Articles from the New Yorker
Blowing Up
April 22 & 29, 2002
DEPARTMENT OF FINANCE
DEPARTMENT OF FINANCE
How Nassim Taleb turned the inevitability of disaster into an
investment strategy
1.
One day in 1996, a Wall Street trader named
Nassim Nicholas Taleb went to see Victor Niederhoffer. Victor
Niederhoffer was one of the most successful money managers in
the country. He lived and worked out of a thirteen-acre compound
in Fairfield County, Connecticut, and when Taleb drove up that
day from his home in Larchmont he had to give his name at the
gate, and then make his way down a long, curving driveway.
Niederhoffer had a squash court and a tennis court and a
swimming pool and a colossal, faux-alpine mansion in which
virtually every square inch of space was covered with
eighteenth- and nineteenth-century American folk art. In those
days, he played tennis regularly with the billionaire financier
George Soros. He had just written a best-selling book, "The
Education of a Speculator," dedicated to his father, Artie
Niederhoffer, a police officer from Coney Island. He had a huge
and eclectic library and a seemingly insatiable desire for
knowledge. When Niederhoffer went to Harvard as an
undergraduate, he showed up for the very first squash practice
and announced that he would someday be the best in that sport;
and, sure enough, he soon beat the legendary Shariff Khan to win
the U.S. Open squash championship. That was the kind of man
Niederhoffer was. He had heard of Taleb's growing reputation in
the esoteric field of options trading, and summoned him to
Connecticut. Taleb was in awe.
"He didn't talk much, so I observed him," Taleb
recalls. "I spent seven hours watching him trade. Everyone else
in his office was in his twenties, and he was in his fifties,
and he had the most energy of them all. Then, after the markets
closed, he went out to hit a thousand backhands on the tennis
court." 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," Taleb went on. "He was part chevalier,
part scholar. My respect for him was intense." There was just
one problem, however, and it is the key to understanding the
strange path that Nassim Taleb has chosen, and the position he
now holds as Wall Street's principal dissident. Despite his envy
and admiration, he did not want to be Victor Niederhoffer -- not
then, not now, and not even for a moment in between. For when he
looked around him, at the books and the tennis court and the
folk art on the walls -- when he contemplated the countless
millions that Niederhoffer had made over the years -- he could
not escape the thought that it might all have been the result of
sheer, dumb luck.
Taleb knew how heretical that thought was. Wall
Street was dedicated to the principle that when it came to
playing the markets there was such a thing as expertise, that
skill and insight mattered in investing just as skill and
insight mattered in surgery and golf and flying fighter jets.
Those who had the foresight to grasp the role that software
would play in the modern world bought Microsoft in 1985, and
made a fortune. Those who understood the psychology of
investment bubbles sold their tech stocks at the end of 1999 and
escaped the Nasdaq crash. Warren Buffett was known as the "sage
of Omaha" because it seemed incontrovertible that if you started
with nothing and ended up with billions then you had to be
smarter than everyone else: Buffett was successful for a reason.
Yet how could you know, Taleb wondered, whether that reason was
responsible for someone's success, or simply a rationalization
invented after the fact? George Soros seemed to be successful
for a reason, too. He used to say that he followed something
called "the theory of reflexivity." But then, later, Soros wrote
that in most situations his theory "is so feeble that it can be
safely ignored." An old trading partner of Taleb's, a man named
Jean-Manuel Rozan, once spent an entire afternoon arguing about
the stock market with Soros. Soros was vehemently bearish, and
he had an elaborate theory to explain why, which turned out to
be entirely wrong. The stock market boomed. Two years later,
Rozan ran into Soros at a tennis tournament. "Do you remember
our conversation?" Rozan asked. "I recall it very well," Soros
replied. "I changed my mind, and made an absolute fortune." He
changed his mind! The truest thing about Soros seemed to be what
his son Robert had once said:
My father will sit down and give you theories to
explain why he does this or that. But I remember seeing it as a
kid and thinking, Jesus Christ, at least half of this is
bullshit. I mean, you know the reason he changes his position on
the market or whatever is because his back starts killing him.
It has nothing to do with reason. He literally goes into a
spasm, and it?s this early warning sign.
