Re:Balance -- Jim Peterson

"The Black Swan," Nassim Nicholas Taleb

I’m happy to have been an early supporter of “The Black Swan.” Not that Nassim Nicholas Taleb’s best-seller of last spring needed my contribution. Taleb explores the human inability to recognize or appreciate the likelihood or impact of extreme events. Since he has stopped giving interviews, we can only imagine his satisfaction at the graphic global demonstration of his hypotheses delivered by the blind herd behaviors during the turmoil in the credit markets that started last spring with a virus in American subprime mortgages and quickly spread worldwide.

Those willing to stand the combination of erudition, authorial attitude and quirkiness will also find his website rewarding -- here .

Book Report: A Meditation on Chance

Originally published in the International Herald Tribune on May 4, 2007

The Black Swan: The Impact of the Highly Improbable By Nassim Nicholas Taleb Random House, 292 pages

A stranger walks into a crowded bar. How does his arrival affect the customer profile?

Because of physical human limits, his presence has a trivial impact on the average age, height or weight of the patrons. But what about wealth? If the guy is Bill Gates, suddenly - on average - everyone in the place is many times a multimillionaire.

For Gates, who could have predicted it? Despite the superior technology of Apple, Microsoft enjoyed the lucky opportunity of an early lead, which it then exploited to market dominance and immense wealth creation.
To explain the serendipity of business success – the same as for casualties of war, damage from natural disasters, action in the stock markets, or even emergence of best-selling books - the traditional tools of the economist and the social scientist are not getting it.

For a meditation on the cognitive shortcomings that cause us to under-appreciate the frequency of randomized, highly improbable but severely consequential events, see Nassim Nicholas Taleb's new book, "The Black Swan." In my neighborhood bookseller it is found on the Science shelf - only because the shop doesn't have separate sections for Uncertainty, Empirical Skepticism or Epistemology.

Taleb, who has taught at the university level in the United States and was once a trader and investment manager, takes his title, and his themes, from the rare bird, unknown in the West until discovered in Australia. No number of white swan observations could disprove the existence of a black swan, although no one had ever seen one, but a single sighting destroys the conventional contention that they did not exist.

Taleb is spreading his own wings after the success of his previous book, "Fooled by Randomness." The new book concentrates on the unexpected frequency and impact of black-swan events in the world of financial markets. Expanding the observation that we are unable to predict or identify events that are exceedingly rare but deeply meaningful, he explores the collection of biases that cause us to misinterpret these events after the fact.

Taleb navigates between the metaphorical landscapes of Mediocristan - a smoothed-down domain, lacking extremes and outliers - and Extremistan, where singular events can impact the whole. Much of life occurs in the former, and Taleb does not argue otherwise. What he does illuminate is our failure to know the difference between the two realms - especially to recognize that the likes of Warren Buffett and Long-Term Capital Management populate the latter, along with 9/11 and Columbine and Virginia Tech.

There are many sources for our lapses, one being the willful ignorance of the "silent evidence," such that much human endeavor will not make an impact: The many garage inventors who, instead of becoming Bill Gates or Steve Jobs, toil forever in obscurity; in sports, the failed Cinderellas whose desperation putts and last-second shots just do not drop; the blown-up brokers and fund managers whose disappearance from the data pools of memory contribute to the inflated egos of the survivors.

Taleb also shows us the impaired vision of the game theoreticians, who seek wisdom about risk-taking from casino games, but miss the basic point: Despite the appealing stories of the occasional lucky weekend punter, the casinos always win. As Taleb points out, casino games are not random in any really interesting way. Rather, the type of risk that really threatens a casino might be that its headline entertainer would be mauled by a tiger - something unthinkable before it happened in 2003 to the illusionist Roy Horn, of Siegfried and Roy, at the Mirage in Las Vegas.

Taleb himself is a beneficiary of a black swan event: the market turmoil of October 1987, which under conventional predictive tools should not have happened. The financial success he had from astute trading strategies freed him to emulate his role models, Voltaire and Montaigne, who retired from the hubbub of commercial and political affairs to the reflective quiet of their libraries and studies.

Taleb's sources extend from the physician and philosopher Sextus Empiricus, in second century Alexandria, to the Yale mathematician Benoit Mandelbrot, guru of the field of fractal geometry, to whom Taleb dedicates his book. The elegance with which Mandelbrot generates highly complex structures out of simple mathematical rules lies at the heart of Taleb's ability to explain the extreme events that lie beyond the smooth bell curves of conventional analysis.

Taleb disavows that "Fooled by Randomness," his earlier work, was intended as a book on business and investing, and his vision for "The Black Swan" is broader still. But anyone who has read this book is unlikely to think the same way about any number of life-shaping decisions, including how resources are deployed and priorities are set, how to invest both time and treasure, what risks to absorb and which to lay off by insurance.

