Nassim Taleb: Renegade Trader with Renegade Ideas - That Work 32 comments
Guy Bennett
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Last month as the Dow dropped 20% and portfolios were battered, one investor was prepared. Nassim Nicholas Taleb, who founded the risk management firm Universa Investments, watched his portfolio soar 65% and 115%.
If Taleb’s name sounds familiar, that’s because his book The Black Swan: The Impact of the Highly Improbable spent 17 weeks on the New York Times Bestseller list.
Universa was launched in December 2007 with $300 million in assets. It is now estimated to be worth close to $2 billion. Technically Taleb is an “external advisor” to Universa, which is managed and owned by former professional trader Mark Spitznagel.
How did Universa Investments gain 115% in the vortex of the worst bear market in two decades?
Did they look into a crystal ball and see the credit crisis playing out as it has. Did they employ a room full of PhD chart wizards? The answer is “no”.
Universa’s trading theories are based on Taleb’s ideas about profiting from rare events – or “Black Swans.” When those rare events occur, they are in for a big payday.
In this case, Universa purchased far out-of-the-money “put” options on stocks and broad market indices. A put option gives the owner the right, but not the obligation, to sell an underlying asset at a set price within a specified time period. It’s a bet that a stock or market is going down.
For the past year, Universa has been betting that the market would take a radical turn for the worse. I made the same call (“Why The Dow is Going to 8,000”) back in July, but I didn’t have $300 million to back up my prediction.
Universa makes a lot of small bets and watches most of them go bad. However, when one hits, it’s big.
The foundation of Taleb’s strategy is revealed in his first book, Fooled By Randomness. It’s required reading material here at Q1 Publishing. Here is the core of Taleb’s philosophy:
We are genetically still very close to our ancestors who roamed the savannah. The formation of our beliefs is fraught with superstitions. Just as one day some primitive tribesman scratched his nose, saw rain falling, and developed an elaborate method of scratching his nose to bring on the much-needed rain, we link economic prosperity to some rate cut by the Federal Reserve Board.
Taleb’s assertion that people will frantically search for - and find - causal connections where none exist, leads to the second leg of his investing theory: investors are so programmed to seek order that they neglect to account for rare or “random” events. In fact, scientists - who are trained to think analytically - will often discard data that falls outside a statistical norm. When confronted with an anomaly, they throw up their hands and say, “This is crazy, so let’s not count it.” Instead of, “Apparently crazy things happen, let’s factor it in.”
“The typical case is as follows. You invest in a hedge fund that enjoys stable returns and no volatility, until one day, you receive a letter stating, ‘An unforeseen and unexpected event, deemed a rare occurrence…’ However, rare events exist precisely because they are unexpected. They are generally caused by panics, themselves the results of liquidations.”
Taleb’s hedge fund exploits investors’ reluctance to factor in random events, which he traces to deeply rooted narcissism. Wealthy people, for instance, invariably assume they gained their wealth through skill, knowledge and hard work. That may be true in some instances. However, the fact remains, if you invite 1,000 monkeys to play roulette, 10 of them are going to end up fabulously rich.
Universa keeps 90% of its assets in cash or cash equivalents and simply tries to break even as it places small bets on rare events.
Five weeks ago when the S&P 500 was trading around 1200, Universa bought S&P 500 Index put options with a strike price of 850, due to expire late October. They were betting an “unlikely” drop would occur.
They paid around 90 cents for those options. By Oct. 10, the S&P had dropped 300 points in a month. The options Universa purchased for 90 cents were now trading for $60 each. Universa cashed out of its position around $50, good for a gain of 5455%.
Universa also paid $1.29 for a put option on the insurance company AIG. They’d be in the money if AIG dipped below $25 a share by September. AIG imploded in a tangle of bad debt and Universa sold the AIG put options for $21 apiece.
Most of the time, Taleb simply stands on the sidelines. He’s one of the few money managers with the patience or the inclination to make allowances for rare events. He first made a killing when the stock market crashed in 1987. Typically, Taleb has a couple of big wins a decade.
Taleb’s views on risk are starting to attract a lot of attention. He received a $4 million advance for his next book. He also teaches mathematical finance at
Former Federal Reserve Chairman Alan Greenspan probably wishes he’d read Taleb’s book. He recently admitted to Congress that there was a “flaw” in his financial strategy that contributed to a “once-in-a-century credit tsunami.”
“I was shocked,” said Greenspan, referring to the recent market meltdown, “because I’d been going for 40 years with evidence that it was working exceptionally well.”
In other words, Greenspan failed to factor in the likelihood and impact of a rare event. In this case, it was a meltdown in real estate that not only brought down real estate values and REIT share prices, but the entire global economy, as well.
Taleb’s strategy isn’t for everyone. It takes patience to wait around for a rare event. However, when that event happens it can be very profitable.
