This article originally appeared in the New Yorker in April
2002.
One day in 1996, a Wall Street trader named Nassim Nicholas
Taleb went to see Victor Niederhoffer. Victor Niederhoffer was one of the most
successful money managers in the country. He lived and worked out of a
thirteen-acre compound in Fairfield County, Connecticut, and when Taleb drove
up that day from his home in Larchmont he had to give his name at the gate, and
then make his way down a long, curving driveway. Niederhoffer had a squash
court and a tennis court and a swimming pool and a colossal, faux-alpine
mansion in which virtually every square inch of space was covered with
eighteenth- and nineteenth-century American folk art. In those days, he played
tennis regularly with the billionaire financier George Soros. He had just
written a best-selling book, “The Education of a Speculator,” dedicated to his
father, Artie Niederhoffer, a police officer from Coney Island. He had a huge
and eclectic library and a seemingly insatiable desire for knowledge. When
Niederhoffer went to Harvard as an undergraduate, he showed up for the very
first squash practice and announced that he would someday be the best in that
sport; and, sure enough, he soon beat the legendary Shariff Khan to win the
U.S. Open squash championship. That was the kind of man Niederhoffer was. He
had heard of Taleb’s growing reputation in the esoteric field of options
trading, and summoned him to Connecticut. Taleb was in awe.
“He didn’t talk much, so I observed him,” Taleb recalls. “I
spent seven hours watching him trade. Everyone else in his office was in his
twenties, and he was in his fifties, and he had the most energy of them all.
Then, after the markets closed, he went out to hit a thousand backhands on the
tennis court.” Taleb is Greek-Orthodox Lebanese and his first language was
French, and in his pronunciation the name Niederhoffer comes out as the
slightly more exotic Nieder hoffer. “Here was a guy living in a mansion with
thousands of books, and that was my dream as a child,” Taleb went on. “He was
part chevalier, part scholar. My respect for him was intense.” There was just
one problem, however, and it is the key to understanding the strange path that
Nassim Taleb has chosen, and the position he now holds as Wall Street’s
principal dissident. Despite his envy and admiration, he did not want to be
Victor Niederhoffer — not then, not now, and not even for a moment in between.
For when he looked around him, at the books and the tennis court and the folk
art on the walls — when he contemplated the countless millions that
Niederhoffer had made over the years — he could not escape the thought that it
might all have been the result of sheer, dumb luck.
Taleb knew how heretical that thought was. Wall Street was
dedicated to the principle that when it came to playing the markets there was
such a thing as expertise, that skill and insight mattered in investing just as
skill and insight mattered in surgery and golf and flying fighter jets. Those
who had the foresight to grasp the role that software would play in the modern
world bought Microsoft in 1985, and made a fortune. Those who understood the
psychology of investment bubbles sold their tech stocks at the end of 1999 and
escaped the Nasdaq crash. Warren Buffett was known as the “sage of Omaha”
because it seemed incontrovertible that if you started with nothing and ended
up with billions then you had to be smarter than everyone else: Buffett was
successful for a reason. Yet how could you know, Taleb wondered, whether that
reason was responsible for someone’s success, or simply a rationalization
invented after the fact? George Soros seemed to be successful for a reason,
too. He used to say that he followed something called “the theory of
reflexivity.” But then, later, Soros wrote that in most situations his theory
“is so feeble that it can be safely ignored.” An old trading partner of
Taleb’s, a man named Jean-Manuel Rozan, once spent an entire afternoon arguing
about the stock market with Soros. Soros was vehemently bearish, and he had an
elaborate theory to explain why, which turned out to be entirely wrong. The
stock market boomed. Two years later, Rozan ran into Soros at a tennis
tournament. “Do you remember our conversation?” Rozan asked. “I recall it very
well,” Soros replied. “I changed my mind, and made an absolute fortune.” He
changed his mind! The truest thing about Soros seemed to be what his son Robert
had once said:
My father will sit down and give you theories to explain why
he does this or that. But I remember seeing it as a kid and thinking, Jesus
Christ, at least half of this is bullshit. I mean, you know the reason he
changes his position on the market or whatever is because his back starts killing
him. It has nothing to do with reason. He literally goes into a spasm, and it?s
this early warning sign.
