September 21, 2019

The Black Swan Swims with the Fishes

The Godfather

When Victor Niederhoffer called Nassim Taleb, "The Black Swan" author, to his Connecticut mansion in 2002, who was teaching who?

When one of the most successful hedge fund managers blows up, the investment world takes notice. Victor Niederhoffer is one of the legends of Wall Street but had two funds completely collapse. Even today, with the recent $2 billion loss by J.P. Morgan, the focus is on risk management. That’s where Nassim Taleb comes in.

Taleb is the author of Fooled by Randomness and The Black Swan, with the latter hailed by The Sunday Times as one of the twelve most influential books since World War II. Taleb’s basic premise is that small probabilities of disaster happen much more often that would be expected – and help explain financial busts.

Niederhoffer was so different than Taleb’s risk-averse ways and the message seemed to be that the Black Swan swims with the fishes. But history isn’t done with the two hedge fund managers.

Malcolm Gladwell wrote a piece in The New Yorker in 2002 chronicling Taleb and Niederhoffer’s overlapping lives. It’s well-worth, well, at least reading my summary.

One day in 1996, a Wall Street trader named Nassim Nicholas Taleb went to see Victor Niederhoffer. Niederhoffer was one of the most successful money managers in the country. He had just written a best-selling book, “The Education of a Speculator”.

“He didn’t talk much, so I spent seven hours watching him trade,” Taleb recalls. Taleb is Greek-Orthodox Lebanese and his first language was French, and in his pronunciation the name Niederhoffer comes out as the slightly more exotic Nieder hoffer. “Here was a guy living in a mansion with thousands of books, and that was my dream as a child.”

So here is what Taleb took from Niederhoffer: He saw that Niederhoffer was a serious athlete, and he decided that he would be, too. He would bicycle to work and exercise in the gym. Niederhoffer was a staunch empiricist, who turned to Taleb that day in Connecticut and said to him sternly, “Everything that can be tested must be tested,” and so when Taleb started his own hedge fund, he called it Empirica. But that is where it stopped. Nassim Taleb decided that he could not pursue an investment strategy that had any chance of blowing up.

Taleb lives in a four-bedroom Tudor with and four thousand books. He runs Empirica Capital outside Greenwich. Taleb sits in one corner, in front of a laptop, with Mark Spitznagel, the chief trader, close by. Empirica trades in options, making indirect bets on stocks and bonds. The fund runs on the premise that there are many more outlying events, or “black swans” than statisticians used to modelling the physical world would have imagined.

Taleb trades based on the existence of black swans – on the possibility of some random, unexpected event sweeping the markets. He never sells options, then. He only buys them. He’s never the one who can lose a great deal of money if G.M. stock suddenly plunges. Nor does he ever bet on the market moving in one direction or another. So he buys options on both sides, on the possibility of the market moving both up and down. So Taleb buys out-of-the-money options by the truckload. He buys them for hundreds of different stocks, and if they expire before he gets to use them he simply buys more. Taleb doesn’t even invest in stocks, seeing them as a gamble. So all of Taleb’s personal wealth and Empirica’s hundreds of millions in reserve are in Treasury bills.

Taleb buys options because he is certain that, at root, he knows nothing, or, more precisely, that other people believe they know more than they do. He distinguishes himself from the traders he used to work with at the investment bank First Boston whose traders wore Saville Row suits and Ferragamo ties. Taleb was confused by their all-consuming urge for market news.

But there is something else that explains Taleb’s shrugging off the conventional wisdom of the markets. It happened a year before he went to see Niederhoffer. Taleb had been working as a trader at the Chicago Mercantile Exchange, and developed a persistently hoarse throat. At first, he thought nothing of it: a hoarse throat was an occupational hazard of spending every day in the pit. Then he went to see a doctor: he had throat cancer. Taleb was young – he had never smoked. He was a black swan! The cancer is now beaten, but the memory of it is also Taleb’s secret, because once you have been a black swan — not just seen one, but lived and faced death as one — it becomes easier to imagine another on the horizon.

we are drawn to the Niederhoffers of this world because we are all, at heart, like Niederhoffer: we associate the willingness to risk great failure — and the ability to climb back from catastrophe–with courage. But in this we are wrong. That is the lesson of Taleb and Niederhoffer, and also the lesson of our volatile times. There is more courage and heroism in defying the human impulse, in taking the purposeful and painful steps to prepare for the unimaginable.

Even though this story is ten years old, my grandmother likes to say, Those who forget history are bound to repeat its mistakes. Gladwell since those years has turned into a consistent #1 New York Times bestselling author. Taleb’s early observances are taken into account by Wall Street firms and his books are sometimes required reading. Meanwhile, he teaches on the side. Niederhoffer is still running money and maintains an investing blog, Daily Speculations. So early doubters who may have said that the Black Swan swims with the fishes, can look at Wall Street’s huge losses to realize his prescient warnings.

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