As a derivatives trader he puts his money where his mouth is, and used Black Swans as the centre of his work philosophy. While unable to build a career betting on black swans, with the opinion there are not enough tradable opportunities, he avoided being exposed to them by protecting the portfolio against large losses.
In order to eliminate the dependence on randomness, Taleb focused on the technical inefficiencies between complicated instruments, and on exploiting these opportunities without exposure to the rare event. He is a co-director of the Decision Research Laboratory at the London Business School and one of its research programs, “We Don’t Quite Know What We Are Talking About When We Talk About Volatility”, examines fund managers making mistakes in defining volatility.
This research concludes that finance professionals, who are regularly exposed to notions of volatility, seem to confuse mean absolute deviation with standard deviation, causing an underestimation of 25 per cent with theoretical Gaussian (or normal distribution) variables. His research shows that in some ‘fat tailed’ markets the underestimation can be up to 90 per cent, but concludes that a lack of statistical knowledge does not appear to be the impediment, but rather a difficulty in translating a nonlinear measure into a real-world application.
In this book, too, he tackles distribution models and goes so far as to warn readers of “experts” who are charlatans who believe in bell curves, in which most distribution is to the centre – ordinary and knowable. Instead Taleb argues that in order to understand a phenomenon, the extremes need to be considered, particularly if they carry a cumulative effect.
In this way, he argues the unexpected is the key to understanding financial markets, but also more generally, to understanding history. And while on the surface it is true no one can look into the future, or indeed predict events that occur outside the square, the message for our industry may be that those that are aware that not all risks can be measured, predicted or accounted for, may be better off. In a time where risk measurement and budgeting is a key focus, isn’t it better to consider there are more risks than less?
Other papers Taleb has co-authored a the London Business School include: ‘Why We Have Never Used the Black-Scholes-Merton Option Pricing Formula’; ‘The Illusions of Dynamic Replication’; and ‘Finiteness of Variance is Irrelevant in the Practice of Quantitative Finance’.