For Taleb, then, the question why someone was a success in
the financial marketplace was vexing. Taleb could do the arithmetic in his
head. Suppose that there were ten thousand investment managers out there, which
is not an outlandish number, and that every year half of them, entirely by
chance, made money and half of them, entirely by chance, lost money. And
suppose that every year the losers were tossed out, and the game replayed with
those who remained. At the end of five years, there would be three hundred and
thirteen people who had made money in every one of those years, and after ten
years there would be nine people who had made money every single year in a row,
all out of pure luck. Niederhoffer, like Buffett and Soros, was a brilliant
man. He had a Ph.D. in economics from the University of Chicago. He had
pioneered the idea that through close mathematical analysis of patterns in the
market an investor could identify profitable anomalies. But who was to say that
he wasn’t one of those lucky nine? And who was to say that in the eleventh year
Niederhoffer would be one of the unlucky ones, who suddenly lost it all, who
suddenly, as they say on Wall Street, “blew up”?
Taleb remembered his childhood in Lebanon and watching his
country turn, as he puts it, from “paradise to hell” in six months. His family
once owned vast tracts of land in northern Lebanon. All of that was gone. He
remembered his grandfather, the former Deputy Prime Minister of Lebanon and the
son of a Deputy Prime Minister of Lebanon and a man of great personal dignity,
living out his days in a dowdy apartment in Athens. That was the problem with a
world in which there was so much uncertainty about why things ended up the way
they did: you never knew whether one day your luck would turn and it would all
be washed away.
So here is what Taleb took from Niederhoffer. He saw that
Niederhoffer was a serious athlete, and he decided that he would be, too. He
would bicycle to work and exercise in the gym. Niederhoffer was a staunch
empiricist, who turned to Taleb that day in Connecticut and said to him
sternly, “Everything that can be tested must be tested,” and so when Taleb
started his own hedge fund, a few years later, he called it Empirica. But that
is where it stopped. Nassim Taleb decided that he could not pursue an
investment strategy that had any chance of blowing up.
Nassim Taleb is a tall, muscular man in his early forties,
with a salt-and-pepper beard and a balding head. His eyebrows are heavy and his
nose is long. His skin has the olive hue of the Levant. He is a man of moods,
and when his world turns dark the eyebrows come together and the eyes narrow
and it is as if he were giving off an electrical charge. It is said, by some of
his friends, that he looks like Salman Rushdie, although at his office his
staff have pinned to the bulletin board a photograph of a mullah they swear is
Taleb’s long-lost twin, while Taleb himself maintains, wholly implausibly, that
he resembles Sean Connery. He lives in a four-bedroom Tudor with twenty-six
Russian Orthodox icons, nineteen Roman heads, and four thousand books, and he
rises at dawn to spend an hour writing. He is the author of two books, the
first a technical and highly regarded work on derivatives, and the second a
treatise entitled “Fooled by Randomness,” which was published last year and is
to conventional Wall Street wisdom approximately what Martin Luther’s
ninety-five theses were to the Catholic Church. Some afternoons, he drives into
the city and attends a philosophy lecture at City University. During the school
year, in the evenings, he teaches a graduate course in finance at New York
University, after which he can often be found at the bar at Odeon Café in
Tribeca, holding forth, say, on the finer points of stochastic volatility or
his veneration of the Greek poet C. P. Cavafy.
Taleb runs Empirica Capital out of an anonymous, concrete
office park somewhere in the woods outside Greenwich, Connecticut. His offices
consist, principally, of a trading floor about the size of a Manhattan studio
apartment. Taleb sits in one corner, in front of a laptop, surrounded by the
rest of his team — Mark Spitznagel, the chief trader, another trader named
Danny Tosto, a programmer named Winn Martin, and a graduate student named
Pallop Angsupun. Mark Spitznagel is perhaps thirty. Win, Danny, and Pallop look
as if they belonged in high school. The room has an overstuffed bookshelf in
one corner, and a television muted and tuned to CNBC. There are two ancient
Greek heads, one next to Taleb’s computer and the other, somewhat bafflingly,
on the floor, next to the door, as if it were being set out for the trash.
There is almost nothing on the walls, except for a slightly battered poster for
an exhibition of Greek artifacts, the snapshot of the mullah, and a small
pen-and-ink drawing of the patron saint of Empirica Capital, the philosopher
Karl Popper.
On a recent spring morning, the staff of Empirica were concerned
with solving a thorny problem, having to do with the square root of n, where n
is a given number of random set of observations, and what relation n might have
to a speculator’s confidence in his estimations. Taleb was up at a whiteboard
by the door, his marker squeaking furiously as he scribbled possible solutions.