For Taleb, then, the question why someone was a
success in the financial marketplace was vexing. Taleb could do
the arithmetic in his head. Suppose that there were ten thousand
investment managers out there, which is not an outlandish
number, and that every year half of them, entirely by chance,
made money and half of them, entirely by chance, lost money. And
suppose that every year the losers were tossed out, and the game
replayed with those who remained. At the end of five years,
there would be three hundred and thirteen people who had made
money in every one of those years, and after ten years there
would be nine people who had made money every single year in a
row, all out of pure luck. Niederhoffer, like Buffett and Soros,
was a brilliant man. He had a Ph.D. in economics from the
University of Chicago. He had pioneered the idea that through
close mathematical analysis of patterns in the market an
investor could identify profitable anomalies. But who was to say
that he wasn't one of those lucky nine? And who was to say that
in the eleventh year Niederhoffer would be one of the unlucky
ones, who suddenly lost it all, who suddenly, as they say on
Wall Street, "blew up"?
Taleb remembered his childhood in Lebanon and
watching his country turn, as he puts it, from "paradise to
hell" in six months. His family once owned vast tracts of land
in northern Lebanon. All of that was gone. He remembered his
grandfather, the former Deputy Prime Minister of Lebanon and the
son of a Deputy Prime Minister of Lebanon and a man of great
personal dignity, living out his days in a dowdy apartment in
Athens. That was the problem with a world in which there was so
much uncertainty about why things ended up the way they did: you
never knew whether one day your luck would turn and it would all
be washed away.
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, a few years later, 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.
2.
Nassim Taleb is a tall, muscular man in his
early forties, with a salt-and-pepper beard and a balding head.
His eyebrows are heavy and his nose is long. His skin has the
olive hue of the Levant. He is a man of moods, and when his
world turns dark the eyebrows come together and the eyes narrow
and it is as if he were giving off an electrical charge. It is
said, by some of his friends, that he looks like Salman Rushdie,
although at his office his staff have pinned to the bulletin
board a photograph of a mullah they swear is Taleb's long-lost
twin, while Taleb himself maintains, wholly implausibly, that he
resembles Sean Connery. He lives in a four-bedroom Tudor with
twenty-six Russian Orthodox icons, nineteen Roman heads, and
four thousand books, and he rises at dawn to spend an hour
writing. He is the author of two books, the first a technical
and highly regarded work on derivatives, and the second a
treatise entitled "Fooled by Randomness," which was published
last year and is to conventional Wall Street wisdom
approximately what Martin Luther's ninety-five theses were to
the Catholic Church. Some afternoons, he drives into the city
and attends a philosophy lecture at City University. During the
school year, in the evenings, he teaches a graduate course in
finance at New York University, after which he can often be
found at the bar at Odeon Café in Tribeca, holding forth, say,
on the finer points of stochastic volatility or his veneration
of the Greek poet C. P. Cavafy.
Taleb runs Empirica Capital out of an anonymous,
concrete office park somewhere in the woods outside Greenwich,
Connecticut. His offices consist, principally, of a trading
floor about the size of a Manhattan studio apartment. Taleb sits
in one corner, in front of a laptop, surrounded by the rest of
his team -- Mark Spitznagel, the chief trader, another trader
named Danny Tosto, a programmer named Winn Martin, and a
graduate student named Pallop Angsupun. Mark Spitznagel is
perhaps thirty. Win, Danny, and Pallop look as if they belonged
in high school. The room has an overstuffed bookshelf in one
corner, and a television muted and tuned to CNBC. There are two
ancient Greek heads, one next to Taleb's computer and the other,
somewhat bafflingly, on the floor, next to the door, as if it
were being set out for the trash. There is almost nothing on the
walls, except for a slightly battered poster for an exhibition
of Greek artifacts, the snapshot of the mullah, and a small
pen-and-ink drawing of the patron saint of Empirica Capital, the
philosopher Karl Popper.
On a recent spring morning, the staff of
Empirica were concerned with solving a thorny problem, having to
do with the square root of n, where n is a given number of
random set of observations, and what relation n might have to a
speculator's confidence in his estimations. Taleb was up at a
whiteboard by the door, his marker squeaking furiously as he
scribbled possible solutions. Spitznagel and Pallop looked on
intently. Spitznagel is blond and from the Midwest and does
yoga: in contrast to Taleb, he exudes a certain laconic
levelheadedness. In a bar, Taleb would pick a fight. Spitznagel
would break it up. Pallop is of Thai extraction and is doing a
Ph.D. in financial mathematics at Princeton. He has longish
black hair, and a slightly quizzical air. "Pallop is very lazy,"
Taleb will remark, to no one in particular, several times over
the course of the day, although this is said with such affection
that it suggests that "laziness," in the Talebian nomenclature,
is a synonym for genius. Pallop's computer was untouched and he
often turned his chair around, so that he faced completely away
from his desk. He was reading a book by the cognitive
psychologists Amos Tversky and Daniel Kahneman, whose arguments,
he said a bit disappointedly, were "not really quantifiable."
