The Black Swan: The Impact of the Highly Improbable

So the Bank of Sweden and the Nobel Academy are largely responsible for giving credence to the use of the Gaussian Modern Portfolio Theory as institutions have found it a great cover-your-behind approach. Software vendors have sold “Nobel crowned” methods for millions of dollars. How could you go wrong using it? Oddly enough, everyone in the business world initially knew that the idea was a fraud, but people get used to such methods. Alan Greenspan, the chairman of the Federal Reserve bank, supposedly blurted out, “I’d rather have the opinion of a trader than a mathematician.” Meanwhile, the Modern Portfolio Theory started spreading. I will repeat the following until I am hoarse: it is contagion that determines the fate of a theory in social science, not its validity.

I only realized later that Gaussian-trained finance professors were taking over business schools, and therefore MBA programs, and producing close to a hundred thousand students a year in the United States alone, all brainwashed by a phony portfolio theory. No empirical observation could halt the epidemic. It seemed better to teach students a theory based on the Gaussian than to teach them no theory at all. It looked more “scientific” than giving them what Robert C. Merton (the son of the sociologist Robert K. Merton we discussed earlier) called the “anecdote.” Merton wrote that before portfolio theory, finance was “a collection of anecdotes, rules of thumb, and manipulation of accounting data.” Portfolio theory allowed “the subsequent evolution from this conceptual potpourri to a rigorous economic theory.” For a sense of the degree of intellectual seriousness involved, and to compare neoclassical economics to a more honest science, consider this statement from the nineteenth-century father of modern medicine, Claude Bernard: “Facts for now, but with scientific aspirations for later.” You should send economists to medical school.

So the Gaussian[60] pervaded our business and scientific cultures, and terms such as sigma, variance, standard deviation, correlation, R square, and the eponymous Sharpe ratio, all directly linked to it, pervaded the lingo. If you read a mutual fund prospectus, or a description of a hedge fund’s exposure, odds are that it will supply you, among other information, with some quantitative summary claiming to measure “risk.” That measure will be based on one of the above buzzwords derived from the bell curve and its kin. Today, for instance, pension funds’ investment policy and choice of funds are vetted by “consultants” who rely on portfolio theory. If there is a problem, they can claim that they relied on standard scientific method.

More Horror

Things got a lot worse in 1997. The Swedish academy gave another round of Gaussian-based Nobel Prizes to Myron Scholes and Robert C. Merton, who had improved on an old mathematical formula and made it compatible with the existing grand Gaussian general financial equilibrium theories—hence acceptable to the economics establishment. The formula was now “useable.” It had a list of long forgotten “precursors,” among whom was the mathematician and gambler Ed Thorp, who had authored the bestselling Beat the Dealer, about how to get ahead in blackjack, but somehow people believe that Scholes and Merton invented it, when in fact they just made it acceptable. The formula was my bread and butter. Traders, bottom-up people, know its wrinkles better than academics by dint of spending their nights worrying about their risks, except that few of them could express their ideas in technical terms, so I felt I was representing them. Scholes and Merton made the formula dependent on the Gaussian, but their “precursors” subjected it to no such restriction.[61]