Spitznagel and Pallop looked on intently. Spitznagel is blond and from the
Midwest and does yoga: in contrast to Taleb, he exudes a certain laconic
levelheadedness. In a bar, Taleb would pick a fight. Spitznagel would break it
up. Pallop is of Thai extraction and is doing a Ph.D. in financial mathematics
at Princeton. He has longish black hair, and a slightly quizzical air. “Pallop
is very lazy,” Taleb will remark, to no one in particular, several times over
the course of the day, although this is said with such affection that it
suggests that “laziness,” in the Talebian nomenclature, is a synonym for
genius. Pallop’s computer was untouched and he often turned his chair around,
so that he faced completely away from his desk. He was reading a book by the
cognitive psychologists Amos Tversky and Daniel Kahneman, whose arguments, he
said a bit disappointedly, were “not really quantifiable.” The three argued
back and forth about the solution. It appeared that Taleb might be wrong, but
before the matter could be resolved the markets opened. Taleb returned to his
desk and began to bicker with Spitznagel about what exactly would be put on the
company boom box. Spitznagel plays the piano and the French horn and has
appointed himself the Empirica d.j. He wanted to play Mahler, and Taleb does
not like Mahler. “Mahler is not good for volatility,” Taleb complained. “Bach
is good. St. Matthew’s Passion!” Taleb gestured toward Spitznagel, who was
wearing a gray woollen turtleneck. “Look at him. He wants to be like von
Karajan, like someone who wants to live in a castle. Technically superior to
the rest of us. No chitchatting. Top skier. That’s Mark!” As Spitznagel rolled
his eyes, a man whom Taleb refers to, somewhat mysteriously, as Dr. Wu wandered
in. Dr. Wu works for another hedge fund, down the hall, and is said to be
brilliant. He is thin and squints through black-rimmed glasses. He was asked
his opinion on the square root of n but declined to answer. “Dr. Wu comes here
for intellectual kicks and to borrow books and to talk music with Mark,” Taleb
explained after their visitor had drifted away. He added darkly, “Dr. Wu is a
Mahlerian.”
Empirica follows a very particular investment strategy. It
trades options, which is to say that it deals not in stocks and bonds but with
bets on stocks and bonds. Imagine, for example, that General Motors stock is
trading at fifty dollars, and imagine that you are a major investor on Wall
Street. An options trader comes up to you with a proposition. What if, within
the next three months, he decides to sell you a share of G.M. at forty-five
dollars? How much would you charge for agreeing to buy it at that price? You
would look at the history of G.M. and see that in a three-month period it has
rarely dropped ten per cent, and obviously the trader is only going to make you
buy his G.M. at forty-five dollars if the stock drops below that point. So you
say you’ll make that promise, or sell that option, for a relatively small fee, say,
a dime. You are betting on the high probability that G.M. stock will stay
relatively calm over the next three months, and if you are right you’ll pocket
the dime as pure profit. The trader, on the other hand, is betting on the
unlikely event that G.M. stock will drop a lot, and if that happens his profits
are potentially huge. If the trader bought a million options from you at a dime
each and G.M. drops to thirty-five dollars, he’ll buy a million shares at
thirty-five dollars and turn around and force you to buy them at forty-five
dollars, making himself suddenly very rich and you substantially poorer.
That particular transaction is called, in the argot of Wall
Street, an “out-of-the-money option.” But an option can be configured in a vast
number of ways. You could sell the trader a G.M. option at thirty dollars, or,
if you wanted to bet against G.M. stock going up, you could sell a G.M. option
at sixty dollars. You could sell or buy options on bonds, on the S. & P.
index, on foreign currencies or on mortgages, or on the relationship among any
number of financial instruments of your choice; you can bet on the market
booming, or the market crashing, or the market staying the same. Options allow
investors to gamble heavily and turn one dollar into ten. They also allow
investors to hedge their risk. The reason your pension fund may not be wiped
out in the next crash is that it has protected itself by buying options. What
drives the options game is the notion that the risks represented by all of
these bets can be quantified; that by looking at the past behavior of G.M. you
can figure out the exact chance of G.M. hitting forty-five dollars in the next
three months, and whether at a dollar that option is a good or a bad
investment. The process is a lot like the way insurance companies analyze
actuarial statistics in order to figure out how much to charge for a
life-insurance premium, and to make those calculations every investment bank
has, on staff, a team of Ph.D.s, physicists from Russia, applied mathematicians
from China, computer scientists from India. On Wall Street, those Ph.D.s are
called “quants.”
Nassim Taleb and his team at Empirica are quants. But they
reject the quant orthodoxy, because they don’t believe that things like the
stock market behave in the way that physical phenomena like mortality
statistics do. Physical events, whether death rates or poker games, are the
predictable function of a limited and stable set of factors, and tend to follow
what statisticians call a “normal distribution,” a bell curve. But do the ups
and downs of the market follow a bell curve? The economist Eugene Fama once
studied stock prices and pointed out that if they followed a normal
distribution you’d expect a really big jump, what he specified as a movement
five standard deviations from the mean, once every seven thousand years. In
fact, jumps of that magnitude happen in the stock market every three or four
years, because investors don’t behave with any kind of statistical orderliness.