The three argued back and forth about the solution. It appeared
that Taleb might be wrong, but before the matter could be
resolved the markets opened. Taleb returned to his desk and
began to bicker with Spitznagel about what exactly would be put
on the company boom box. Spitznagel plays the piano and the
French horn and has appointed himself the Empirica d.j. He
wanted to play Mahler, and Taleb does not like Mahler. "Mahler
is not good for volatility," Taleb complained. "Bach is good.
St. Matthew's Passion!" Taleb gestured toward Spitznagel, who
was wearing a gray woollen turtleneck. "Look at him. He wants to
be like von Karajan, like someone who wants to live in a castle.
Technically superior to the rest of us. No chitchatting. Top
skier. That's Mark!" As Spitznagel rolled his eyes, a man whom
Taleb refers to, somewhat mysteriously, as Dr. Wu wandered in.
Dr. Wu works for another hedge fund, down the hall, and is said
to be brilliant. He is thin and squints through black-rimmed
glasses. He was asked his opinion on the square root of n but
declined to answer. "Dr. Wu comes here for intellectual kicks
and to borrow books and to talk music with Mark," Taleb
explained after their visitor had drifted away. He added darkly,
"Dr. Wu is a Mahlerian."
Empirica follows a very particular investment
strategy. It trades options, which is to say that it deals not
in stocks and bonds but with bets on stocks and bonds. Imagine,
for example, that General Motors stock is trading at fifty
dollars, and imagine that you are a major investor on Wall
Street. An options trader comes up to you with a proposition.
What if, within the next three months, he decides to sell you a
share of G.M. at forty-five dollars? How much would you charge
for agreeing to buy it at that price? You would look at the
history of G.M. and see that in a three-month period it has
rarely dropped ten per cent, and obviously the trader is only
going to make you buy his G.M. at forty-five dollars if the
stock drops below that point. So you say you'll make that
promise, or sell that option, for a relatively small fee, say, a
dime. You are betting on the high probability that G.M. stock
will stay relatively calm over the next three months, and if you
are right you'll pocket the dime as pure profit. The trader, on
the other hand, is betting on the unlikely event that G.M. stock
will drop a lot, and if that happens his profits are potentially
huge. If the trader bought a million options from you at a dime
each and G.M. drops to thirty-five dollars, he'll buy a million
shares at thirty-five dollars and turn around and force you to
buy them at forty-five dollars, making himself suddenly very
rich and you substantially poorer.
That particular transaction is called, in the
argot of Wall Street, an "out-of-the-money option." But an
option can be configured in a vast number of ways. You could
sell the trader a G.M. option at thirty dollars, or, if you
wanted to bet against G.M. stock going up, you could sell a G.M.
option at sixty dollars. You could sell or buy options on bonds,
on the S. & P. index, on foreign currencies or on mortgages, or
on the relationship among any number of financial instruments of
your choice; you can bet on the market booming, or the market
crashing, or the market staying the same. Options allow
investors to gamble heavily and turn one dollar into ten. They
also allow investors to hedge their risk. The reason your
pension fund may not be wiped out in the next crash is that it
has protected itself by buying options. What drives the options
game is the notion that the risks represented by all of these
bets can be quantified; that by looking at the past behavior of
G.M. you can figure out the exact chance of G.M. hitting
forty-five dollars in the next three months, and whether at a
dollar that option is a good or a bad investment. The process is
a lot like the way insurance companies analyze actuarial
statistics in order to figure out how much to charge for a
life-insurance premium, and to make those calculations every
investment bank has, on staff, a team of Ph.D.s, physicists from
Russia, applied mathematicians from China, computer scientists
from India. On Wall Street, those Ph.D.s are called "quants."
Nassim Taleb and his team at Empirica are
quants. But they reject the quant orthodoxy, because they don't
believe that things like the stock market behave in the way that
physical phenomena like mortality statistics do. Physical
events, whether death rates or poker games, are the predictable
function of a limited and stable set of factors, and tend to
follow what statisticians call a "normal distribution," a bell
curve. But do the ups and downs of the market follow a bell
curve? The economist Eugene Fama once studied stock prices and
pointed out that if they followed a normal distribution you'd
expect a really big jump, what he specified as a movement five
standard deviations from the mean, once every seven thousand
years. In fact, jumps of that magnitude happen in the stock
market every three or four years, because investors don't behave
with any kind of statistical orderliness. They change their
mind. They do stupid things. They copy each other. They panic.
