Monday, 11 June 2007

Investment charlatans

Interesting bit on the back of FTFM today -

Get real on investment charlatans
By Jonathan Davis

Published: June 11 2007 12:12 | Last updated: June 11 2007 12:12

Can the business of investment really be dominated by charlatans? In a provocative new book, entitled Black Swan, Nassim Nicholas Taleb says, in as many words, that the answer is Yes.

The arguments he advances in support of this claim are, it may pain some readers of these pages to hear, remarkably convincing. In fact many of his arguments are beyond rebuttal.

Forget for a moment, however, the pejorative connotations that the word “charlatan” has in common speech.

Mr Taleb, who made a name for himself with an earlier book, Fooled by Randomness, in which he castigated human beings’ capacity to see meaningful patterns in random data or events, is no stranger to self-regard.

You have only to read a few pages of his latest book to discover the pleasure he takes in the rage that his ideas are prone to incite in others, notably self-important Nobel Prize winners in economics.

Yet such ad hominem weaknesses should not detract from the force of his arguments. If you define a charlatan as someone who promises (and is paid for) results that he or she knows cannot in reality be delivered, the allegation need not reflect poorly on the integrity of the professional involved. It is perfectly possible to go about your business with the best of intentions and the loftiest of motives, while continuing to be a pedlar of false promises, simply because your job is undoable.

Economic forecasters, for example, are in this position much of the time. They make forecasts not because they know, but because they are asked. So what, if they are likely to be providing an illusory comfort blanket to investors and businessmen? Fulfilling a demand for bogus precision about an unknowable future is a service of sorts, even if the results rarely stand up to intensive scrutiny – which, interestingly, they rarely are given.

The reason that Mr Taleb’s new book should be required reading for all would-be investment professionals is not because of his scorn for self-righteous seers of all types, entertaining though his many asides can be. (“Being an executive does not require very developed frontal lobes, but rather a combination of charisma, a capacity to sustain boredom and the ability to shallowly perform on harrowing schedules. Add to this task the duty of attending opera performances!”)

The real reason for saying Black Swan is a powerful antidote to most received wisdom on investment is that its subject is a fundamental issue that confronts anyone involved in financial decision-making, namely how to confront the limitations of knowledge and the human mind in processing and acting on unreliable information in conditions of complex and persistent uncertainty.

Mr Taleb’s biggest bugbear is the academic community, with its attempts to impose models on financial markets that are built on entirely false and unrealistic premises, such as that returns in the financial world are normally distributed. Even though this is patently not the case, models built on probability theory, what Mr Taleb calls “the ludic fallacy”, the idea that markets follow the same rules as a game of dice, are still the basis of most finance theory that is taught in business schools.

The black swan of his title is an unexpected “fat tail” event of the kind that emerged to confound Long Term Capital Management and Amaranth, among others. In the latter case, he notes drily, only days before its demise the fund had written to its investors urging them to take comfort from the fact that the firm now had 12 “risk managers” in place. (In the same spirit he quotes a letter from the captain of the Titanic, boasting that he never expected to be involved in a dangerous incident at sea.)

Mr Taleb’s point is that the most important events in the financial world, the ones with the greatest consequences, are almost always “fat tail” events that are not and often cannot be predicted.

If 9/11 had been foreseen, it would surely have been prevented. These trend-breaking occurrences are the ones for which investors must be prepared, even if they cannot hope to predict them.

In Pasteur’s words, “luck favours the prepared”. Those who think that regressions and correlations based on past data are a guide to the future, however perfect the fit, are guilty of wishful thinking. Being able to live with rare events that nevertheless have seismic consequences is uncomfortable, but it is the mark of the true risk manager in finance.

Yet by a strange irony, notes Mr Taleb, those who think of themselves as conservative financiers are often the most blind to risk, such as the senior bankers who saw the entire cumulative earnings of the banking system to that point wiped out in the international debt crisis of the early 1980s.

The literature of scientific discovery and behavioural finance, on which Mr Taleb draws freely, helps to explain why in practice human beings prefer to impose comforting retrospective order on events that in reality are more random and non-sequential than the mind likes to pretend.

It is hard to think of any subject that is more relevant to fund managers and stockbrokers, who work in a business where reality and marketing perceptions are often widely divergent.

The fundamental pitch that both trades make for some kind of forecasting ability is demonstrably false, certainly at an aggregate level and often in individual cases as well.

It is small wonder if cognitive dissonance is commonplace among those who make their living by pretending that they have some superior insight into the future, while daily confronting the reality that in practice their understanding of risk is partial at best.

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