Robin posted this review of The Black Swan by Nassim Nicholas Taleb a week ago. Taleb responds to the review at his own website:
First, the empirical & logical mistakes:
“Oddly, Taleb’s argument is weakest in the area he knows best, namely finance. Only on Wall Street do people seem to give proper credence—not too much, not too little—to very unlikely events (…) Stock and bond markets offer simple ways to bet on black swans. (…)These investments pay off precisely when the rest of the market does not anticipate the scope for surprise. Yet “long-shot” strategies are well-studied, and they do not yield extra profit.”
A brief summary of what I will discuss next:
1) Selling long shots have yielded (monstrous) extra losses since those selling them (credit, options) go bust periodically. Saying “long-shot” strategies (…)do not yield extra profit” requires removing too many “outliers” from the data and confining the studies to a narrow subset of instruments. In my analysis in TBS I took a long history of all the businesses that depended on a large move: derivatives, credit instruments, bank loans, reinsurance. Betting against large deviations in type-2 randomness does not pay.
2) The market may be collectively able to guess type-1 variables, like the number of beans in a jar, not price instruments that depend on a single unpredictable large event.
The results Cowen refers to may holds solely in a very narrow subset of index options (not stock options), which requires excluding the crash of 1987, and ignoring the impact of the errors.