listening to one of my talks, reported that he was struck by the presence of
an acute state of cognitive dissonance in the audience. But how people resolve
this cognitive tension, as it strikes at the core of everything they have
been taught and at the methods they practice, and realize that they will
continue to practice, can vary a lot. It was symptomatic that almost all
people who attacked my thinking attacked a deformed version of it, like
"it is all random and unpredictable" rather than "it is largely random," or
got mixed up by showing me how the bell curve works in some physical
domains. Some even had to change my biography. At a panel in Lugano,
Myron Scholes once got in to a state of rage, and went after a transformed
version of my ideas. I could see pain in his face. Once, in Paris, a prominent
member of the mathematical establishment, who invested part of his life
on some minute sub-sub-property of the Gaussian, blew a fuse—right
when I showed empirical evidence of the role of Black Swans in markets.
He turned red with anger, had difficulty breathing, and started hurling insults
at me for having desecrated the institution, lacking pudeur (modesty);
he shouted "I am a member of the Academy of Science!" to give
more strength to his insults. (The French translation of my book was out
of stock the next day.) My best episode was when Steve Ross, an economist
perceived to be an intellectual far superior to Scholes and Merton,
and deemed a formidable debater, gave a rebuttal to my ideas by signaling
small errors or approximations in my presentation, such as "Markowitz
was not the first to . . ." thus certifying that he had no answer to my main
point. Others who had invested much of their lives in these ideas resorted
to vandalism on the Web. Economists often invoke a strange argument by
Milton Friedman that states that models do not have to have realistic assumptions
to be acceptable—giving them license to produce severely defective
mathematical representations of reality. The problem of course is
that these Gaussianizations do not have realistic assumptions and do not
produce reliable results. They are neither realistic nor predictive. Also note
a mental bias I encounter on the occasion: people mistake an event with a
small probability, say, one in twenty years for a periodically occurring one.
They think that they are safe if they are only exposed to it for ten years.
I had trouble getting the message about the difference between Mediocristan
and Extremistan through—many arguments presented to me were
L O C K E ' S MADMEN, OR B E L L CURVES IN T H E W R O N G PLACES 2 8 1
about how society has done well with the bell curve—just look at credit
bureaus, etc.
The only comment I found unacceptable was, "You are right; we need
you to remind us of the weakness of these methods, but you cannot throw
the baby out with the bath water," meaning that I needed to accept their
reductive Gaussian distribution while also accepting that large deviations
could occur—they didn't realize the incompatibility of the two approaches.
It was as if one could be half dead. Not one of these users of portfolio
theory in twenty years of debates, explained how they could accept the
Gaussian framework as well as large deviations. Not one.
Confirmation
Along the way I saw enough of the confirmation error to make Karl Popper
stand up with rage. People would find data in which there were no
jumps or extreme events, and show me a "proof" that one could use the
Gaussian. This was exactly like my example of the "proof" that O. J .
Simpson is not a killer in Chapter 5. The entire statistical business confused
absence of proof with proof of absence. Furthermore, people did not
understand the elementary asymmetry involved: you need one single observation
to reject the Gaussian, but millions of observations will not fully
confirm the validity of its application. Why? Because the Gaussian bell
curve disallows large deviations, but tools of Extremistan, the alternative,
do not disallow long quiet stretches.
I did not know that Mandelbrot's work mattered outside aesthetics
and geometry. Unlike him, I was not ostracized: I got a lot of approval
from practitioners and decision makers, though not from their research
staffs.
But suddenly I got the most unexpected vindication.
IT WAS JUST A BLACK SWAN
Robert Merton, Jr., and Myron Scholes were founding partners in the
large speculative trading firm called Long-Term Capital Management, or
LTCM, which I mentioned in Chapter 4. It was a collection of people with
top-notch résumés, from the highest ranks of academia. They were considered
geniuses. The ideas of portfolio theory inspired their risk management
of possible outcomes—thanks to their sophisticated "calculations."