Fama concluded that if you charted the ups and downs of the
stock market the graph would have a "fat tail,"meaning that at
the upper and lower ends of the distribution there would be many
more outlying events than statisticians used to modelling the
physical world would have imagined.
In the summer of 1997, Taleb predicted that
hedge funds like Long Term Capital Management were headed for
trouble, because they did not understand this notion of fat
tails. Just a year later, L.T.C.M. sold an extraordinary number
of options, because its computer models told it that the markets
ought to be calming down. And what happened? The Russian
government defaulted on its bonds; the markets went crazy; and
in a matter of weeks L.T.C.M. was finished. Spitznagel, Taleb's
head trader, says that he recently heard one of the former top
executives of L.T.C.M. give a lecture in which he defended the
gamble that the fund had made. "What he said was, Look, when I
drive home every night in the fall I see all these leaves
scattered around the base of the trees,?" Spitznagel recounts.
"There is a statistical distribution that governs the way they
fall, and I can be pretty accurate in figuring out what that
distribution is going to be. But one day I came home and the
leaves were in little piles. Does that falsify my theory that
there are statistical rules governing how leaves fall? No. It
was a man-made event." In other words, the Russians, by
defaulting on their bonds, did something that they were not
supposed to do, a once-in-a-lifetime, rule-breaking event. But
this, to Taleb, is just the point: in the markets, unlike in the
physical universe, the rules of the game can be changed. Central
banks can decide to default on government-backed securities.
One of Taleb's earliest Wall Street mentors was
a short-tempered Frenchman named Jean-Patrice, who dressed like
a peacock and had an almost neurotic obsession with risk.
Jean-Patrice would call Taleb from Regine's at three in the
morning, or take a meeting in a Paris nightclub, sipping
champagne and surrounded by scantily clad women, and once
Jean-Patrice asked Taleb what would happen to his positions if a
plane crashed into his building. Taleb was young then and
brushed him aside. It seemed absurd. But nothing, Taleb soon
realized, is absurd. Taleb likes to quote David Hume: "No amount
of observations of white swans can allow the inference that all
swans are white, but the observation of a single black swan is
sufficient to refute that conclusion." Because L.T.C.M. had
never seen a black swan in Russia, it thought no Russian black
swans existed. Taleb, by contrast, has constructed a trading
philosophy predicated entirely 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. That would require Taleb to assume
that he understands the market, and he doesn't. He hasn't Warren
Buffett's confidence. So he buys options on both sides, on the
possibility of the market moving both up and down. And he
doesn't bet on minor fluctuations in the market. Why bother? If
everyone else is vastly underestimating the possibility of rare
events, then an option on G.M. at, say, forty dollars is going
to be undervalued. 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, not for Empirica and not
for his own personal account. Buying a stock, unlike buying an
option, is a gamble that the future will represent an improved
version of the past. And who knows whether that will be true? So
all of Taleb's personal wealth, and the hundreds of millions
that Empirica has in reserve, is in Treasury bills. Few on Wall
Street have taken the practice of buying options to such
extremes. But if anything completely out of the ordinary happens
to the stock market, if some random event sends a jolt through
all of Wall Street and pushes G.M. to, say, twenty dollars,
Nassim Taleb will not end up in a dowdy apartment in Athens. He
will be rich.
Not long ago, Taleb went to a dinner in a French
restaurant just north of Wall Street. The people at the dinner
were all quants: men with bulging pockets and open-collared
shirts and the serene and slightly detached air of those who
daydream in numbers. Taleb sat at the end of the table, drinking
pastis and discussing French literature. There was a chess grand
master at the table, with a shock of white hair, who had once
been one of Anatoly Karpov's teachers, and another man who over
the course of his career had worked, in order, at Stanford
University, Exxon, Los Alamos National Laboratory, Morgan
Stanley, and a boutique French investment bank. They talked
about mathematics and chess and fretted about one of their party
who had not yet arrived and who had the reputation, as one of
the quants worriedly said, of "not being able to find the
bathroom." When the check came, it was given to a man who worked
in risk management at a big Wall Street bank, and he stared at
it for a long time, with a slight mixture of perplexity and
amusement, as if he could not remember what it was like to deal
with a mathematical problem of such banality. The men at the
table were in a business that was formally about mathematics but
was really about epistemology, because to sell or to buy an
option requires each party to confront the question of what it
is he truly knows. 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. But there were
plenty of people around that table who sold options, who thought
that if you were smart enough to set the price of the option
properly you could win so many of those one-dollar bets on
General Motors that, even if the stock ever did dip below
forty-five dollars, you'd still come out far ahead. They believe
that the world is a place where, at the end of the day, leaves
fall more or less in a predictable pattern.
