Posts Tagged ‘Nassim Nicholas Taleb’

Epistemic arrogance, running through traffic lights & Black Swans

Thursday, November 25th, 2010

Today, we received an email from one of our readers. After reading Failure to understand Black Swan leads to fallacious thinking, this is what he thought:

I liked your use of the term “Epistemic arrogance”. Recently I was driving and almost ran straight through a red light at a pedestrian crossing and I was trying to think how I could have been so reckless. I mean I am a great driver (?) and I had been down that road numerous times, yet I still almost managed to run down an almost-unfortunate couple. Sure the red light is in a seemingly random position, and the green light at the intersection 50m down the road can cause very slight confusion, but a red light is a red light.

Its then I theorised the issue. If it was my first time driving, or my first time driving down this road, there would be no way that I would have missed this red light. I would watch out for all hazards because I know that I don’t know. An arrogant driver on the other hand, as I was, thinking they know the lay of the land, can get into strife when the unexpected (in their mind) pops up.

Its this “epistemic arrogance” which leads the learned to cause crashes and accidents… I’m sure there are many top minds in the world who fail to look beyond their view… Learning from one’s mistakes is a great way to improve your management of risk!

This is a very great point. And by the way, it is Nassim Nicholas Taleb that came up with the term “”epistemic arrogance.”

We also have an example that is relevant to investing. Marc Faber once mentioned that the financial valuation of asset prices severely underestimate the possibility of geo-political Black Swans. The recent North Korean artillery pot-shots at their southern neighbour is a case in point. The US and South Koreans are planning to hold military exercises this coming Sunday in response to North Korea’s provocation. The North Korean had already warned repeatedly that they will be provoked with such actions, especially when they are happening so closely to the border. With a juvenile rookie dictator-in-waiting probably calling the shots in Pyongyang, we wonder at the wisdom of the American and South Koreans.

The Korean peninsular is just one example of geo-political Black Swans. We can also include Afghanistan, Lebanon, Iran, Pakistan as well.

How should you go about investing in silver?

Friday, July 10th, 2009

After having read our series of articles on silver, you may wonder how you should go about investing in silver. Knowing about the potential for silver prices to sky-rocket is one thing. Benefiting from it is another. Today, we will go into that.

First, as you may already have known by now, when we used the word “silver,” we mean physical silver bullion. Financial assets disguised as silver (e.g. silver ETF, silver certificate, etc), at the end of the day, are just paper assets- they are not the real thing. This is especially true for silver ETFs. For example, in the SEC filings for the iShares Silver Trust, it has clauses that say something like “the liquidity of the iShares may decline and price of the price of the iShares may fluctuate independently of the price of silver and may fall” and the “iShares are intended to constitute a simple and cost-effective means of making an investment similar to an investment in silver.” Silver paper assets are great for trading silver, but you may not want them as long-term investments.

Next, if you are very sure that silver prices will roar mightily in the future, should you pour all your life savings acquiring it?

To answer this question you have to understand that investing in silver falls under the Black Swan investment category. For those who haven’t already, we urge that you read Failure to understand Black Swan leads to fallacious thinking first. We encounter frequent and stubborn misunderstanding of the concepts of Black Swan. As we wrote in that article,

As we talk to more and more people, we encounter a very frequent lack of understanding of Black Swans (for those who wants to learn more about Black Swans in detail, we recommend this book: The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb). As a result, many people have this erroneous belief that contrarians are predictors of gloom and doom. The more entrenched this lack of understanding (of Black Swans) is, the deeper the fallacy one will fall into. This lack of understanding will degrade the quality of one?s thinking, which can translate to severe financial loss when investing.

Today, we will again attack the stubborn entrenchment of this conception black hole.