They change their mind. They do stupid things. They copy each other. They
panic. Fama concluded that if you charted the ups and downs of the stock market
the graph would have a “fat tail,”meaning that at the upper and lower ends of
the distribution there would be many more outlying events than statisticians
used to modelling the physical world would have imagined.
In the summer of 1997, Taleb predicted that hedge funds like
Long Term Capital Management were headed for trouble, because they did not
understand this notion of fat tails. Just a year later, L.T.C.M. sold an
extraordinary number of options, because its computer models told it that the
markets ought to be calming down. And what happened? The Russian government
defaulted on its bonds; the markets went crazy; and in a matter of weeks
L.T.C.M. was finished. Spitznagel, Taleb’s head trader, says that he recently
heard one of the former top executives of L.T.C.M. give a lecture in which he
defended the gamble that the fund had made. “What he said was, Look, when I
drive home every night in the fall I see all these leaves scattered around the
base of the trees,?” Spitznagel recounts. “There is a statistical distribution
that governs the way they fall, and I can be pretty accurate in figuring out
what that distribution is going to be. But one day I came home and the leaves
were in little piles. Does that falsify my theory that there are statistical
rules governing how leaves fall? No. It was a man-made event.” In other words,
the Russians, by defaulting on their bonds, did something that they were not
supposed to do, a once-in-a-lifetime, rule-breaking event. But this, to Taleb,
is just the point: in the markets, unlike in the physical universe, the rules
of the game can be changed. Central banks can decide to default on
government-backed securities.
One of Taleb’s earliest Wall Street mentors was a
short-tempered Frenchman named Jean-Patrice, who dressed like a peacock and had
an almost neurotic obsession with risk. Jean-Patrice would call Taleb from
Regine’s at three in the morning, or take a meeting in a Paris nightclub,
sipping champagne and surrounded by scantily clad women, and once Jean-Patrice
asked Taleb what would happen to his positions if a plane crashed into his
building. Taleb was young then and brushed him aside. It seemed absurd. But
nothing, Taleb soon realized, is absurd. Taleb likes to quote David Hume: “No
amount of observations of white swans can allow the inference that all swans
are white, but the observation of a single black swan is sufficient to refute
that conclusion.” Because L.T.C.M. had never seen a black swan in Russia, it
thought no Russian black swans existed. Taleb, by contrast, has constructed a
trading philosophy predicated entirely on the existence of black swans. on the
possibility of some random, unexpected event sweeping the markets. He never
sells options, then. He only buys them. He’s never the one who can lose a great
deal of money if G.M. stock suddenly plunges. Nor does he ever bet on the
market moving in one direction or another. That would require Taleb to assume
that he understands the market, and he doesn’t. He hasn’t Warren Buffett’s
confidence. So he buys options on both sides, on the possibility of the market
moving both up and down. And he doesn’t bet on minor fluctuations in the
market. Why bother? If everyone else is vastly underestimating the possibility
of rare events, then an option on G.M. at, say, forty dollars is going to be
undervalued. So Taleb buys out-of-the-money options by the truckload. He buys
them for hundreds of different stocks, and if they expire before he gets to use
them he simply buys more. Taleb doesn’t even invest in stocks, not for Empirica
and not for his own personal account. Buying a stock, unlike buying an option,
is a gamble that the future will represent an improved version of the past. And
who knows whether that will be true? So all of Taleb’s personal wealth, and the
hundreds of millions that Empirica has in reserve, is in Treasury bills. Few on
Wall Street have taken the practice of buying options to such extremes. But if
anything completely out of the ordinary happens to the stock market, if some
random event sends a jolt through all of Wall Street and pushes G.M. to, say,
twenty dollars, Nassim Taleb will not end up in a dowdy apartment in Athens. He
will be rich.
Not long ago, Taleb went to a dinner in a French restaurant
just north of Wall Street. The people at the dinner were all quants: men with
bulging pockets and open-collared shirts and the serene and slightly detached
air of those who daydream in numbers. Taleb sat at the end of the table,
drinking pastis and discussing French literature. There was a chess grand
master at the table, with a shock of white hair, who had once been one of
Anatoly Karpov’s teachers, and another man who over the course of his career
had worked, in order, at Stanford University, Exxon, Los Alamos National
Laboratory, Morgan Stanley, and a boutique French investment bank. They talked
about mathematics and chess and fretted about one of their party who had not
yet arrived and who had the reputation, as one of the quants worriedly said, of
“not being able to find the bathroom.” When the check came, it was given to a
man who worked in risk management at a big Wall Street bank, and he stared at
it for a long time, with a slight mixture of perplexity and amusement, as if he
could not remember what it was like to deal with a mathematical problem of such
banality. The men at the table were in a business that was formally about
mathematics but was really about epistemology, because to sell or to buy an
option requires each party to confront the question of what it is he truly
knows. Taleb buys options because he is certain that, at root, he knows
nothing, or, more precisely, that other people believe they know more than they
do. But there were plenty of people around that table who sold options, who
thought that if you were smart enough to set the price of the option properly
you could win so many of those one-dollar bets on General Motors that, even if
the stock ever did dip below forty-five dollars, you’d still come out far
ahead. They believe that the world is a place where, at the end of the day,
leaves fall more or less in a predictable pattern.