They managed to enlarge the ludic fallacy to industrial proportions.
2 8 2 THOSE GRAY SWANS OF EXTREMISTAN
Then, during the summer of 1998, a combination of large events, triggered
by a Russian financial crisis, took place that lay outside their models.
It was a Black Swan. LTCM went bust and almost took down the
entire financial system with it, as the exposures were massive. Since their
models ruled out the possibility of large deviations, they allowed themselves
to take a monstrous amount of risk. The ideas of Merton and
Scholes, as well as those of Modern Portfolio Theory, were starting to go
bust. The magnitude of the losses was spectacular, too spectacular to
allow us to ignore the intellectual comedy. Many friends and I thought
that the portfolio theorists would suffer the fate of tobacco companies:
they were endangering people's savings and would soon be brought to account
for the consequences of their Gaussian-inspired methods.
None of that happened.
Instead, MBAs in business schools went on learning portfolio theory.
And the option formula went on bearing the name Black-Scholes-Merton,
instead of reverting to its true owners, Louis Bachelier, Ed Thorp, and others.
How to "Prove" Things
Merton the younger is a representative of the school of neoclassical economics,
which, as we have seen with LTCM, represents most powerfully
the dangers of Platonified knowledge.* Looking at his methodology, I see
the following pattern. He starts with rigidly Platonic assumptions, completely
unrealistic—such as the Gaussian probabilities, along with many
more equally disturbing ones. Then he generates "theorems" and "proofs"
from these. The math is tight and elegant. The theorems are compatible
with other theorems from Modern Portfolio Theory, themselves compatible
with still other theorems, building a grand theory of how people consume,
save, face uncertainty, spend, and project the future. He assumes
that we know the likelihood of events. The beastly word equilibrium is always
present. But the whole edifice is like a game that is entirely closed,
like Monopoly with all of its rules.
* I am selecting Merton because I found him very illustrative of academically
stamped obscurantism. I discovered Merton's shortcomings from an angry and
threatening seven-page letter he sent me that gave me the impression that he was
not too familiar with how we trade options, his very subject matter. He seemed to
be under the impression that traders rely on "rigorous" economic theory—as if
birds had to study (bad) engineering in order to fly.
L O C K E ' S MADMEN, OR B E L L CURVES IN T H E WRONG PLACES 2 8 3
A scholar who applies such methodology resembles Locke's definition
of a madman: someone "reasoning correctly from erroneous premises."
Now, elegant mathematics has this property: it is perfectly right, not
99 percent so. This property appeals to mechanistic minds who do not
want to deal with ambiguities. Unfortunately you have to cheat somewhere
to make the world fit perfect mathematics; and you have to fudge
your assumptions somewhere. We have seen with the Hardy quote that
professional "pure" mathematicians, however, are as honest as they come.
So where matters get confusing is when someone like Merton tries to
be mathematical and airtight rather than focus on fitness to reality.
This is where you learn from the minds of military people and those
who have responsibilities in security. They do not care about "perfect"
ludic reasoning; they want realistic ecological assumptions. In the end,
they care about lives.
I mentioned in Chapter 11 how those who started the game of "formal
thinking," by manufacturing phony premises in order to generate "rigorous"
theories, were Paul Samuelson, Merton's tutor, and, in the United
Kingdom, John Hicks. These two wrecked the ideas of John Maynard
Keynes, which they tried to formalize (Keynes was interested in uncertainty,
and complained about the mind-closing certainties induced by
models). Other participants in the formal thinking venture were Kenneth
Arrow and Gerard Debreu. All four were Nobeled. All four were in a delusional
state under the effect of mathematics—what Dieudonné called "the
music of reason," and what I call Locke's madness. All of them can be
safely accused of having invented an imaginary world, one that lent itself
to their mathematics. The insightful scholar Martin Shubik, who held that
the degree of excessive abstraction of these models, a few steps beyond necessity,
makes them totally unusable, found himself ostracized, a common
fate for dissenters.*
If you question what they do, as I did with Merton Jr., they will ask for
"tight proof." So they set the rules of the game, and you need to play by
them. Coming from a practitioner background in which the principal asset
is being able to work with messy, but empirically acceptable, mathematics,
* Medieval medicine was also based on equilibrium ideas when it was top-down and
similar to theology. Luckily its practitioners went out of business, as they could not
compete with the bottom-up surgeons, ecologically driven former barbers who
gained clinical experience, and after whom a-Platonic clinical science was born. If
I am alive, today, it is because scholastic top-down medicine went out of business
a few centuries ago.