The “get rich quick” bull market is over. It’s a different ball game now. There is a historically proven, conservative investing strategy that will help you to rebuild your portfolio. Taleb’s big October win reminds us that successful investors seldom follow the herd.
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This article has 32 comments:
I have read both his books "Fooled by Randomness" and "The Black Swan" and have found them to be life changing. Investing literally makes more sense after reading his books. In my opinion, this man does a better job (then anybody on the face of this planet) of explaining the role that luck plays in all our endeavors .
Taleb doesn't try to predict Black Swan (rare random) events, he just believes that most of society puts too much emphasise on empirical evidence. In other words, be a little less sure of yourself...always be prepared. This is why the stock market is known as the great humbler.
My point is this: If you play any casino game long enough the house is going to make the vigorish and you are going to lose it. Taleb makes hundreds of bets and most lose small and a few win big. If he can make money doing that it means that the options he is buying, in the aggregate, are underpriced while the big winners are overpriced. It's either that or Taleb has enough prediction abilities to milk a fair system. This last is doubtful by his own admission.
Taleb should probably shut down Universa Investments when the bear market ends. In a bull market the mis-pricing of put options might not be enough to make money his way. Last year I was buying out-of-the-money call options and did quite well. That ended with the onset of the bear market. During the bear market I'm making money selling call options. Buy the bull and sell the bear.
>>>What's he say to do now? If his portfolio is up 100% plus in the past few months, shouldn't he take profits off the table? <<<
Taleb does not have a portfolio in the traditional sense. You must have missed the following:
"Universa keeps 90% of its assets in cash or cash equivalents and simply tries to break even as it places small bets on rare events."
So his winnings "are" off the table already.
Unless we understand the underlying causes of the current financial crisis, we are certain to repeat them. And, unfortunately, even when we learn the lessons, we seem to forget in a very short period of time.
On Nov 09 10:23 AM Gtarras wrote:
> Is not Universa the reason Taleb is suddenly all over the place with
> "doom and gloom" predictions? I am curious if Dr Roubini and others
> in the same camp have vested interests in destroying the financial
> system?
I read all three of his books. His black swan theory applies to life style as well as living. I was diagnosed with cancer 6 years past so that was my black swan. For me, gambling and greed preempts risk averse tatics.
Now i'm paying the price. My new life was to begin Jan. 09. that is gone.
As a christian (also republican) i must take responsibility for my actions.
It saddens me deeply. No bailout for me, only work.
waynei
His fund has gone from 300 million to 2 billion in 22 months. Where are the super bowl funds done that have beaten that record?
The kicker is that this strategy only works because most traders are addicted to the the entertainment value of gambling in the markets - very entertaining but a sure loser long term. Look at Cramer, the biggest loser of them all, and the most entertaining.
If you look into the really serious research that has been done on mechanical trading systems, they all point to the same answer: the more boring the system, the more money it makes. The best mechanical systems lose money most of each year, but the few winning streaks that occur make up for all of the small losses.
how true.
i would like to point out that the reason you can make money in a black swan event is that risk has not been properly quantified by one party to the benefit of the other. if the probability of an event was properly assessed Taleb would over time see zero gain to this strategy. what he is exploiting is an error in someone's risk assessment.
So why are there no profitable hedge funds in 2008?
Incidentally, wouldn't it be a hoot if Taleb's fund bought some of those long-term stock market puts that Buffet sold?
So why are there no profitable hedge funds in 2008?
Incidentally, wouldn't it be a hoot if Taleb's fund bought some of those long-term stock market puts that Buffet sold?
If that was the case, then why did tens of millions of Americans lose $100's of billions in their 401(k)'s? If it was so obvious that there was going to be a market crash (of sorts) why didn't the leaders at AIG buy all kinds of puts on Bear Stearns thus preventing AIG from becoming practically insolvent?
You, max, are making the same error that Taleb warns about in his books. You now have the benefit of hindsight, thus you are now able to post seemingly intelligent, cynical posts. You say that "this wasn't a Black Swan at all." But, it was, because no one knew when or where or in what form the fall would come - if it would at all...
And if you want to get even more picky, you could say that a Black Swan event is one that fools most of the people most of the time. I would say that most people had no idea. I still chuckle when I think of all the people that there were predicting a downturn to low 10,000's and then back on to DOW 20,000.
You have a historical bias, and Taleb would disapprove.
On Nov 09 07:43 PM max Zeledon wrote:
> Cute article. But here is the only problem with this story: The subprime
> crisis and stock meltdown was not a Black Swan--everyone with half
> a brain and some common sense not to trust quant models or Wall Street
> charlatans knew what was coming over a year ago. The hedge fund managers
> I know were short 15 months ago. This was not a black swan.at all.
> The only ones who didn't know anything was CNBC and Jim Cramer!