Many people have heard of and read Nassim Nicholas Taleb’s book, The Black Swan: The Impact of the Highly Improbable. But not many really understand it properly. It took us a few re-readings of Taleb’s winding meandering prose to fully grasp the concept of Black Swans. If you have not read Failure to understand Black Swan leads to fallacious thinking, please read that first…

… now that you have read that article, you should be able to appreciate this fact: when we talk about the potential of silver prices to explode, we are not making a ‘prediction’ of the future. As we wrote in that article, a parachutist packing a backup parachute is not making the ‘prediction’ that his primary parachute will fail. The backup parachute is there to ensure his survival should his primary parachute fail, which is unlikely based on statistical probability. In the same vein, based on statistical probability, it is improbable that the silver fuses (that we wrote before) will light up because it had not happened before. But should the fuses light up, you can be sure that the price impact will be massive.

Therefore, to profit from Black Swan investing, you have to implement an asymmetric pay-off strategy. This idea is very similar to the one that we wrote in the guide, How to profit from a stock market crash?. As we wrote in this article in that guide,

The basic idea behind the asymmetric payoff strategy is simple. First, you structure your bet in the market such that if you lose the bet, your loss is very tiny, but if you win, your gain is very massive. Next, you bet that the market will crash within a specific period of time. If you lose that bet, place another bet for the next period of time. You do this repeatedly until the day of the Black Swan event when your profit overwhelmingly overshadows your accumulated small losses.

Obviously, the disadvantage of this strategy is that it requires fortitude to absorb small losses indefinitely while waiting for a highly rewarding final vindication in the end.

In the same vein, investing in silver means accumulating it slowly, bit by bit and patiently waiting for the silver fuse day. Because you are investing one tiny bit at a time, it should not have any material financial impact on your day-to-day life. In other words, you are investing with your ‘loose change.’

Maybe the day of silver fuse will never come. In that case, the most you will lose are your ‘loose change.’ But should the day of silver fuse arrives, your ‘loose change’ is going to be worth many times over, maybe even a fortune.

Remember, do not bet a large chunk of your life savings into the silver fuse story.

Why do some black box strategies that ‘worked,’ stop working when you use it?

Thursday, May 14th, 2009

Let’s imagine you come across an online advertisement that tries to sell you a ‘secret’ trading technique that brought investors untold returns over the past, say 20 (or 30 or 40 or whatever) years. That technique is based on complex black-box algorithm that involves processing huge amount of data. The underlying message from the advertisement is that since this technique is successful over so many years, it is one that ‘works.’ That advertisement may show you past trading records and perhaps even back-tests of that technique.

Impressive isn’t it?

How was the ‘secret’ trading technique derived? Such advertisements will usually claim that the ‘soundness’ of the techniques are based on studying the market over a long time and ‘proven’ by the ‘stellar’ performance of the technique. But in reality, such ‘proofs’ are an illusion. Let’s turn to the Chapter 1 commentary of Benjamin Graham’s The Intelligent Investor:

?If you look at a large quantity of data long enough, a huge number of patterns will emerge?if only by chance. By random luck alone, the companies that produce above-average stock returns will have plenty of things in common. But unless those factors cause the stocks to outperform, they can?t be used to predict future returns.

This is the basic thesis of Nassim Nicholas Taleb’s book, Fooled by Randomness. Therefore, buyers beware!

Fund managers bewildered by Bell curve breakdown

Tuesday, November 4th, 2008

Today, we will talk about the Bell curve again. As we quoted Nassim Nicholas Taleb in How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud,

So the Gaussian [Bell curve] pervaded our business and scientific cultures, and terms such as sigma, variance, standard deviation, correlation, R square, and the eponymous Sharpe ratio, all directly linked to it, pervaded the lingo. If you read a mutual fund prospectus, or a description of a hedge fund?s exposure, odds are that it will supply you, among other information, with some quantitative summary claiming to measure ?risk.? That measure will be based on one of the above buzzwords derived from the bell curve and its kin. Today, for instance, pension funds? investment policy and choice of funds are vetted by ?consultants? who rely on portfolio theory. If there is a problem, they can claim that they relied on standard scientific method.