The distinction between these two sides is the
divide that emerged between Taleb and Niederhoffer all those
years ago in Connecticut. Niederhoffer's hero is the
nineteenth-century scientist Francis Galton. Niederhoffer called
his eldest daughter Galt, and there is a full-length portrait of
Galton in his library. Galton was a statistician and a social
scientist (and a geneticist and a meteorologist), and if he was
your hero you believed that by marshalling empirical evidence,
by aggregating data points, you could learn whatever it was you
needed to know. Taleb's hero, on the other hand, is Karl Popper,
who said that you could not know with any certainty that a
proposition was true; you could only know that it was not true.
Taleb makes much of what he learned from Niederhoffer, but
Niederhoffer insists that his example was wasted on Taleb. "In
one of his cases, Rumpole of the Bailey talked about being tried
by the bishop who doesn't believe in God," Niederhoffer says.
"Nassim is the empiricist who doesn't believe in empiricism."
What is it that you claim to learn from experience, if you
believe that experience cannot be trusted? Today, Niederhoffer
makes a lot of his money selling options, and more often than
not the person who he sells those options to is Nassim Taleb. If
one of them is up a dollar one day, in other words, that dollar
is likely to have come from the other. The teacher and pupil
have become predator and prey.
3.
Years ago, Nassim Taleb worked at the investment
bank First Boston, and one of the things that puzzled him was
what he saw as the mindless industry of the trading floor. A
trader was supposed to come in every morning and buy and sell
things, and on the basis of how much money he made buying and
selling he was given a bonus. If he went too many weeks without
showing a profit, his peers would start to look at him funny,
and if he went too many months without showing a profit he would
be gone. The traders were often well educated, and wore Savile
Row suits and Ferragamo ties. They dove into the markets with a
frantic urgency. They read the Wall Street Journal closely and
gathered around the television to catch breaking news. "The Fed
did this, the Prime Minister of Spain did that," Taleb recalls.
"The Italian Finance Minister says there will be no competitive
devaluation, this number is higher than expected, Abby Cohen
just said this." It was a scene that Taleb did not understand.
"He was always so conceptual about what he was
doing," says Howard Savery, who was Taleb?s assistant at the
French bank Indosuez in the nineteen-eighties. "He used to drive
our floor trader (his name was Tim) crazy. Floor traders are
used to precision: "Sell a hundred futures at eighty-seven."
Nassim would pick up the phone and say, "Tim, sell some." And
Tim would say, "How many?" And he would say, "Oh, a social
amount." It was like saying, "I don't have a number in mind, I
just know I want to sell." There would be these heated arguments
in French, screaming arguments. Then everyone would go out to
dinner and have fun. Nassim and his group had this attitude that
we're not interested in knowing what the new trade number is.
When everyone else was leaning over their desks, listening
closely to the latest figures, Nassim would make a big scene of
walking out of the room."
At Empirica, then, there are no Wall Street
Journals to be found. There is very little active trading,
because the options that the fund owns are selected by computer.
Most of those options will be useful only if the market does
something dramatic, and, of course, on most days the market
doesn't. So the job of Taleb and his team is to wait and to
think. They analyze the company's trading policies, back-test
various strategies, and construct ever-more sophisticated
computer models of options pricing. Danny, in the corner,
occasionally types things into the computer. Pallop looks
dreamily off into the distance. Spitznagel takes calls from
traders, and toggles back and forth between screens on his
computer. Taleb answers e-mails and calls one of the firm's
brokers in Chicago, affecting, as he does, the kind of Brooklyn
accent that people from Brooklyn would have if they were
actually from northern Lebanon: "Howyoudoin?" It is closer to a
classroom than to a trading floor.
"Pallop, did you introspect?" Taleb calls out as
he wanders back in from lunch. Pallop is asked what his Ph.D. is
about. "Pretty much this," he says, waving a languid hand around
the room.
"It looks like we will have to write it for
him," Taleb chimes in, "because Pollop is very lazy."
