Black Swans to the rescue?

Author:Seymour, Richard
Position:TOPIC
 
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Several unexpected events - 9/11, the financial crisis and now the turmoil in the Arab world - made nonsense of well-laid-out plans and led to huge losses. The question is: can the unexpected be factored in when making investment decisions? Richard Seymour argues that it can, as he explains the 'Black Swan' phenomenon.

John Meriwether was once described as an 'Uber-trader'. Formerly a bond trader at Salomon Brothers, Meriwether was one of the pioneers of modern finance, which now sees mathematicians poring over computer models more than it does traders on the trading floor living on their wits, shouting to be heard over everybody else.

A brief scandal caused him to leave his post, but he went on to create, in 1993, Long-Term Capital Management (LTCM) - a hedge fund capitalised to the tune of $2.5bn. LTCM's ability to predict the future made it, and its clients, a lot of money. In 1998, LTCM sold a large number of options, betting that the markets would go through a period of stability because their computer models said they would. What the models did not predict, however, was that the Russian government was about to default on its bonds. When they did so, the markets reacted with volatility. LTCM's bet had not paid off and within weeks it closed down for good.

The computer models had failed because it is not possible to programme in every possible variable. They counted on everyone behaving as they were supposed to. But no one told the Russians. Despite his team of geniuses, Meriwether floundered like everyone else. Such predictive models are based on the bell-curve distribution. At either extreme, the ability to predict events is low, but in the middle where the curve peaks, the markets follow, more or less, a pattern. And this relies on the notion that the way the markets behaved in the past is how they are more than likely going to behave in the future. For the most part, the bell-curve method works. Except when it doesn't. Just ask LTCM.

Fat-tailed markets

Nassim Nicholas Taleb is the author of the 2007 book The Black Swan. The book's title refers to a parable of the same name. In 17th century Europe it was thought that all swans were white as no swan, other than white ones, had been seen. But in the 18th century this belief was overturned forever by the discovery of black swans in Australia.

Now a university professor, Taleb once founded a hedge fund, Empirica Capital, that was run along very different lines to those of LTCM. It was...

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