The distinction between these two sides is the divide that
emerged between Taleb and Niederhoffer all those years ago in Connecticut.
Niederhoffer’s hero is the nineteenth-century scientist Francis Galton.
Niederhoffer called his eldest daughter Galt, and there is a full-length
portrait of Galton in his library. Galton was a statistician and a social
scientist (and a geneticist and a meteorologist), and if he was your hero you
believed that by marshalling empirical evidence, by aggregating data points, you
could learn whatever it was you needed to know. Taleb’s hero, on the other
hand, is Karl Popper, who said that you could not know with any certainty that
a proposition was true; you could only know that it was not true. Taleb makes
much of what he learned from Niederhoffer, but Niederhoffer insists that his
example was wasted on Taleb. “In one of his cases, Rumpole of the Bailey talked
about being tried by the bishop who doesn’t believe in God,” Niederhoffer says.
“Nassim is the empiricist who doesn’t believe in empiricism.” What is it that
you claim to learn from experience, if you believe that experience cannot be
trusted? Today, Niederhoffer makes a lot of his money selling options, and more
often than not the person who he sells those options to is Nassim Taleb. If one
of them is up a dollar one day, in other words, that dollar is likely to have
come from the other. The teacher and pupil have become predator and prey.
Years ago, Nassim Taleb worked at the investment bank First
Boston, and one of the things that puzzled him was what he saw as the mindless
industry of the trading floor. A trader was supposed to come in every morning
and buy and sell things, and on the basis of how much money he made buying and
selling he was given a bonus. If he went too many weeks without showing a
profit, his peers would start to look at him funny, and if he went too many
months without showing a profit he would be gone. The traders were often well
educated, and wore Savile Row suits and Ferragamo ties. They dove into the markets
with a frantic urgency. They read the Wall Street Journal closely and gathered
around the television to catch breaking news. “The Fed did this, the Prime
Minister of Spain did that,” Taleb recalls. “The Italian Finance Minister says
there will be no competitive devaluation, this number is higher than expected,
Abby Cohen just said this.” It was a scene that Taleb did not understand.
“He was always so conceptual about what he was doing,” says
Howard Savery, who was Taleb?s assistant at the French bank Indosuez in the
nineteen-eighties. “He used to drive our floor trader (his name was Tim) crazy.
Floor traders are used to precision: “Sell a hundred futures at eighty-seven.”
Nassim would pick up the phone and say, “Tim, sell some.” And Tim would say, “How
many?” And he would say, “Oh, a social amount.” It was like saying, “I don’t
have a number in mind, I just know I want to sell.” There would be these heated
arguments in French, screaming arguments. Then everyone would go out to dinner
and have fun. Nassim and his group had this attitude that we’re not interested
in knowing what the new trade number is. When everyone else was leaning over
their desks, listening closely to the latest figures, Nassim would make a big
scene of walking out of the room.”
At Empirica, then, there are no Wall Street Journals to be
found. There is very little active trading, because the options that the fund
owns are selected by computer. Most of those options will be useful only if the
market does something dramatic, and, of course, on most days the market
doesn’t. So the job of Taleb and his team is to wait and to think. They analyze
the company’s trading policies, back-test various strategies, and construct
ever-more sophisticated computer models of options pricing. Danny, in the
corner, occasionally types things into the computer. Pallop looks dreamily off
into the distance. Spitznagel takes calls from traders, and toggles back and
forth between screens on his computer. Taleb answers e-mails and calls one of
the firm’s brokers in Chicago, affecting, as he does, the kind of Brooklyn
accent that people from Brooklyn would have if they were actually from northern
Lebanon: “Howyoudoin?” It is closer to a classroom than to a trading floor.
“Pallop, did you introspect?” Taleb calls out as he wanders
back in from lunch. Pallop is asked what his Ph.D. is about. “Pretty much
this,” he says, waving a languid hand around the room.
“It looks like we will have to write it for him,” Taleb
chimes in, “because Pollop is very lazy.”
