The most exciting interview this morning with Keene and Prewitt was with Nassim Taleb who comes out swinging against Portfolio Theory. His watchword is that the more it looks like science, the less it works. His new direction is towards tinkering.
The bad news is that he finds that it's going to take a long time to get the current class of academics to change their ways. Those tenured academics who sit at the throne of Merton and Scholes are going to perhaps have to die off before the industry changes. There are a million miseduated MBAs out there according to Taleb, the auther of The Black Swan. His question is how do we survive economically in a world of imperfect information - how do we reverse the hubris of economists?
The answers may be deceptively simple. But understand this, Taleb says that quantitative risk management is essentially dead, and he says that he can prove it. His analysis includes 20million securities over 40 years and he finds that over half of them react to a single variable. The implications are that risk simply cannot me managed with math. There's probably a better way to say it, but he is unequivocal on the point.
His solution is tinkering. He says that the culture of America is especially amenable to an empirical bias. We accept small failures in this culture. We expect people to make mistakes and get back on the horse. Tinkering is encouraged. Trial and error.
Secondly he suggests that the way to manage risk is to only put a small fraction of one's portfolio at risk. The idea of spreading risk through weighting is dead says Taleb. You invest in zero risk or near zero risk items for the overwhelming majority of your portfolio and then let the rest be pure speculation. The result is low risk. What's near zero risk? You tell me.
Finally, he suggest that we pay particular attention to military discipline. Armies always plan for the impossible and highly highly unlikely scenario, and they constantly reassess that every day. What blew up today? It's a different kind of mentality than doubling down and playing the odds on the possibility that you can model the deck of cards.
We're thus going to end up with a different set of tools for managing assets in the future. Taleb invokes Steins rule, what can't go on forever will eventually stop. Portfolio theory cannot go on forever.
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