The FT’s “The Short View” columnist John Authers is blogging for FT Alphaville from Vancouver at the annual gathering of the CFA Institute:
Nassim Nicholas Taleb ended his speech by predicting that he already knew what the questions would be. And he indeed had a slide ready for the most popular question which was: “If you’re so clever, now that you’ve scared us so much, tell us what we should do to guard against black swans in future?”
Here is Taleb’s list of bullet points for action, from which he swiftly deviated as he warmed to his theme:
- Sharpe ratios (dividing a poprtfolio’s excess return over a risk-free rate by the standard deviation of the portfolio’s return) are a trap, because they do not predict future Sharpe ratios. So abandon them.
- Don’t use standard deviations, and instead use mean variation.
- Diversification doesn’t work. You might need as many as 12,000 companies before it truly works. Another example he uses is profits from the drug industry, which are concentrated in a tiny proportion of successful drugs – so you would need to buy a lot of drugs stocks to be truly diversified.
- As for derivatives: “Take a walk and see if you can rid yourself of the desire to use derivatives. It’s amazing how little people who claim to know derivatives really know derivatives.”
Perhaps the biggest point he tried to get across in his presentation is that the “black swan” term has been misunderstood. He does not mean that “black swan” events happen a lot, or more often than expected, but that when they do happen they will have truly huge consequences.
Also, he says, people do not understand the link with the concept of volatility. In a market, if returns do not follow a “normal” bell curve distribution (as appears to be the case), volatility will actually be less than the bell curve would predict. For much more than the predicted two-thirds of the time, returns will be very close to the average. Such low volatility, counter-intuitively, is a danger sign that there is a greater risk of true “black swan” events, when returns do deviate from the norm, because it shows that returns do not follow a normal bell curve.
His geopolitical analogy is with Italy and Saudi Arabia. Italy has had many different governments since the war, while the same family has retained power in Saudi Arabia. This means that Italy is the more volatile but, he says, that Saudi Arabia is more risky, because if something does change in the political situation there, it will have much greater consequences.
So on his argument, risk managers should penalise exposure to “tail risks” or extreme “black swan” events. They should not be worried about minimising volatility, as this is not a problem. But, he said in exasperated tones, “we seem to go the other way”.
That, at any rate, is a very brief summary of some of his main points from a long, dense and provocative presentation. He was at least proud that the black swan has now even given its name to a boutique in San Francisco (slogan: “Expect the Unexpected”).
And he did, on occasion, relent in his criticism of his hosts. When one delegate asked if he should bother coming to the rest of the conference, or just take the opportunity to explore Vancouver, Taleb urged him to stay in the conference hall and get more information.
“But if there’s an equation, try to close your eyes until it goes away.”