What Empirica has done is to invert the traditional
psychology of investing. You and I, if we invest conventionally in the market,
have a fairly large chance of making a small amount of money in a given day
from dividends or interest or the general upward trend of the market. We have
almost no chance of making a large amount of money in one day, and there is a
very small, but real, possibility that if the market collapses we could blow
up. We accept that distribution of risks because, for fundamental reasons, it feels
right. In the book that Pallop was reading by Kahneman and Tversky, for
example, there is a description of a simple experiment, where a group of people
were told to imagine that they had three hundred dollars. They were then given
a choice between (a) receiving another hundred dollars or (b) tossing a coin,
where if they won they got two hundred dollars and if they lost they got
nothing. Most of us, it turns out, prefer (a) to (b). But then Kahneman and
Tversky did a second experiment. They told people to imagine that they had five
hundred dollars, and then asked them if they would rather (c) give up a hundred
dollars or (d) toss a coin and pay two hundred dollars if they lost and nothing
at all if they won. Most of us now prefer (d) to (c). What is interesting about
those four choices is that, from a probabilistic standpoint, they are
identical. They all yield an expected outcome of four hundred dollars.
Nonetheless, we have strong preferences among them. Why? Because we’re more
willing to gamble when it comes to losses, but are risk averse when it comes to
our gains. That’s why we like small daily winnings in the stock market, even if
that requires that we risk losing everything in a crash.
At Empirica, by contrast, every day brings a small but real
possibility that they’ll make a huge amount of money in a day; no chance that
they’ll blow up; and a very large possibility that they’ll lose a small amount
of money. All those dollar, and fifty-cent, and nickel options that Empirica
has accumulated, few of which will ever be used, soon begin to add up. By
looking at a particular column on the computer screens showing Empirica’s
positions, anyone at the firm can tell you precisely how much money Empirica
has lost or made so far that day. At 11:30 A.M., for instance, they had
recovered just twenty-eight percent of the money they had spent that day on
options. By 12:30, they had recovered forty per cent, meaning that the day was
not yet half over and Empirica was already in the red to the tune of several
hundred thousand dollars. The day before that, it had made back eighty-five per
cent of its money; the day before that, forty-eight per cent; the day before
that, sixty-five per cent; and the day before that also sixty-five per cent;
and, in fact-with a few notable exceptions, like the few days when the market
reopened after September 11th — Empirica has done nothing but lose money since
last April. “We cannot blow up, we can only bleed to death,” Taleb says, and
bleeding to death, absorbing the pain of steady losses, is precisely what human
beings are hardwired to avoid. “Say you’ve got a guy who is long on Russian
bonds,” Savery says. “He’s making money every day. One day, lightning strikes
and he loses five times what he made. Still, on three hundred and sixty-four
out of three hundred and sixty-five days he was very happily making money. It’s
much harder to be the other guy, the guy losing money three hundred and
sixty-four days out of three hundred and sixty-five, because you start
questioning yourself. Am I ever going to make it back? Am I really right? What
if it takes ten years? Will I even be sane ten years from now?” What the normal
trader gets from his daily winnings is feedback, the pleasing illusion of
progress. At Empirica, there is no feedback. “It’s like you’re playing the
piano for ten years and you still can’t play chopsticks,” Spitznagel say, “and
the only thing you have to keep you going is the belief that one day you’ll
wake up and play like Rachmaninoff.” Was it easy knowing that Niederhoffer — who
represented everything they thought was wrong — was out there getting rich
while they were bleeding away? Of course it wasn’t . If you watched Taleb
closely that day, you could see the little ways in which the steady drip of
losses takes a toll. He glanced a bit too much at the Bloomberg. He leaned
forward a bit too often to see the daily loss count. He succumbs to an array of
superstitious tics. If the going is good, he parks in the same space every day;
he turned against Mahler because he associates Mahler with the last year’s long
dry spell. “Nassim says all the time that he needs me there, and I believe
him,” Spitznagel says. He is there to remind Taleb that there is a point to
waiting, to help Taleb resist the very human impulse to abandon everything and
stanch the pain of losing. “Mark is my cop,” Taleb says. So is Pallop: he is
there to remind Taleb that Empirica has the intellectual edge.
“The key is not having the ideas but having the recipe to
deal with your ideas,” Taleb says. “We don’t need moralizing. We need a set of
tricks.” His trick is a protocol that stipulates precisely what has to be done
in every situation. “We built the protocol, and the reason we did was to tell
the guys, Don’t listen to me, listen to the protocol. Now, I have the right to
change the protocol, but there is a protocol to changing the protocol. We have
to be hard on ourselves to do what we do. The bias we see in Niederhoffer we
see in ourselves.” At the quant dinner, Taleb devoured his roll, and as the
busboy came around with more rolls Taleb shouted out “No, no!” and blocked his
plate. It was a never-ending struggle, this battle between head and heart. When
the waiter came around with wine, he hastily covered the glass with his hand.
