DateApril 23, 2018
Chances are you are familiar with the story of Long-Term Capital Management (LTCM), the hedge fund that blew up in spectacular fashion in 1998, a decade before anyone had heard the term ‘global financial crisis’. At the time, the likes of Bear Stearns, Lehmann Brothers and AIG must have seemed like avatars of prudence in comparison to LTCM’s hubristic attempt to ‘academise’ an industry that had been built on some arcane but safe heuristics. LTCM was insanely profitable for a few years. One dollar invested in March 1994 would have grown to over $4 in April 1998, and by this point the fund was generating eye-watering profits with what seemed like a mathematical certitude. But only five months later, that one dollar was worth about 30 cents, and America’s major banks, even those with significant exposure, could not get away fast enough. Only a desperate plea from the New York Fed could avert a total meltdown.
Of course, there are some obvious explanations for LTCM’s demise. The Asian Financial Crisis and the subsequent Russian default are such explanations – the kind that stare you right in the face. Perhaps no one could have predicted that Boris Yeltsin would wake up one morning and decide the world was going to take a haircut. Maybe that’s just something LTCM’s investors had to accept. You take the (very) good with the (very) bad. But for those investors who had lost a lot, including those who thought LTCM was ‘too smart to fail’, this might not be a totally satisfactory explanation. The lesson of LTCM is that it is exactly these sort of highly improbable yet totally devastating events that investors should be most interested in – so-called ‘tail risks’. And it is these tail risks that author Nassim Taleb has spent the better part of his life trying to understand. But Taleb’s solution is not, as might be expected from a mathematician, to resort to ever-more complex risk management frameworks. Instead, Taleb is more sympathetic to a return to the old heuristics that once governed the business of trading and investing – something like your grandmother’s wisdom.
Taleb’s writing is directly relevant for anyone involved in the risk management industry, and is certain to resonate with money managers, traders, superannuants, and anyone who has invested their own time and money in an enterprise. Taleb’s message is that in order for something to survive – whether a fund, a restaurant, or even an entire species – it needs ‘skin in the game’. That is, it needs to be exposed to risk in a way that makes it attuned to the consequences of its actions, both good and bad. Taleb provides a helpful list of those who might be considered to have skin in the game. These include business owners, entrepreneurs, speculators, writers and citizens. In contrast, those who Taleb deems as having no skin in the game (or worse, other people’s skin in their game) include the likes of bankers, bureaucrats, executives, politicians and consultants. Taleb is not kind to those he sees as having insufficient skin in the game, and inter-disciplinarian jabs at popular names such as Seven Pinker, Richard Thaler and even Richard Dawkins are littered throughout the book. Poor Robert Rubin is mercilessly mocked as the architect of the ‘Bob Rubin trade’ (a trade with visible benefits but large and hidden tail risks). Even if these jabs are entertaining (and, to a degree, valid), the reader is left wondering if there is not some deeper resentment at play. Or if the Taleb/Pinker rivalry is not something positively encouraged by their common publisher.
Nevertheless, it is refreshing to see an author so openly critical of his peers, and so ready to provoke debate. From his constant Twitter arguments and attacks on perfectly upstanding people like historian Mary Beard and statistician Nate Silver, you might be tempted to think he is a bit too mercurial and a bit too controversial for a mainstream audience. But there is a reason why the biggest companies and news outlets keep coming back. Taleb is totally unafraid, and totally prepared to hold anyone to account, no matter who they are. This is Taleb as the perennial outsider, the person who talks truth to power and in the process puts his reputation on the line. Taleb does not pick his fights at random. His targets are those he sees as creating too much unnecessary complication and, in the process, giving the public a false sense of certainty. Taleb warns against the abusers of science – a class of people he calls the ‘Intellectual-Yet-Idiot’ (or IYI for short). The IYI is someone with no skin in the game, who perpetuates a naïve view of science that is needlessly complex, overly concerned with aesthetics (that is, looking like science), and designed to justify the existence of a certain profession. This is the problem of ‘scientism’. Science cannot simply be the process of applied scepticism, it needs to be sexy, sophisticated, and most of all elusive (at least to the uninitiated).
