I want to steer clear of critiquing the work of others but my comments on long odds seem to have evoked a torrent of emails about Nassim Taleb and his work on randomness and black swans. Let me start off by sketching the points on which we agree. I think that Taleb is absolutely right that we (in academic finance and model building) have become enamored with normal distributions when building models. The real world delivers far more jumps, surprises and asymmetric movements than can be justified by a normal distribution. I also believe that what Taleb is saying was said much better by Benoit Mandelbrot several decades ago, in his argument for power distributions (which allow for bigger jumps than the normal distribution). My book on strategic risk taking has an extended discussion of Mandelbrot's work.
Here is where I part ways with Taleb. While I agree that we are always susceptible to the unforeseen event (the black swan), I do not subscribe to his prescriptions. The first one (and I may be mistaken in this) is that planning, forecasting and valuation are useless since they will all be rendered to waste by the "black swan'' event. This is the equivalent of arguing that it is pointless planning and saving for retirement, since you may be hit by lightning tomorrow... logical, maybe, but not very sensible. The second one is that you can somehow make money off the fact that model builders have a normal distribution fixation.. Taleb argues that since models are built upon normal distributions, investors can make money by buying out of the money options and other investments that profit from big moves. I think that the mistake here is assuming that people who build models actually set market prices. If markets reflect reality rather than models, there should be no scope for profits.
Here is what I think. We have to make our best estimates of the future and value assets accordingly. We have to assume that there will be shocks to the system that we cannot anticipate and build an appropriate risk premium to reflect these risks. We cannot plan for the unforeseeable... and live our lives expecting black swans to show up..
Very good post.
ReplyDeleteFrom my interpretation Taleb's strategy appears to be a modified form of gambling and certainly not investing. You are only trying to skew the averages with payoffs from improbable events that greatly outweigh costs incurred. This is not a criticism as I think Taleb's methods have some intellectual basis and, from a probability standpoint, can be very rewarding. But one should never confuse an absolute 'Black Swan' approach with investing.
I agree with you Sir. We can nly make "informed guessess" about the future and hence the relevance of Financial Modelling.
ReplyDeleteInfact, the IT age's importance lies from it's promise of enhancing knowledge for better guesswork!!
I like to see value as a function of people’s beliefs and expectations.
ReplyDeleteSince these two may change suddenly and radically, although it doesn’t happen that frequently, the same may happen to value.
That’s why we se events like those from recent days.
And the fact that life is like this doesn’t mean that we should not estimate value.
It’s just important to remember that whatever estimate we reach, it’s subject to change suddenly. Quite uncomfortable, but that’s the way it is.
I feel Taleb's strategy is not just about buying plain OTM put and calls on random assets and waiting for miracle (black swan).
ReplyDeleteWhat he tries to prove is that we underestimate (financial / non-financial) "unknown unknowns" of this world; leading to anomalies which can be exploited with 'Black Swan' strategies.
Also I believe that the Taleb’s true intention while ridiculing conventional financial models is to emphasize that understanding the limitations and flaws in financial models is more important than trying to create a seemingly perfect model which eventually fails.
Well at least he successful in making money out his theories ... check out this link
I very much apreciate Taleb's view.
ReplyDeleteWhy FED bailed out AIG?mzx
.....tooo much risk assumed without capital base.
Dear Prof. Damodaran,
ReplyDeleteWith due respect, you can plan for the unforeseen.
1. Buy insurance for your car.
2. Buy insurance for your house.
3. Stay as close to very high variable cost but low fixed costs companies who always 'rent' and never binge on 'credit'
4. Work for such a company
5. Own such a company
And voila! You're a billionaire!
oy veh, looks like my idea to title a critique of Taleb "The White Swan, the Black Swan, and the Blue Swan" has already been taken, maybe I'll go ahead with my post and pretend I never saw this...
ReplyDeletePhillipCharles: what IS the difference between gambling and investing (aside from the fact that in investing you don't quite know the probabilities but the odds are probably in your favor and that in gambling you know the odds are against you)? You're still betting on outcomes.
finiverse: you can't plan for the unforeseen, that's a contradiction in terms. If you planned for it, you foresaw it (i.e. considered it a possible event). Also, your formula is misconceived and simplistic. If there were such a way to become a billionaire, more people would do it, filling up the demand.
Totally idiotic. There is no such thing as a risk premium, nor an average cost of capital, nor pricing in this risk or that. The concept of an absolute or precise valuation is an illusion. There is no formula that will give you a discount rate with which to assess an assets value (as Prof. D. falsely postulates in his little book on valuation, better used as a paper weight).
ReplyDeleteStep back, forget the math and your fancy degrees for a second and come join us in the real world: trying to avoid the big and obvious landmines, puttting yourself on the right side of serendipity & pouncing on the big upside opportunities when you have the good fortune of stumbling on them... and, for the love of God stopping with the falsely accurate formulas you feed the young.
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ReplyDelete