What the Dog Saw [26]
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 one another. 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 modeling 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, LTCM 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 LTCM was finished. Spitznagel, Taleb’s head trader, says that he recently heard one of the former top executives of LTCM 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