The problem of scientism is arguably still relevant for the funds management industry, even in the post-GFC world where the most complex products have fallen out of favour. The reason LTCM’s John Meriwether was so keen to recruit big academic names like Robert Merton and Myron Scholes was that they were able to dazzle investors with the maths, without really giving away much of how the fund worked in practice. Scholes in particular understood the potent force of charisma combined with the comfort of a scientific-looking process. Even for those funds with decidedly less ambitious aims than LTCM can fall prey to a kind of scientism that ultimately reduces transparency and leaves investors vulnerable to hidden risks. To what extent do industry professionals attempt to justify their existence through impenetrable language, processes, or models? As Taleb argues, the more skin in the game you have, the more incentive there is to do away with needless complication.
The most important concept Taleb raises is ergodicity, a technical term in probability theory brought to life in the final chapters. An ergodic system is one that has the same behaviour averaged over time as averaged over the space of all the system’s states (thank you Wikipedia). Investing can be thought of not just as a game, but as a series of games – each day you are invested is another day you are taking on risk. But the risk you take on today is not the same as the risk you are taking on over the course of your investing life. How many times have you picked up a brochure for an investment product and seen a chart showing you how much money you would have accumulated if you had invested from the start (and stayed fully invested)? These charts are completely ubiquitous, but they ignore some fundamental truths about the nature of investing. As we know, investors are not always fully invested, and this can be for a variety of reasons. Importantly, if an investor starts losing too much money, he or she may be forced to reduce their exposure in order to avoid total ruin. While this might seem like irrational behaviour, it is only irrational if the investor has unlimited pockets. For everyone else, sequence matters. This is now becoming a key focus for the retirement industry, and one informed less by the new discipline of behavioural finance than our animal instincts – in order to benefit from something, you first have to survive.
Taleb’s book is incredibly wide-ranging, covering everything from religion, history, and ethics to evolution, anthropology, and genetics. Everything is ultimately tied back to probability and risk, but sometimes in very subtle ways, and always to demonstrate the power of common sense and time-honoured heuristics over complex solutions. For those interested (and mathematically inclined), there is of course the technical appendix, which exists as much as an analytical complement to the narrative as a means of signalling to would-be critics that they may wish to tread carefully. The most interesting parts are undoubtedly those completely unrelated to finance, yet there are truths that readers of this review will understand intuitively. Perhaps the most exciting insight is that skin in the game is necessary, not only to be credible and guard against risks (especially tail risks), but to continue to learn and develop. “Without skin in the game we are dumb,” as Taleb says.
There is a certain irony in reviewing Skin in the Game given Taleb’s view on book reviewers, although thankfully he is referring to those who review books for a living. According to Taleb, there is a skin in the game problem with book reviewers, namely: “a conflict of interest between professional reviewers who think they ought to decide how books should be written, and genuine readers who actually read books because they like to read books.” Taleb’s books are undoubtedly very readable, and structured in a way that is logical and keeps the reader engaged without blowing all the interesting and important stuff in the first chapters. But it is not entirely beyond criticism. His contempt for professional researchers can be difficult to swallow, and will understandably be rejected by finance academics. And while everyone can agree on the need to reduce needless complexity and create better incentives, managing money is not always an entirely simple game – this is ultimately the reason investors rely on professionals in the first place.
Even with good incentives in place, there is always the risk of some highly damaging, low-probability event from wiping us out. Despite investing $146 million of their own capital in the portfolio, the geniuses at LTCM were unable to guard against the risk of devastation. Exactly what this means for risk managers and how incentives can be better aligned to ensure decision-makers are made to “eat their own cooking” is never really spelled out. Yet the book is a satisfying read on so many levels. Amid the anecdotes, asides, friendly swipes, and array of ‘Talebisms’, there is a lot of wisdom packed into these pages. This book is not just for money managers, but for anyone interested in contributing to our own and humanity’s evolution.
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