the authors of these theories, as the Nobel’s credibility can be extremely harmful. Boycott professional associations that give certificates in financial analysis that promoted these methods. Remove Value-at-Risk books from the shelves – quickly. Do not be afraid for your reputation. Please act now. Do not just walk by. Remember the scriptures: “Thou shalt not follow a multitude to do evil.”

[Ed. Note: Nassim Nicholas Taleb is a professor of risk engineering at New York University PolyTechnic Institute. Pablo Triana is a derivatives consultant and author. His new book, ‘Lecturing Birds on Flying’, will be released in spring 2009.

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[Rude Endnote: We mentioned yesterday that we will be running our yearly “Best in Rude” series shortly. To vote for your favorite column, feel free to peruse our archives here and send your selection to the address below. Next week we will whittle down the nominations to a 2008 Rude Short List.

This might also be a good time to mention that our Agora Financial Reserve lifetime package is now accepting new members…though we may have to close the doors earlier than expected. This is the first time we’ve ever offered a $1,500 one-time dividend check, to be mailed Feb. 16 to successful applicants. Consequently, positions are filling somewhat quicker than expected.

To ensure you don’t miss out on this offer, please take a few moments to review the conditions of application right here. If you are already an existing subscriber to one of our services, this is doubly important, as account consolidation can considerably reduce your upfront cost. Again, the details are here, but you’ll want to be quick.

That’s all from us today. Tune in tomorrow for our regular weekly wrap and remember to cast your votes for this year’s Best in Rude at the address below.

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com