Nassim Taleb and Future of Finance MBA

I am a big fan of this man, Nicholas Nassim Taleb. Ever since I read his bestseller, "Fooled by Randomness" and subsequent masterpiece, "The Black Swan" I have paid great attention to whatever this man says about the markets. One big reason for my admiration, is the way he dismisses the so-called Wall Street "experts" and the quants and PhDs who apply "deep work in mathematics" to claim mastery over the gyrations seen in the financial markets across various asset classes (obviously not all; Taleb has his favorites). Highly irreverent, Taleb takes on the likes of Myron Scholes and Robert Merton (creators of Black-Scholes option pricing model)for relying on elegant mathematical models to predict the direction of asset prices. These two Nobel Laureates were part of Wall Street "dream team" under John Meriwether, founder of a hedge fund, Long Term Capital Management, which blew up spectacularly during the 1998 Russian Rouble crisis.

Why do I bring up Taleb, now? I happened to read an interesting article written in January 2009 in Portfolio.com; it's about the "battle of minds", the back-and-forth between Taleb and Merton. Here is the link to that article - "Taleb Vs Merton Cont." What got my attention was the way the writer concluded his article. Here is what he says:

...The interesting thing for me about this particular academic feud, however, is that for all its viciousness, the stakes really aren't low at all. Taleb is working towards nothing less than the outright dismantling of Black-Scholes, portfolio theory, and the enormous financial edifices which have been built upon them; if he's successful, essentially all the quants on Wall Street would be out of a job...

Taleb has scant respect for those who continue to rely on Gaussian model in finance. He has derided the experts, who kept denying the possibility of housing crash and subsequent 'credit crisis', as their models kept belying the probability of a crash due to a historic wave of defaults in the subprime mortgage world. He blames this on the hapless products of business & economics schools who possess a very poor understanding of "Black Swan" events in the financial markets, and yet go on to become economists/financial analysts/business managers of institutions that manage large amounts of money; make bets without a clear understanding of tail risks. Taleb feels that business schools continue to teach finance using the same, failed financial theories such as, Black-Scholes option model, Portfolio theory, efficient market hypothesis...and hence, the future of capital management is as bleak as today. What essentially Taleb is saying, is that, the current practices simply do not prepare a money manager/asset allocator, to anticipate "tail events" and protect his portfolio. Therefore, those who entrust their hard-earned money with these managers, hoping for a healthy retirement fund, will continue to suffer, if these tail events become more frequent.

Taleb has a point. However, it is so difficult to change the status quo. Use of Gaussian model is firmly rooted in financial analysis. We use it all the time and feel good about our "risk-return" models, Sharpe ratios for risk-adjusted returns, Value at Risk (VaR), option prices based on historic volatility (and the simple assumption that price change is continuous, especially at a time when gap-ups and gap-downs are so common), efficient frontiers for polrtfolio selection etc.

Can Taleb provide a new model? I hope he works with the right people within the academia to bring about some much needed change. For a man who mocked at the Nobel committee for getting into " the habit of handing out Nobel prizes to those who "bring rigor" to the process with pseudoscience and phony mathematics" it is time to be an agent of change. The pillars of capitalism, including the financial institutions, are weakening considerably, as this snowball is only seem to be gathering momentum now; the European debt crisis is a case in point. The global financial crisis has shaken the very foundations of our system. Phony and greedy people at the top of fabled institutions, the arrogance of Ivy league finance professionals who seem to possess very little understanding of realities of this giant organic system called the "global financial markets" and the rigid academic establishment, which encourages only those who conform to the existing norms, are all the reasons why we need people like Taleb to continue to question the establishment; and, no doubt, his inimitable style gets attention.