What Empirica has done is to invert the
traditional psychology of investing. You and I, if we invest
conventionally in the market, have a fairly large chance of
making a small amount of money in a given day from dividends or
interest or the general upward trend of the market. We have
almost no chance of making a large amount of money in one day,
and there is a very small, but real, possibility that if the
market collapses we could blow up. We accept that distribution
of risks because, for fundamental reasons, it feels right. In
the book that Pallop was reading by Kahneman and Tversky, for
example, there is a description of a simple experiment, where a
group of people were told to imagine that they had three hundred
dollars. They were then given a choice between (a) receiving
another hundred dollars or (b) tossing a coin, where if they won
they got two hundred dollars and if they lost they got nothing.
Most of us, it turns out, prefer (a) to (b). But then Kahneman
and Tversky did a second experiment. They told people to imagine
that they had five hundred dollars, and then asked them if they
would rather (c) give up a hundred dollars or (d) toss a coin
and pay two hundred dollars if they lost and nothing at all if
they won. Most of us now prefer (d) to (c). What is interesting
about those four choices is that, from a probabilistic
standpoint, they are identical. They all yield an expected
outcome of four hundred dollars. Nonetheless, we have strong
preferences among them. Why? Because we're more willing to
gamble when it comes to losses, but are risk averse when it
comes to our gains. That's why we like small daily winnings in
the stock market, even if that requires that we risk losing
everything in a crash.
At Empirica, by contrast, every day brings a
small but real possibility that they'll make a huge amount of
money in a day; no chance that they'll blow up; and a very large
possibility that they'll lose a small amount of money. All those
dollar, and fifty-cent, and nickel options that Empirica has
accumulated, few of which will ever be used, soon begin to add
up. By looking at a particular column on the computer screens
showing Empirica's positions, anyone at the firm can tell you
precisely how much money Empirica has lost or made so far that
day. At 11:30 A.M., for instance, they had recovered just
twenty-eight percent of the money they had spent that day on
options. By 12:30, they had recovered forty per cent, meaning
that the day was not yet half over and Empirica was already in
the red to the tune of several hundred thousand dollars. The day
before that, it had made back eighty-five per cent of its money;
the day before that, forty-eight per cent; the day before that,
sixty-five per cent; and the day before that also sixty-five per
cent; and, in fact-with a few notable exceptions, like the few
days when the market reopened after September 11th -- Empirica
has done nothing but lose money since last April. "We cannot
blow up, we can only bleed to death," Taleb says, and bleeding
to death, absorbing the pain of steady losses, is precisely what
human beings are hardwired to avoid. "Say you've got a guy who
is long on Russian bonds," Savery says. "He's making money every
day. One day, lightning strikes and he loses five times what he
made. Still, on three hundred and sixty-four out of three
hundred and sixty-five days he was very happily making money.
It's much harder to be the other guy, the guy losing money three
hundred and sixty-four days out of three hundred and sixty-five,
because you start questioning yourself. Am I ever going to make
it back? Am I really right? What if it takes ten years? Will I
even be sane ten years from now?" What the normal trader gets
from his daily winnings is feedback, the pleasing illusion of
progress. At Empirica, there is no feedback. "It's like you're
playing the piano for ten years and you still can't play
chopsticks," Spitznagel say, "and the only thing you have to
keep you going is the belief that one day you'll wake up and
play like Rachmaninoff." Was it easy knowing that Niederhoffer
-- who represented everything they thought was wrong -- was out
there getting rich while they were bleeding away? Of course it
wasn't . If you watched Taleb closely that day, you could see
the little ways in which the steady drip of losses takes a toll.
He glanced a bit too much at the Bloomberg. He leaned forward a
bit too often to see the daily loss count. He succumbs to an
array of superstitious tics. If the going is good, he parks in
the same space every day; he turned against Mahler because he
associates Mahler with the last year's long dry spell. "Nassim
says all the time that he needs me there, and I believe him,"
Spitznagel says. He is there to remind Taleb that there is a
point to waiting, to help Taleb resist the very human impulse to
abandon everything and stanch the pain of losing. "Mark is my
cop," Taleb says. So is Pallop: he is there to remind Taleb that
Empirica has the intellectual edge.