2 8 4 THOSE GRAY SWANS OF EXTREMISTAN
TABLE 4: TWO WAYS TO APPROACH RANDOMNESS
Skeptical Empiricism
and the a-Platonic School
Interested in what lies outside the Platonic
fold
Respect for those who have the guts
to say "I don't know"
Fat Tony
Thinks of Black Swans as a dominant
source of randomness
Bottom-up
Would ordinarily not wear suits (except
to funerals)
Prefers to be broadly right
Minimal theory, consides theorizing as
a disease to resist
Does not believe that we can easily
compute probabilities
Model: Sextus Empiricus and the
school of evidence-based, minimumtheory
empirical medicine
Develops intuitions from practice,
goes from observations to books
Not inspired by any science, uses
messy mathematics and computational
methods
Ideas based on skepticism, on the unread
books In the library
Assumes Extremistan as a starting
point
Sophisticated craft
Seeks to be approximately right across
a broad set of eventualities
The Platonic Approach
Focuses on the inside of the Platonic
fold
"You keep criticizing these models.
These models are all we have."
Dr. John
Thinks of ordinary fluctuations as a
dominant source of randomness, with
jumps as an afterthought
Top-down
Wears dark suits, white shirts; speaks in
a boring tone
Precisely wrong
Everything needs to fit some grand,
general socioeconomic model and
"the rigor of economic theory"; frowns
on the "descriptive"
Built their entire apparatus on the assumptions
that we can compute
probabilities
Model: Laplacian mechanics, the
world and the economy like a clock
Relies on scientific papers, goes from
books to practice
Inspired by physics, relies on abstract
mathematics
Ideas based on beliefs, on what they
think they know
Assumes Mediocristan as a starting
point
Poor science
Seeks to be perfectly right in a narrow
model, under precise assumptions
L O C K E ' S MADMEN, OR B E L L CURVES IN T H E W R O N G PLACES 2 8 5
I cannot accept a pretense of science. I much prefer a sophisticated craft,
focused on tricks, to a failed science looking for certainties. Or could these
neoclassical model builders be doing something worse? Could it be that
they are involved in what Bishop Huet calls the manufacturing of certainties?
Let us see.
Skeptical empiricism advocates the opposite method. I care about the
premises more than the theories, and I want to minimize reliance on theories,
stay light on my feet, and reduce my surprises. I want to be broadly
right rather than precisely wrong. Elegance in the theories is often indicative
of Platonicity and weakness—it invites you to seek elegance for elegance's
sake. A theory is like medicine (or government): often useless,
sometimes necessary, always self-serving, and on occasion lethal. So it
needs to be used with care, moderation, and close adult supervision.
The distinction in the above table between my model modern, skeptical
empiricist and what Samuelson's puppies represent can be generalized
across disciplines.
I've presented my ideas in finance because that's where I refined them. Let
us now examine a category of people expected to be more thoughtful: the
philosophers.
THE UNCERTAINTY OF THE PHONY
Philosophers in the wrong places—Uncertainty about (mostly) lunch—What I
don't care about—Education and intelligence
This final chapter of Part Three' focuses on a major ramification of the
ludic fallacy: how those whose job it is to make us aware of uncertainty
fail us and divert us into bogus certainties through the back door.
LUDIC FALLACY REDUX
I have explained the ludic fallacy with the casino story, and have insisted
