A strategy for hedge funds and dangerous drivers

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There are business lessons to be drawn from the bad habits of French drivers. We need to beware of activities whose outcomes have a Taleb distribution – many small gains punctuated by occasional large losses.

I have been driving in France again. I have been tailgated and overtaken on the inside. More than once I only just avoided a driver on the wrong side of a blind mountain bend. Why do they do it?

I used to think that French drivers could behave like that because they knew their roads better than I did. The broken glass and the dented cars tell another story. And so do the statistics. Despite the empty roads of rural France, there are so many accidents that the French transport minister has recently taken the extreme step of imploring his compatriots to drive “comme les Anglais”.

The practice of bad driving has what I call a Taleb distribution, after one of the themes in Nassim Nicholas Taleb’s brilliant Fooled by Randomness. A Taleb distribution has the property that many small profits are mixed with occasional large losses. Overtaking on the inside is an activity with a Taleb distribution.

We engage in Taleb distributions because it is so easy to dissociate the losses from the profits. The losses are out of the normal run of things. The cars on the French tow trucks and the drivers in the back of the ambulances were victims of unforeseeable events. They suffered from what commercially minded accountants long ago christened exceptional items. The rule is that you do not match exceptional items against ordinary profits.

Taleb distributions are good when you have experienced only the upside. A Taleb distribution led to the crises in the Lloyd’s insurance market. Excess-of-loss policies – t he LMX spiral – insured other syndicates against losses of unprecedented magnitude. The underwriters pointed out that they had taken in premiums for many years and paid nothing out. You do not have to be as smart as Taleb to see the flaw but you do have to be a little smarter than the Feltrim and Gooda Walker syndicates.

There are other, less abstruse examples. Drinking more than is good for us has a Taleb distribution. So does smoking – after all, most smokers do not get lung cancer.

Many apparently successful traders and business people are still on the upside of their Taleb distribution. They are accidents waiting to happen. It puzzled me for years that so many organisations believed they were making money out of proprietary trading in securities markets. These businesses were trading mostly with each other: since there is no perpetual motion, where did the money to fuel the system come from? From Taleb distributions.

Arbitrage in financial markets generates a continuing stream of small profits. Large losses are exceptional items. They are the product of misjudgments, rogue traders, unpredictable events and the failures of risk control. The same misjudgments, rogue drivers, unpredictable events and system failures that lead to crashes on the French motorways.

We find Taleb distributions not only on the road and in financial institutions. Hedge funds make them accessible to a general public. Business people learnt centuries ago that you can water the milk again and again and again. Until Taleb strikes back: people notice and take their custom elsewhere. Marks and Spencer, the UK retailer, pushed to the limit of what its customers could stand until it discovered that it had crossed that limit. Banks have treated their account holders the same way. Eventually, you pass on the inside once too often.

Evolution favours Taleb distributions. The gene pool of dreadful French drivers is depleted by road accidents – but only at the rate of 8,000 a year. Most young Frenchmen make it to their dates. Evolution within organisations has a similar bias. Someone who makes steady, small gains ranks as a safe pair of hands and is promoted until he meets his apotheosis.

Can we escape the Taleb problem? Understanding risk is the prelude to managing it. We know instinctively that the tailgating driver is not really smart – and nor is the high-yield bond trader. Taleb exploits his distribution by looking for its opposite: trading strategies in securities markets that offer frequent small losses and occasional large gains.

His insight is that no financial institution will tolerate people who lose money nine days out of 10. Another fairly bad day at the office, dear? I hope that Mrs Taleb will continue to be indulgent.

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