The remarkable fact is that legions of acclaimed pundits and policymakers either failed to realise the obvious, or found the preceding party so alluring that they preferred not to see the elephant walking into the room.
Most of the time the market will go up. Therefore, any fool should know that its better to invest when the market is going up rather than wait for the once in while downturns and buy puts. Better still invest both in bull and bear markets; no need to discriminate just get the direction right. I don't understand how people can believe something that so blatantly flies in the face of logic.
And this sort of bear market bet he made is not his only strategy. The vast majority of the money is kept safe while a small portion is used to make risky bets. This can be getting in early on a future positive black swan, like the next google. He favors tech and ingenuity. Anything that involves tinkering.
He recomends staying away from businesses that bet against a black swan occurance, such as insurance and banking. Eh, just read the book. It's very, very nuanced. And finance is just a small part of it.
On Nov 09 11:23 AM captainccs wrote:
> It takes a very special kind of personality to be able to lose time
> and time again, hundreds of times, before getting a win. Also, there
> is no way to predict these rare and unusual results so what Taleb
> is really playing is the mis-pricing of options. Playing options
> with Black-Scholes is like playing carps with loaded dice.
>
> My point is this: If you play any casino game long enough the house
> is going to make the vigorish and you are going to lose it. Taleb
> makes hundreds of bets and most lose small and a few win big. If
> he can make money doing that it means that the options he is buying,
> in the aggregate, are underpriced while the big winners are overpriced.
> It's either that or Taleb has enough prediction abilities to milk
> a fair system. This last is doubtful by his own admission.
>
> Taleb should probably shut down Universa Investments when the bear
> market ends. In a bull market the mis-pricing of put options might
> not be enough to make money his way. Last year I was buying out-of-the-money
> call options and did quite well. That ended with the onset of the
> bear market. During the bear market I'm making money selling call
> options. Buy the bull and sell the bear.
Let's suppose there are two players in the options market, Taleb, the put buyer and Aladdin the put seller. If Taleb is a winner then Aladdin must be a loser because options is a zero sum game. My contention is that Taleb is a winner because the option pricing model is wrong and Taleb certainly agrees with that since it is based on Gaussian distribution. Using a different option pricing model, Aladdin might become the winner and Taleb the loser.
In other words, Black Swans are irrelevant to Taleb's options strategy. He just found a very round about way to discover that the Black-Scholes option pricing model does not produce a fair price. What Taleb discovered is that stocks rise and fall with the market, some more than others. I'm fairly certain that once the bear market ends so will Taleb's run. His 90% cash position is what is going to save his fund.
On Nov 10 01:26 AM jvi wrote:
> Taleb specifically warns against comparing reality to a casino game.
> He calls it the ludic fallacy. Google it.
>
> And this sort of bear market bet he made is not his only strategy.
> The vast majority of the money is kept safe while a small portion
> is used to make risky bets. This can be getting in early on a future
> positive black swan, like the next google. He favors tech and ingenuity.
> Anything that involves tinkering.
>
> He recomends staying away from businesses that bet against a black
> swan occurance, such as insurance and banking. Eh, just read the
> book. It's very, very nuanced. And finance is just a small part
> of it.
You read Taleb to gain an overall perspective of the market - white swans can keep coming long after the black swan hunter is bankrupt.
Taleb's main contributions are (1) style, and (2) highlighting that black swans exist when there's been too many white swans in the sky.
On Nov 09 11:21 AM softomic wrote:
> I loved the book Black Swan and I am a big fan of Taleb. What's he
> say to do now? If his portfolio is up 100% plus in the past few months,
> shouldn't he take profits off the table? You know that making money
> isn't so hard, as long as you know when to sell. Also, black swans
> "turn white" once they are discovered so be wary. I have read about
> lots of fund manager, who are good at managing growth of a multi-million
> dollar funds, but find that they are lost when the stakes go up.
> For some reason picking winners doesn't scale well when your NAV
> grows 10X or even 100X, so congratulations to Universa, however,
> now might be a good time to take the money and run.
I am long on Taleb... My bet is that if he still cares to dabble in the market he will still be way up...
As to a Hyperinflation scenario, he has enough rare first editions to sell to the less fortunate for their bullion coins..
Well for starters, a 300 mio fund that is up 115% does not get to a couple of billion unless its seeing inflows. Why is one reader impressed with the gains? Money is flowing to him as a hedge against the long only manager. It will flow out just as fast when the market stabilizes.
Second, where is his cash invested? with Lehman, Bear, AIG? Those are the better black swan trades.
Third, this joker has no idea how to parlay his winnings. To make money when you have trades that are making 6600%, 1530% and 5455% respectively but you are only up 115% means that you either have some real dog trades or you have no idea how to size trades in a portfolio. Look to manager like Soros and John Paulson to see how to make money from your profitable trades. Leverage does not have to be there on the way in, but once you are winning- press!