The necessity for error, stress and risk

Nassim Nicholas Taleb, a successful options trader on Wall Street, is one of the most interesting and original writers of our time.  In Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, he wrote of how luck is mistaken for skill.  In The Black Swan: The Impact of the Highly Improbable, he wrote about how frequently people are blindsided by the unpredictable, which is important precisely because people don’t prepare for it.

How do you prepare for the unpredictable?  In his newest book, Antifragile: Things That Gain From Disorder, he tells how.   Antifragile sparkles with wit and is a delight to read.  Taleb invents dialogues about life and high finance between two fictional characters, the intellectual Nero Tulip and the street-smart Fat Tony.  He tells fascinating anecdotes about his personal life, starting with his boyhood in the Christian community in Lebanon and continuing to the present day.  He insults his enemies and boasts of his accomplishments with readable gusto.

In his philosophy, everything falls into one of three categories—fragile, robust and anti-fragile.  A delicate wine glass is fragile.  In mythology, the fragile is symbolized by the Sword of Damocles.  Nobody knows when it is going to fall, but it can fall at any time.  The robust is symbolized by the Phoenix.  No matter what you do to the Phoenix, it keeps being reborn.  The anti-fragile is Taleb’s original idea.  It is symbolized by the Hydra.  When you whack off its head or limbs, it grows more.  Attacking the Hydra makes it stronger.

A delicate wine glass is fragile.  You don’t know if it will break tomorrow or last a thousand years, but you do know that any little thing can break it.  A granite block is robust.  Few things can damage it, but over time it is going to be ground down.  A roaring fire is antifragile.  Whatever you throw into it or do to it (within limits), it is going to grow stronger.

The reputation of writers is antifragile.  Any attack on a writer’s book will stimulate interest in the book.  It doesn’t matter how many people dislike a writer, only how many are admirers.  Taleb noted that few people saw any merit in the work of the young Ludwig Wittgenstein, but it didn’t matter, because two who did were Bertrand Russell and John Maynard Keynes.

Living things are antifragile (up to a point).  Exposing yourself to error, stress and risk can make you smarter, stronger and safer.  If you spend a month in bed, you grow weaker.  If you spend a month doing hard physical work in the out of doors, you grow stronger.

Taleb tells of twin Greek Cypriot brothers who settled in London at the same time.  One became a taxi driver, the other went to work for a bank.  The taxi driver’s income varied quite a bit from day to day, week to week and month to month, while the bank employee’s income was completely predictable.  Although over time, they earned roughly the same amount of money, it would have seemed that the taxi driver was less secure—that is, until the current banking crisis, which has left the bank employee in jeopardy of being laid off and having to start over in middle age.

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The banker brother is an example of what Taleb calls the turkey problem—inspired by the empirical chicken in Bertrand Russell’s The Problems of Philosophy.  The turkey, noting that it is fed every day at 9 a.m., decides this is a law of nature, right up until the day before Thanksgiving.

The problem with the modern world, according to Taleb, is the illusion that life can be planned and controlled.  The result is fewer minor setbacks and more big crises.  Putting out every little forest fire allows flammable material to accumulate until there is enough for a really big fire that goes out of control.  The illusion by “fragilista” Alan Greenspan and others that they could eliminate the boom-and-bust economic cycle resulted in problems building up into a major economic crisis.

The alternative is trial and error, provided the errors are small and the potential gains are great.  Taleb, an immigrant said the greatness of the United States is that it encourages people to attempt new enterprises, with little penalty and no disgrace for failure, but big rewards for success.

Intellectuals put too much stress on the ability to articulate knowledge, Taleb says.  He wrote a Platonic dialogue between Socrates and Fat Tony, in which Fat Tony refutes Socrates’ contention that he lacks understanding unless his actions are based on clearly-defined terms and theory.  Taleb says the fact is that practice is seldom based on theory, but rather theory is an attempt to explain practice after the fact.  Theorists want to “teach birds how to fly.”

Nassim Nicholas Taleb’s five rules for policy

Rule 1.  Think of the economy as more like a cat than a washing machine.

Rule 2.  Favor businesses that benefit from their own mistakes, not those whose mistakes percolate into the system.

Rule 3.  Small is beautiful, but it is also efficient.

Rule 4.  Trial and error beats academic knowledge.

Rule 5.  Decision-makers must have skin in the game.

Nassim Nicholas Taleb is a successful Wall Street options trader and author of a new book, ANTIFRAGILE: Things That Gain from Disorder.  In a recent article in the Wall Street Journal, he laid down those five wise rules for economic policy-makers.

The economy is organic, like a cat, and not mechanical, like a washing machine.  Every kind of stress on a machine causes it to wear out faster.  But a living animal thrives on stress, up to a point.  Animals and other organic systems are best left alone, except in dire emergency.

One of Taleb’s examples of businesses that learn from their own mistakes is the airline industry.  Every time there is an airplane crash, the airline companies study the causes of the crash and incorporate that information into their practices.  In a sense, every airline crash makes the airlines safer.  Another example is Silicon Valley, where failure is not regarded as a disgrace and the idea is to “fail quickly” so you can go on to try something.   The opposite of this is the Wall Street banking industry, where every bank failure weakens the overall system.

An industry is strongest when it consists of many small units, where the failure of an individual business makes the survivors stronger.  Taleb cited the restaurant business, in which the failure of an individual restaurant is common but the failure of the restaurant industry as a whole is unimaginable.  Failures mean the best restaurants survive, and so the industry is ever-improving (assuming, I would add, that the big chain restaurants don’t drive the individually-owned restaurants out of business).  Government is least harmful, he wrote, when it is vested in the lowest and possible unit, as in Switzerland.

