“Taleb runs Empirica Capital out of an anonymous concrete office park in the woods on the outskirts of Greenwich, Connecticut…. Empirica follows a very particular investment strategy. It trades options, which is to say that it deals not in stocks and bonds but in the volatility of stocks and bonds… 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 pointed out that if the movement of stock prices 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….
In the summer of 1997, Taleb predicted that hedge finds 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 longdated indexed 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. Mark 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…
Taleb likes to invoke Popper: “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’s moving in one direction or another. That would require Taleb to assume that he understands the market, and he knows that he doesn’t. He doesn’t have Warren Buffett’s confidence. So he buys options on both sides — on the possibility of the market’s 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-themoney options by the truckload. He buys them for hundreds of different stocks, and if they expire worthless 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?… Taleb’s hero…is Karl Popper, who said that you cannot know with certainty that a theory is true; you can only know that it is not true.”
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