Trade The Trader: Taleb Vs Niederhoffer

Submitted by Nicholas Colas of DataTrek

Today we resurrect a classic article on trading and investing and discuss what lessons it offers for getting through the current equity market volatility. All of us have deep-seated biases that inform how we set up portfolios and deal with rough patches. Success can often come down with aligning your personality to your positions.

Trade the trader” is an old Wall Street saying and never more appropriate than right now. It means that different people perform better in different markets. Only the greats have the mental flexibility to profit in all seasons. The rest of us need the self-awareness to know when the times suit us, and when they don’t.

We’ve been chatting about a legendary example of “personality investing” with friends over the last few days: Malcolm Gladwell’s 2002 New Yorker magazine profile of Nassim Taleb and Vic Niederhoffer. We’ve attached a link at the end of this section, but we will simplify the piece to give you a quick summary of each man and what we think it means.

First, the two protagonists:

  • Niederhoffer has made several fortunes as a trader but has also gone bust more than once. The reason: he tends to bet on tomorrow being much like yesterday and uses options to juice that prosaic approach. When unusual events occur, the options exposure eats him alive. In between those periods, he kills it.
  • Taleb, famous for his “Black Swan” metaphor that unusual events occur far more frequently than statistical models or people appreciate, takes an entirely different approach. He is happy to wait years, if necessary, for improbable events to occur knowing they are slightly more likely than not. In the interim, he tries to lose as little money as possible. But when the black swan appears, he generates fantastic returns.

Since the article is now 16 years old, we have the benefit of hindsight to evaluate these approaches.

  • Taleb’s hedge fund, called Emperica, closed back in 2005. A similar fund started by an alumnus called Universa has had some strong returns this decade. Taleb himself is now better known as a writer and media personality.
  • Niederhoffer, after being a partner at George Soros’ Quantum Fund, went off on his own and blew up twice – once in 1997 and once in the Financial Crisis. He now has a blog and a Twitter account with just over 5,000 followers.

The genius of Gladwell’s piece is that he identifies why each trader developed their own distinct investment styles.

  • Taleb is Lebanese from a well-known/wealthy family, before the 1975 revolution took all that away. He sees risk as something humans consistently underappreciate, and standard quantitative approaches to market analysis miss an unknowable “X factor” partly due to that blind spot. Tomorrow can look radically worse than today, so you need to plan for that and make sure you are more than 100% hedged.
  • Niederhoffer is both a consummate quant, believing in the data above all else, and a textbook example of the “American dream”: the child of a NYC policeman and teacher who went to Harvard undergrad and University of Chicago for his Ph.D. For him, tomorrow is usually a slightly better version of today. Big hedges are the greenery around your mansion.

Over the years I have observed that long-term investors are much more like Niederhoffer than Taleb, but with human emotion taking the place of options as the factor that blows up portfolios. Left to their own devices, US equities tend to compound at reasonable rates over +10 years. Even horrible years like 2001-2003 and 2008 set up a bounce back that erases those losses in subsequent periods. Fear at the bottom kills returns just as much as ill-advised options positions at the top.

What all this means now in terms of the current market churn and portfolio positioning:

  • We don’t see volatility letting up any time soon. History is clear on this point: October’s drop signals continued choppiness for several more weeks and, perhaps, months.
  • Whatever approach you take to this challenge, you will do better if it is consistent with your personality. Yes, that sounds very New Age-y, but you’ll be less likely to be shaken out if your positions match your natural inclinations. Bullish or bearish…
  • Neither Taleb nor Niederhoffer ultimately proved to be outstanding money managers. Strength of conviction made them ideal subjects for Gladwell’s article, not long term performance. But dogmatic approaches to investing, taken to their extremes, don’t work well. Yes, just like life…

Source: New Yorker article