We should honor failed entrepreneurs in the same spirit that we honor warriors who fall in battle.  It is through their individual sacrifice contributes that society as a whole survives and prospers.

He is skeptical of top-down planning, whether done by government, corporations or some other form of corporation.  The best economic and social system is one that allows trial and error in which the errors are small and are a source of knowledge and improvement.  Experimentation and tinkering, not theory, is the source of technological and economic progress.

The trouble with most journalists, academics and government policy-makers is that they suffer no penalty for being wrong, not even a loss of reputation.  Even worse are Wall Street bankers, who are able to pocket the gains from their successes and push their losses onto the taxpayers.   He said the government in a humane society ought to provide for the weak and help the unlucky get back on their feet, but it should never bail out a failed business.  If a business is too big to fail, he said, nobody in that business should receive greater compensation than the most highly-paid civil servant.

Taleb admires Ralph Nader because he is the opposite of a Wall Street banker.  Nader accepts personal risks and sacrifices in order to confer benefits on society as a whole.

How to live in a world you don’t understand

Nassim Nicholas Taleb is the author of  ANTIFRAGILE: Things That Gain From Disorder,  which is about how to thrive in a world that is basically unpredictable.  Taleb said that individuals and societies become stronger when they expose themselves to moderate amounts of stress and risk, and become vulnerable when they try to eliminate stress and risk.   He said it is impossible and unnecessary to predict the future.  What is possible, on an individual and societal level, is to arrange things so that you have more to gain than to lose from change.

In this video he talks about his ideas to his friend Daniel Kahneman, author of Thinking, Fast and Slow, which is about how people make most of their decisions on the basis of intuition, and how thing can lead us astray, particularly when thinking about risk.

I give you fair warning that this video is an hour and nearly 20 minutes long.  I thought it was interesting and maybe you will, too.   Here are some quotes from the book which I hope will pique your interest.

My characterization of a loser is someone who, after making a mistake, doesn’t introspect, doesn’t exploit it, feels embarrassed and defensive rather than enriched with a new piece of information, and tries to explain why he made the mistake rather than moving on.

He who has never sinned is less reliable than he who has only sinned once.  And someone who has made plenty of errors—though never the same error more than once—is more reliable than someone who has never made any.

As a rule, intervening to limit size (of companies, airports, or sources of pollution), concentrations and speed are beneficial in reducing Black Swan risks.  These actions may be devoid of iatrogenics—but it is hard to get governments to limit the size of government.

My idea of the modern Stoic sage is someone who transforms fear into prudence, pain into information, mistakes into initiation, and desire into undertaking.

The true hero in the Black Swan world is someone who prevents a calamity and, naturally, because the calamity did not happen, does not get recognition—or a bonus—for it.

Anything that needs to be marketed heavily is necessarily either an inferior product or an evil one.

If there is something in nature you don’t understand, odds are it makes sense in a deeper way that is beyond your understanding.

Lessons for Wall Street from Hammurabi’s Code

The Code of Hammurabi in ancient Babylon had this to say about the social responsibility of business.

If a builder builds a house and the house collapses and causes the death of the owner, the builder shall be put to death.  If it causes the death of the son of the owner, a son of the builder shall be put to death.

Nassim Nicholas Talbeb, author of Fooled by Randomness, The Black Swan and the forthcoming Anti-fragile: Things That Gain From Disorder, said in a still-relevant interview last October that the banking crisis is due to the fact that we’ve forgotten the age-old wisdom of every civilization since the time of Hammurabi—that people should be responsible for the consequences of their actions.

The opposite has been the case with the U.S. banking and financial system since the Reagan administration, he said.  The pattern is that financial institutions gain huge profits from taking huge risks, the executives walk away with huge bonuses and then when their gambles fail, they successfully look to taxpayers to be bailed out from the consequences of their actions. This is wrong.

“If there is an upside, there should be a downside,”  Taleb said.  If you get to keep the profits, you should bear the losses.  If your negligence causes other people to suffer, you should suffer yourself.   This has been well understood down through history until very recently.

No executive of a financial institution that has been bailed out should ever receive a bonus, Taleb said; no executive of a financial institution that has been bailed out should be paid more than a civil servant of equal rank.  After all, if the bank or investment firm has been rescued with U.S. tax dollars, then the executive are in effect employees of American taxpayers.

Taleb himself is a speculator in options and derivatives.   Speculation, like high-stakes poker, does no harm so long as the speculator is gambling with his own money and the money of people willing to take a chance on losing it.

Below is a later interview with Taleb.

Ten principles for a Black Swan-proof world

Nassim Nicholas Taleb is a self-taught philosopher and self-described “mathematical trader.” In his books, Fooled by Randomness and The Black Swan, he warned of the dangers of not expecting the unexpected.

In a new chapter in the latest edition of The Black Swan, he wrote of how his principles can be applied to avert a future financial crisis.

1. What is fragile should break early while it is still small. Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks – and hence the most fragile – become the biggest.

2. No socialization of losses and privatization of gains. Whatever may need to be bailed out should be nationalized; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism. In France in the 1980s, the socialists took over the banks. In the US in the 2000s, the banks took over the government. This is surreal.

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus. The economics establishment (universities, regulators, central bankers, government officials, various organizations staffed with economists) lost its legitimacy with the failure of the system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out of this mess. Instead, find the smart people whose hands are clean.

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.