"The key is not having the ideas but having the
recipe to deal with your ideas," Taleb says. "We don't need
moralizing. We need a set of tricks." His trick is a protocol
that stipulates precisely what has to be done in every
situation. "We built the protocol, and the reason we did was to
tell the guys, Don't listen to me, listen to the protocol. Now,
I have the right to change the protocol, but there is a protocol
to changing the protocol. We have to be hard on ourselves to do
what we do. The bias we see in Niederhoffer we see in
ourselves." At the quant dinner, Taleb devoured his roll, and as
the busboy came around with more rolls Taleb shouted out "No,
no!" and blocked his plate. It was a never-ending struggle, this
battle between head and heart. When the waiter came around with
wine, he hastily covered the glass with his hand. When the time
came to order, he asked for steak frites -- without the frites,
please! -- and then immediately tried to hedge his choice by
negotiating with the person next to him for a fraction of his
frites.
The psychologist Walter Mischel has done a
series of experiments where he puts a young child in a room and
places two cookies in front of him, one small and one large. The
child is told that if he wants the small cookie he need only
ring a bell and the experimenter will come back into the room
and give it to him. If he wants the better treat, though, he has
to wait until the experimenter returns on his own, which might
be anytime in the next twenty minutes. Mischel has videotapes of
six-year-olds, sitting in the room by themselves, staring at the
cookies, trying to persuade themselves to wait. One girl starts
to sing to herself. She whispers what seems to be the
instructions -- that she can have the big cookie if she can only
wait. She closes her eyes. Then she turns her back on the
cookies. Another little boy swings his legs violently back and
forth, and then picks up the bell and examines it, trying to do
anything but think about the cookie he could get by ringing it.
The tapes document the beginnings of discipline and self-control
-- the techniques we learn to keep our impulses in check -- and
to watch all the children desperately distracting themselves is
to experience the shock of recognition: that's Nassim Taleb!
There is something else as well that helps to
explain Taleb's resolve -- more than the tics and the systems
and the self-denying ordinances. It happened a year or so 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. Finally, when he moved back to New York, he went to see a
doctor, in one of those Upper East Side prewar buildings with a
glamorous façade. Taleb sat in the office, staring out at the
plain brick of the courtyard, reading the medical diplomas on
the wall over and over, waiting and waiting for the verdict. The
doctor returned and spoke in a low, grave voice: "I got the
pathology report. It's not as bad as it sounds ?" But, of
course, it was: he had throat cancer. Taleb's mind shut down. He
left the office. It was raining outside. He walked and walked
and ended up at a medical library. There he read frantically
about his disease, the rainwater forming a puddle under his
feet. It made no sense. Throat cancer was the disease of someone
who has spent a lifetime smoking heavily. But Taleb was young,
and he barely smoked at all. His risk of getting throat cancer
was something like one in a hundred thousand, almost
unimaginably small. 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.
As the day came to an end, Taleb and his team
turned their attention once again to the problem of the square
root of n. Taleb was back at the whiteboard. Spitznagel was
looking on. Pallop was idly peeling a banana. Outside, the sun
was beginning to settle behind the trees. "You do a conversion
to p1 and p2," Taleb said. His marker was once again squeaking
across the whiteboard. "We say we have a Gaussian distribution,
and you have the market switching from a low-volume regime to a
high-volume. P21. P22. You have your igon value." He frowned and
stared at his handiwork. The markets were now closed. Empirica
had lost money, which meant that somewhere off in the woods of
Connecticut Niederhoffer had no doubt made money. That hurt, but
if you steeled yourself, and thought about the problem at hand,
and kept in mind that someday the market would do something
utterly unexpected because in the world we live in something
utterly unexpected always happens, then the hurt was not so bad.
Taleb eyed his equations on the whiteboard, and arched an
eyebrow. It was a very difficult problem. "Where is Dr. Wu?
Should we call in Dr. Wu?"
4.
A year after Nassim Taleb came to visit him,
Victor Niederhoffer blew up. He sold a very large number of
options on the S. & P. index, taking millions of dollars from
other traders in exchange for promising to buy a basket of
stocks from them at current prices, if the market ever fell. It
was an unhedged bet, or what was called on Wall Street a "naked
put," meaning that he bet everyone on one outcome: he bet in
favor of the large probability of making a small amount of
money, and against the small probability of losing a large
amount of money-and he lost. On October 27, 1997, the market
plummeted eight per cent, and all of the many, many people who
had bought those options from Niederhoffer came calling all at
once, demanding that he buy back their stocks at pre-crash
prices. He ran through a hundred and thirty million dollars --
his cash reserves, his savings, his other stocks -- and when his
broker came and asked for still more he didn't have it. In a
day, one of the most successful hedge funds in America was wiped
out. Niederhoffer had to shut down his firm. He had to mortgage
his house. He had to borrow money from his children. He had to
call Sotheby's and sell his prized silver collection -- the
massive nineteenth-century Brazilian "sculptural group of
victory" made for the Visconde De Figueirdeo, the massive silver
bowl designed in 1887 by Tiffany & Company for the James Gordon
Bennet Cup yacht race, and on and on. He stayed away from the
auction. He couldn't bear to watch.