Along Taleb's free-flowing highway of erudition are signposts that are no less useful in the commercial world than anywhere else:

The compulsion to concoct after-the-fact rationalizations out of nearby anecdotes means that daily market analysis is at best meaningless noise.
Market strategies that are designed upon bell-curve models suffer the built-in defect of excluding the potential for wildly extreme events.
If we could predict what we don't know, it wouldn't be unknown. Better the discerning, and humble, recognition of the wide scope of our ignorance.

For these guides to a modern world both more complex and less predictable than we may believe - as well as for welcome relief from the superficiality of the typical business and investing publications - Taleb's book deserves our attention, and our thanks.

Blackstone's Pre-IPO Accounting

Hindsight is so wonderful. A week after this column ran in the IHT, Blackstone pulled back from the proposed accounting treatment discussed here. In the circumstances it would be a shame to go back and re-edit the verb tenses.

It also brought its offering at $31, into the teeth of the subprime mortgage meltdown, and saw its price sag immediately below $22. For the company’s principals whose net worth expansion is measured in units with capital “B’”, little sympathy is indicated.

Private Equity Discovers the Value of Myth

Originally published in the International Herald Tribune on May 25, 2007

A timeless but troubling story lurks in the plans of Blackstone Group, the private equity giant, to raise $4 billion through an initial public offering.

Blackstone proposes, through the use of options accounting, to book as immediate profits the gains it estimates that will presumably be made once its transactions are ultimately wound up. In other words, as soon as it goes into a deal, Blackstone's 20 percent carried interest - that great profit engine of private equity - will be valued like a salable financial instrument, and recorded as an asset.

Noncash profits today, in eager anticipation of an undated and uncertain but rosy future, and investors - including the Chinese government - lining up to hurl their funds at the prospects. Sound familiar? Has everyone forgotten Enron, the creative energy trader that crashed, or the academics' darling among the trading models that flamed out, Long-Term Capital Management?

Generations ago, the investment maxim on Wall Street was "buy on the rumor, sell on the news." The lore in the bubble years of the 1990s then became, "Buy on the fantasy." All too often, the result was "hold till the debacle."

The lesson seems irresistible: The origins of the next wave of corporate misadventures will be a new set of compelling stories. After all, we have been eager to devour simplistic myths and fables ever since our ancestors gathered around the fires in front of their caves, to listen to tales spun by those hailed, rightly or wrongly, as the wisest men in the tribe.

Here's an example: Because I dislike shopping, I look increasingly to catalogs. One features clothing and accessories no different in quality or cost from a number of others, but its goods are promoted in seductive little vignettes that locate the wares in such modestly exotic locations as Mumbai, Portofino or West Egg. That's good enough for me.

Consumers willingly buy into a good story. Brands of premium ice creams are all as alike as Tolstoy's happy families, but think of the success of Häagen-Dazs - a word concocted from no known human language, but evocative of Danish quality. And think of two unknown guys from Vermont, Messrs Cohen and Greenfield - mythicized as Ben and Jerry.

We buy look-alike vehicles, by reference to wilderness spots those vehicles will never visit - Denali, Sierra, Tahoe, Kodiak. Again, why? Imagine a marketer trying to sell a 4x4 branded for its real venues - a Chevrolet Strip Mall, a Subaru Speed Bump, or that new luxury offering, the Cadillac Cul-de-Sac.

Financial products and services are subject to the same power of myth. The meltdown this year in the subprime mortgage-backed securities market destroyed a bubble built from two stories: first, that ever-increasing housing prices would forestall a reckoning for credulous but unqualified home buyers, and second, that the inverse relationship between bond coupon and default risk had somehow been suspended for equally credulous investors.

Neither proved true, but the crash in this industry segment has failed to dampen the appetite of a myth-driven market. No less a tale-spinner than Warren Buffett has warned of unsustainable returns for alternative investments. But, depressingly, it appears that the only information commanding attention is that conveyed in stories worthy of re-telling around the modern version of the prehistoric campfire.

So today, the story of Blackstone's IPO overrides two antagonistic realities: that the private equity funds are awash in the cash of ever-smaller investors, even while chasing deals that are bigger and richer but doomed to deterioration in quality and results.

Blackstone's circular approach to its profit picture - booking profits today based on a collective blind vote of confidence on a future bet, as a proxy for real results down the road - not only echoes the immediate past of Enron and LTCM. The same approach came to grief in the late 1960s for the investors in Bernie Cornfeld's Swiss-based Fund of Funds, which did the same in a wild bet on deep oil in the Canadian Arctic.

But memories are short, and if the stories are timeless, so are the failures to learn from the past.