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In December 1996, just as the financial world began making value-at-risk a core component of its risk management practice, Nassim Taleb gave a scathing critique of VAR and its defenders. His interview, which was subsequently published on our web site, has probably captured more hits than any other derivatives page. In a debate in our April 1997 issue with Philippe Jorion, a professor of finance at the University of California at Irvine and author of Value at Risk, Taleb refined his position.
It was clear at the time that Taleb was directing his fiercest criticism at Long-Term Capital Management, then viewed as the ultimate advanced statistical trading firm.
Last year, Taleb started Empirica Capital in what he calls "the woods of the back country of Greenwich." He is also a fellow and adjunct professor of mathematics in finance at New York University's Courant Institute, where he teaches a class on model failure.
"When people ask me what alternative to VAR I have to offer, my answer is smaller leverage, less naive diversification, less reliance on dynamic hedging."
- December 1996, "The World According to Nassim Taleb"
"I believe that the VAR is the alibi bankers will give shareholders (and the bailing-out taxpayer) to show documented due diligence and will express that their blow-up came from truly unforeseeable circumstances and events with low probability--not from taking large risks they did not understand."
- April 1997, "Against VAR"
"The general adoption of value-at-risk by investors will lead to a generalized breakdown of correlations. There are two enemies we have in the financial market. One is excessive leverage based on measurement, even if it's initially the right measurement. The second one is the feedback effect that leads to what I call illusory diversification. Out activities may invalidate our measurements. All markets go down together."
- April 1998, Roundtable: "The Limits of VAR"
Derivatives Strategy: Your criticism of value-at-risk and quantitative risk management seems to have been borne out by events. Do you feel vindicated?

Nassim Taleb: Of course, but not directly surprised. As one of the many volatility traders who saw the collection of crises of the 1980s and 1990s, it was deja vu all over again. What surprised me is that I got no, or little, public recognition after the events. So many people who criticized me before the summer of 1998 were later discussing Long-Term Capital Management as a clearly predictable thing. I was angry and irritated by that.
Then I promised myself that it would not happen again.

DS: What would not happen again?

NT: That I would rely on people's good graces for my welfare, when there are so many better ways to benefit from their blindness. From now on, if I am right I want to focus on just making a buck for my investors instead of being diverted by idle debates with academics, semi-academics, regulators and risk system peddlers. I cannot possibly change their minds. I no longer want to wake up all excited, hoping to get a tap on my shoulder. There are a lot of people listening to the likes of [Philippe] Jorion out there and
I want them to help my investors make money.

DS: How can proponents of VAR help you make money?

NT: By peddling quantitative risk management that weakens financial institutions and causes or exacerbates crises. They believe we made a quantum leap in our civilization once we learned how to measure. There is no point arguing with him; I prefer to limit all my activities to making financial bets. And it is a fact that in spite of LTCM, quantitative risk management has been growing in popularity, which gives us a huge reservoir of trades.
DS: Is VAR growing in popularity?

NT: It was Keynes who said that much of economic policy is caused by the ideas of some dead economist, since it takes a couple of decades for their students to get to power. Likewise, people who studied Markowicz's modern portfolio theory are now getting senior positions and installing these tools in the workplace. Quantitative risk management is being taught everywhere. Look at the impact of the book Against the Gods, which sold 500,000 copies. Written by Peter Bernstein, a modern finance apologist, it convinced more and more people that odds in the market are computable just like a game of chance.
You still hear people in banks who use VAR telling you that it works most of the time, as if one should ride a plane that doesn't crash most of the time.


DS: What do you have against Markowicz and modern finance? NT: Markowicz wrote a summary of his ideas that starts with the following: "if you know E and VĄ­"--that is, the expected return and its variance (what later became the VAR). Given that we may not have a convincing way to know this E and his V, his entire work might be misplaced. Everything in modern finance relies on your ability to know and compute the properties of the returns. From where? Visibly not from the past. It would be so simple if we could measure future properties, but then life would be great if we could read into the future.

DS: In a word, what bothers you about LTCM?

NT: It is the excuse they gave after the fact, and their attitude that their science is above observation. Meriwether wrote a letter to his investors as they were blowing up asking for more money and explaining that "the trades will converge," rather than saying "may converge if we have the right model." Obviously he had (and probably still has) the wrong model. Such blindness also manifests itself with their econometrician saying it was a 10-sigma event. 10 sigma is supposed to occur so infrequently that the probability of having the wrong model is far, far greater. Every time you hear "10 sigma," beware the pseudoscience.
I am also annoyed with LTCM because when I introduce myself as a quantitative trader based in Greenwich, Conn., people think I am just like LTCM, when in fact I do diametrically opposite trades. I crisis-hunt.


DS: Crising hunting? So you are back to trading full time? How does it feel? Did your break help you?

NT: I returned in late 1997 after a two-year study sabbatical. I find trading far more pleasurable than writing and debating. In trading you can repeat the same trade with impunity; you get better as you become more familiar with it. In writing you feel somewhat that you may be uttering too many platitudes. People get tired of your ideas, even though it does not make you less right. Remember Derivatives Strategy got an angry letter in August 1998 by one Eric Falkenstein who said that I was getting tiresome? It was great timing!
The research break did help me in that I picked up techniques that make our trading closer to clinical research than, say, bank trading. I consider Empirica more of a research than a trading firm, except that the research is solely for our own consumption. We have created a link between our research and our trading, something that would be impossible to do in a bank. Being both the boss and the researcher, I can force the trading my way. Banks have difficulty integrating research into their trading. You have the researchers in basement C writing papers on the exact pricing of American puts (under the idealized normal distribution) while traders on the 32nd floor trade on pure hunches.
Finally, I am surrounded by people like me, who have both an obsessive deference to market dynamics and some respect for science. Mark Spitznagel, the Empirica senior trader, is both a former pit trader (in the bond future pit, no less) and a Courant graduate student in mathematics. If you find one of those hybrids, please send them our way.


DS: How is it going for Empirica so far?

NT: Well, distributions seem to have fatter tails than ever before. We had this year in the equity markets an extremely volatile three-month period (February through April), followed by an extremely unvolatile three months (June through August), followed by an even more volatile October. These are very rare by any historical norm, as traders went bust on both the short and the long side of volatility. Volatility is becoming more and more unpredictable and we like that. Correlation matrices are even more unusable than ever before. Everything people were taught about markets seems to be disputed by current events.

DS: How can you do quantitative research yet be so critical of quantitative finance?

NT: I called my company Empirica in deference to the philosopher of science Karl Popper, because we focus principally on what we do not know. We start every day telling ourselves that we have the wrong model, but that we should make the best of it without getting in harm's way. Our risk management is entirely qualitative, but our strategies are quantitative. This is the opposite of what financial engineers seem to currently do. They use quantitative methods to measure the risks, on the back of a style of trading that is largely unrigorous and archaic.

Nassim N. Taleb can be reached at NNTaleb@EmpiricaCapital.com.
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