When the time came to order, he asked for steak frites — without the frites,
please! — and then immediately tried to hedge his choice by negotiating with
the person next to him for a fraction of his frites.
The psychologist Walter Mischel has done a series of
experiments where he puts a young child in a room and places two cookies in
front of him, one small and one large. The child is told that if he wants the
small cookie he need only ring a bell and the experimenter will come back into
the room and give it to him. If he wants the better treat, though, he has to
wait until the experimenter returns on his own, which might be anytime in the
next twenty minutes. Mischel has videotapes of six-year-olds, sitting in the
room by themselves, staring at the cookies, trying to persuade themselves to wait.
One girl starts to sing to herself. She whispers what seems to be the
instructions — that she can have the big cookie if she can only wait. She
closes her eyes. Then she turns her back on the cookies. Another little boy
swings his legs violently back and forth, and then picks up the bell and
examines it, trying to do anything but think about the cookie he could get by
ringing it. The tapes document the beginnings of discipline and self-control —
the techniques we learn to keep our impulses in check — and to watch all the
children desperately distracting themselves is to experience the shock of
recognition: that’s Nassim Taleb!
There is something else as well that helps to explain
Taleb’s resolve — more than the tics and the systems and the self-denying ordinances.
It happened a year or so before he went to see Niederhoffer. Taleb had been
working as a trader at the Chicago Mercantile Exchange, and developed a
persistently hoarse throat. At first, he thought nothing of it: a hoarse throat
was an occupational hazard of spending every day in the pit. Finally, when he
moved back to New York, he went to see a doctor, in one of those Upper East
Side prewar buildings with a glamorous façade. Taleb sat in the office, staring
out at the plain brick of the courtyard, reading the medical diplomas on the
wall over and over, waiting and waiting for the verdict. The doctor returned
and spoke in a low, grave voice: “I got the pathology report. It’s not as bad
as it sounds ?” But, of course, it was: he had throat cancer. Taleb’s mind shut
down. He left the office. It was raining outside. He walked and walked and
ended up at a medical library. There he read frantically about his disease, the
rainwater forming a puddle under his feet. It made no sense. Throat cancer was
the disease of someone who has spent a lifetime smoking heavily. But Taleb was
young, and he barely smoked at all. His risk of getting throat cancer was
something like one in a hundred thousand, almost unimaginably small. He was a
black swan! The cancer is now beaten, but the memory of it is also Taleb’s
secret, because once you have been a black swan — not just seen one, but lived
and faced death as one — it becomes easier to imagine another on the horizon.
As the day came to an end, Taleb and his team turned their
attention once again to the problem of the square root of n. Taleb was back at
the whiteboard. Spitznagel was looking on. Pallop was idly peeling a banana.
Outside, the sun was beginning to settle behind the trees. “You do a conversion
to p1 and p2,” Taleb said. His marker was once again squeaking across the
whiteboard. “We say we have a Gaussian distribution, and you have the market
switching from a low-volume regime to a high-volume. P21. P22. You have your
igon value.” He frowned and stared at his handiwork. The markets were now
closed. Empirica had lost money, which meant that somewhere off in the woods of
Connecticut Niederhoffer had no doubt made money. That hurt, but if you steeled
yourself, and thought about the problem at hand, and kept in mind that someday
the market would do something utterly unexpected because in the world we live
in something utterly unexpected always happens, then the hurt was not so bad.
Taleb eyed his equations on the whiteboard, and arched an eyebrow. It was a
very difficult problem. “Where is Dr. Wu? Should we call in Dr. Wu?”
A year after Nassim Taleb came to visit him, Victor
Niederhoffer blew up. He sold a very large number of options on the S. & P.
index, taking millions of dollars from other traders in exchange for promising
to buy a basket of stocks from them at current prices, if the market ever fell.
It was an unhedged bet, or what was called on Wall Street a “naked put,”
meaning that he bet everyone on one outcome: he bet in favor of the large
probability of making a small amount of money, and against the small
probability of losing a large amount of money-and he lost. On October 27, 1997,
the market plummeted eight per cent, and all of the many, many people who had
bought those options from Niederhoffer came calling all at once, demanding that
he buy back their stocks at pre-crash prices. He ran through a hundred and
thirty million dollars — his cash reserves, his savings, his other stocks — and
when his broker came and asked for still more he didn’t have it. In a day, one
of the most successful hedge funds in America was wiped out. Niederhoffer had
to shut down his firm. He had to mortgage his house. He had to borrow money
from his children. He had to call Sotheby’s and sell his prized silver
collection — the massive nineteenth-century Brazilian “sculptural group of
victory” made for the Visconde De Figueirdeo, the massive silver bowl designed
in 1887 by Tiffany & Company for the James Gordon Bennet Cup yacht race,
and on and on. He stayed away from the auction. He couldn’t bear to watch.