"It was one of the worst things that has ever
happened to me in my life, right up there with the death of
those closest to me," Niederhoffer said recently. It was a
Saturday in March, and he was in the library of his enormous
house. Two weary-looking dogs wandered in and out. He is a tall
man, an athlete, thick through the upper body and trunk, with a
long, imposing face and baleful, hooded eyes. He was shoeless.
One collar on his shirt was twisted inward, and he looked away
as he talked. "I let down my friends. I lost my business. I was
a major money manager. Now I pretty much have had to start from
ground zero." He paused. "Five years have passed. The beaver
builds a dam. The river washes it away, so he tries to build a
better foundation, and I think I have. But I'm always mindful of
the possibility of more failures." In the distance, there was a
knock on the door. It was a man named Milton Bond, an artist who
had come to present Niederhoffer with a painting he had done of
Moby Dick ramming the Pequod. It was in the folk-art style that
Niederhoffer likes so much, and he went to meet Bond in the
foyer, kneeling down in front of the painting as Bond unwrapped
it. Niederhoffer has other paintings of the Pequod in his house,
and paintings of the Essex, the ship on which Melville's story
was based. In his office, on a prominent wall, is a painting of
the Titanic. They were, he said, his way of staying humble. "One
of the reasons I've paid lots of attention to the Essex is that
it turns out that the captain of the Essex, as soon as he got
back to Nantucket, was given another job," Niederhoffer said.
"They thought he did a good job in getting back after the ship
was rammed. The captain was asked, `How could people give you
another ship?' And he said, `I guess on the theory that
lightning doesn't strike twice.' It was a fairly random thing.
But then he was given the other ship, and that one foundered,
too. Got stuck in the ice. At that time, he was a lost man. He
wouldn't even let them save him. They had to forcibly remove him
from the ship. He spent the rest of his life as a janitor in
Nantucket. He became what on Wall Street they call a ghost."
Niederhoffer was back in his study now, his lanky body stretched
out, his feet up on the table, his eyes a little rheumy. "You
see? I can't afford to fail a second time. Then I'll be a total
washout. That's the significance of the Pequod."
A month or so before he blew up, Taleb had
dinner with Niederhoffer at a restaurant in Westport, and
Niederhoffer told him that he had been selling naked puts. You
can imagine the two of them across the table from each other,
Niederhoffer explaining that his bet was an acceptable risk,
that the odds of the market going down so heavily that he would
be wiped out were minuscule, and Taleb listening and shaking his
head, and thinking about black swans. "I was depressed when I
left him," Taleb said. "Here is a guy who goes out and hits a
thousand backhands. He plays chess like his life depends on it.
Here is a guy who, whatever he wants to do when he wakes up in
the morning, he ends up better than anyone else. Whatever he
wakes up in the morning and decides to do, he did better than
anyone else. I was talking to my hero . . ." This was the reason
Taleb didn't want to be Niederhoffer when Niederhoffer was at
his height -- the reason he didn't want the silver and the house
and the tennis matches with George Soros. He could see all too
clearly where it all might end up. In his mind's eye, he could
envision Niederhoffer borrowing money from his children, and
selling off his silver, and talking in a hollow voice about
letting down his friends, and Taleb did not know if he had the
strength to live with that possibility. Unlike Niederhoffer,
Taleb never thought he was invincible. You couldn't if you had
watched your homeland blow up, and had been the one person in a
hundred thousand who gets throat cancer, and so for Taleb there
was never any alternative to the painful process of insuring
himself against catastrophe.
This kind of caution does not seem heroic, of
course. It seems like the joyless prudence of the accountant and
the Sunday-school teacher. The truth is that 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.
Last fall, Niederhoffer sold a large number of
options, betting that the markets would be quiet, and they were,
until out of nowhere two planes crashed into the World Trade
Center. "I was exposed. It was nip and tuck." Niederhoffer shook
his head, because there was no way to have anticipated September
11th. "That was a totally unexpected event."