For the mainstream money-shuffling professionals in the finance industry, their training are rooted on the Bell curve. The Bell curve was formulated back in early 19th century by a mathematician named Carl Friedrich Gauss. It gave a ‘structure’ for systematically evaluating risk and estimating probability. It is the root of mainstream finance and economics and is used everywhere, from options valuation, risk management and measurement, forecasting, portfolio allocation and so on.

There is an underlying assumption with the Bell curve. As Peter Bernstein wrote in his book, Against the Gods- The Remarkable Story of Risk,

… two conditions are necessary for observations to be distributed normally, or symmetrically, around their average. First, there must be as large a number of observations as possible. Second, the observation must be independent, like rows of the dice…

People can make serious mistakes by sampling data that are not independent.

In today’s volatile financial market, price movements are not independent. As we mentioned in Fading glory of the financial services and ?wealth? management industry, October 2008 saw the most fear and panic in the financial markets. We see instances whereby highly leveraged funds have to sell because prices are falling, which in turn depresses prices further. Traders and investors, being confused about what is going on, reacted as prices moved, which in turn leads to more price movements. Funds have to liquidate their positions because investors are demanding redemptions due to falling prices, which in turn lead to more falling prices. Central bankers, governments and regulators observed the behaviour of the financial markets and reacted accordingly, while the markets observed and reacted according to authorities’ reaction. New information about the economy are confusing, contradictory and yields no insight, therefore forcing market participants to base their decision on other participant’s reaction. If price movements are not independent, this basic assumption of the Bell curve breaks down. If so, then all these financial theories that the finance and economics industry rely on breaks down as well.

Assuming that governments are going to fight vigorously the natural deflationary forces with inflation, we can expect more confusion and volatility ahead. Meanwhile, there will be more soul-searching, witch hunts and re-evaluations in the finance and economics industry.

Do property price always go up?

Monday, August 25th, 2008

One of the most entrenched superstitions is that property is a safe and secure asset class that always go up in price over time. It has come to a point that some people believe that property prices never come down. Some people will even cite the trend of the past 10 years to prove the point of this superstition.

But as Nassim Nicholas Taleb said in his book, The Black Swan: The Impact of the Highly Improbable, all you need to prove that not all swans are white is to find a black swan. In the same vein, all we need to prove this superstition false is to come up with examples of the opposite happening. The fact is, history is on our side- with the bursting of the Japanese bubble economy of the 1990s, property prices in Tokyo was said to have collapsed by 70% over the course of the decade. As of today, median house prices in the US has fallen around the order of 15% in one year.

For today’s article, we will draw out another big gun to blast away this superstition. At the beginning of the year, the ABC had a documentary about 350 years of Dutch experience- Dutch history pointing to real estate fall. In that documentary, it reported

The house sugar merchant Cornelis Sasbout built in 1617 at number 150 on Amsterdam’s Herengracht canal tells a cautionary tale about investing in property – prices fluctuate wildly, but are ultimately flat.

In that documentary, when it said “flat” prices, it means “flat” in real terms.

Mind you, the Herengracht is not some piece of forsaken real estate built in the middle of nowhere. It is a prime real estate for over 350 years, as this documentary reported:

Eichholtz says what makes his index stand out from house price histories in other cities is what he calls “constant quality” – the Herengracht has always been prime real estate. The index corrects for rising consumer prices but not wages.

What is the lesson here for Australia? Well, Australia is still sitting on an unprecedented debt bubble. For those who still need convincing, please take a look at Professor Steve Keen’s scary debt charts at Debtwatch No. 25: How much worse can ?It? get? and our commentary at Aussie household debt not as bad as it seems?. When the debt bubble burst eventually, we can be sure the frequently parroted justifications of this superstition (e.g. housing ‘shortage,’ immigration, etc.) will be revealed as hogwash. We would love to see those ‘experts’ who wrote reports that justify this superstition be paraded as clowns when they are proved wrong in due time (see Another faulty analysis: BIS Shrapnel on house prices).