“It was one of the worst things that has ever happened to me
in my life, right up there with the death of those closest to me,” Niederhoffer
said recently. It was a Saturday in March, and he was in the library of his
enormous house. Two weary-looking dogs wandered in and out. He is a tall man,
an athlete, thick through the upper body and trunk, with a long, imposing face
and baleful, hooded eyes. He was shoeless. One collar on his shirt was twisted
inward, and he looked away as he talked. “I let down my friends. I lost my
business. I was a major money manager. Now I pretty much have had to start from
ground zero.” He paused. “Five years have passed. The beaver builds a dam. The
river washes it away, so he tries to build a better foundation, and I think I
have. But I’m always mindful of the possibility of more failures.” In the
distance, there was a knock on the door. It was a man named Milton Bond, an
artist who had come to present Niederhoffer with a painting he had done of Moby
Dick ramming the Pequod. It was in the folk-art style that Niederhoffer likes
so much, and he went to meet Bond in the foyer, kneeling down in front of the
painting as Bond unwrapped it. Niederhoffer has other paintings of the Pequod
in his house, and paintings of the Essex, the ship on which Melville’s story
was based. In his office, on a prominent wall, is a painting of the Titanic.
They were, he said, his way of staying humble. “One of the reasons I’ve paid
lots of attention to the Essex is that it turns out that the captain of the
Essex, as soon as he got back to Nantucket, was given another job,”
Niederhoffer said. “They thought he did a good job in getting back after the
ship was rammed. The captain was asked, `How could people give you another
ship?’ And he said, `I guess on the theory that lightning doesn’t strike
twice.’ It was a fairly random thing. But then he was given the other ship, and
that one foundered, too. Got stuck in the ice. At that time, he was a lost man.
He wouldn’t even let them save him. They had to forcibly remove him from the
ship. He spent the rest of his life as a janitor in Nantucket. He became what
on Wall Street they call a ghost.” Niederhoffer was back in his study now, his
lanky body stretched out, his feet up on the table, his eyes a little rheumy.
“You see? I can’t afford to fail a second time. Then I’ll be a total washout.
That’s the significance of the Pequod.”
A month or so before he blew up, Taleb had dinner with
Niederhoffer at a restaurant in Westport, and Niederhoffer told him that he had
been selling naked puts. You can imagine the two of them across the table from
each other, Niederhoffer explaining that his bet was an acceptable risk, that
the odds of the market going down so heavily that he would be wiped out were
minuscule, and Taleb listening and shaking his head, and thinking about black
swans. “I was depressed when I left him,” Taleb said. “Here is a guy who goes
out and hits a thousand backhands. He plays chess like his life depends on it.
Here is a guy who, whatever he wants to do when he wakes up in the morning, he
ends up better than anyone else. Whatever he wakes up in the morning and
decides to do, he did better than anyone else. I was talking to my hero . . .”
This was the reason Taleb didn’t want to be Niederhoffer when Niederhoffer was
at his height — the reason he didn’t want the silver and the house and the
tennis matches with George Soros. He could see all too clearly where it all
might end up. In his mind’s eye, he could envision Niederhoffer borrowing money
from his children, and selling off his silver, and talking in a hollow voice
about letting down his friends, and Taleb did not know if he had the strength
to live with that possibility. Unlike Niederhoffer, Taleb never thought he was
invincible. You couldn’t if you had watched your homeland blow up, and had been
the one person in a hundred thousand who gets throat cancer, and so for Taleb
there was never any alternative to the painful process of insuring himself
against catastrophe.
This kind of caution does not seem heroic, of course. It
seems like the joyless prudence of the accountant and the Sunday-school
teacher. The truth is that we are drawn to the Niederhoffers of this world
because we are all, at heart, like Niederhoffer: we associate the willingness
to risk great failure — and the ability to climb back from catastrophe–with
courage. But in this we are wrong. That is the lesson of Taleb and
Niederhoffer, and also the lesson of our volatile times. There is more courage
and heroism in defying the human impulse, in taking the purposeful and painful
steps to prepare for the unimaginable.
Last fall, Niederhoffer sold a large number of options,
betting that the markets would be quiet, and they were, until out of nowhere
two planes crashed into the World Trade Center. “I was exposed. It was nip and
tuck.” Niederhoffer shook his head, because there was no way to have
anticipated September 11th. “That was a totally unexpected event.”
