The Smartest Guy in the Room

The following is another great list from Nicholas Taleb. He is one of those people that can take a complicated subject and make it understandable for everyone. This latest one is response to the banking crisis and he makes some excellent points. I previously posted his tips for stock traders here. He coined the phrase Black Swan in his book of the same name. Basically it is about the occurrence of the highly unlikely and how this effects our world. He got the example because before Australia was discovered no one had ever heard of a black swan, so any research you did would of confirmed that swans were only white. He then uses this example in relation to financial markets, no matter how much research you do, there is always the chance that the highly unlikely will happen, making all previous assumptions irrelevant.

 Another great example he gives to illustrate the uncertainty in financial markets is the life of a turkey. (Diagram like all images on this blog created using Skitch, I love it!)

If you take any point in the Turkeys life all research will show that he will continue to gain in weight. Until one day (Thanksgiving) the Turkey is killed. Your belief that the turkeys weight would continue to rise did not take into account the unexpected. This is Taleb's key point, that all financial models do not take into account the highly unlikely events, so when they do occur, disaster ensues. You could just as easily replace the turkey with an airline company, the weight with profits and thanksgiving with 9/11.

Ten principles for a Black Swan-proof world

By Nassim Nicholas Taleb

1. What is fragile should break early while it is still small. Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks – and hence the most fragile – become the biggest.

2. No socialisation of losses and privatisation of gains. Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism. In France in the 1980s, the socialists took over the banks. In the US in the 2000s, the banks took over the government. This is surreal.

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus. The economics establishment (universities, regulators, central bankers, government officials, various organisations staffed with economists) lost its legitimacy with the failure of the system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out of this mess. Instead, find the smart people whose hands are clean.

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.

5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.

6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.

7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”. Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.

8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a temporary problem, it is a structural one. We need rehab.

9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement. Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require. Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control).

10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.

Personally I think that due to the world we live in, and the vested interests of those at the top, it is unlikely that this will be paid any attention to by the people who are in a position to make these changes