Nassim Taleb on How A Wing of Economics Hurts Markets

In the FT:

Academic economists are no more self-serving than other professions. You should blame those in the real world who give them the means to be taken seriously: those awarding that “Nobel” prize.

In 1990 William Sharpe and Harry Markowitz won the prize three years after the stock market crash of 1987, an event that, if anything, completely demolished the laureates’ ideas on portfolio construction. Further, the crash of 1987 was no exception: the great mathematical scientist Benoît Mandelbrot showed in the 1960s that these wild variations play a cumulative role in markets – they are “unexpected” only by the fools of economic theories.

Then, in 1997, the Royal Swedish Academy of Sciences awarded the prize to Robert Merton and Myron Scholes for their option pricing formula. I (and many traders) find the prize offensive: many, such as the mathematician and trader Ed Thorp, used a more realistic approach to the formula years before. What Mr Merton and Mr Scholes did was to make it compatible with financial economic theory, by “re-deriving” it assuming “dynamic hedging”, a method of continuous adjustment of portfolios by buying and selling securities in response to price variations.

Dynamic hedging assumes no jumps – it fails miserably in all markets and did so catastrophically in 1987 (failures textbooks do not like to mention).

Later, Robert Engle received the prize for “Arch”, a complicated method of prediction of volatility that does not predict better than simple rules – it was “successful” academically, even though it underperformed simple volatility forecasts that my colleagues and I used to make a living.

[H/t: Saifedean Ammous]