From time to time it’s worth peering into the minds of some of the: ‘legendary’ traders, essayists and thinkers in our trading world, in order to see what their thoughts are on many of the aspects of trading we experience on a day to day basis.
Of particular relevance is their ability to simply cut through the swathes of copy written on our industry and quite simply “get to the point”. It’s as if their decades of experience are titrated down to perhaps no more than a dozen clear, relevant and brief points that can immediately correct some of our erroneous views and habits. Mark Douglas manages to do this in his excellent book “Trading in the Zone” where his thoughts and beliefs have taken on a legendary status in our industry.
But in this article it’s another giant of the trading world we want to concentrate on – Nassim Taleb* who published nine “rules of thumb” in what was termed his “Trader Risk Management Lore”. Regular readers of these columns will note that (by accident or design) we’ve echoed many of his claims in the countless articles we have created. Moreover, readers will recognise Taleb’s concentration, bordering on obsession, regarding overall risk and money management, a constantly recurring theme in many of our articles.
At the footer of this article we’ve clipped a few paragraphs from Wikipedia relating to Taleb and for traders within our community looking for reading material to both pass the time between trading set ups and to develop a more rounded and overall holistic approach to our industry we’d recommend reading books by Taleb including Black Swan and Fooled By Randomness.
Taleb’s first non-technical book, Fooled by Randomness, about the underestimation of the role of randomness in life, around the same time as the September 11 attacks, was selected by Fortune as one of the smartest 75 books known.
His second non-technical book, The Black Swan, about unpredictable events, was published in 2007, selling close to 3 million copies (as of February 2011). It spent 36 weeks on the New York Times Bestseller list, 17 as hardcover and 19 weeks as paperback and was translated into 31 languages. The Black Swan has been credited with predicting the banking and economic crisis of 2008.
Trader Risk Management Lore: Taleb’s Major Rules of Thumb
Rule No. 1- Do not venture in markets and products you do not understand. You will be a sitting duck.
Rule No. 2- The large hit you will take next will not resemble the one you took last. Do not listen to the consensus as to where the risks are (that is, risks shown by VAR). What will hurt you is what you expect the least.
Rule No. 3- Believe half of what you read, none of what you hear. Never study a theory before doing your own observation and thinking. Read every piece of theoretical research you can-but stay a trader. An unguarded study of lower quantitative methods will rob you of your insight.
Rule No. 4- Beware of the non-market-making traders who make a steady income-they tend to blow up. Traders with frequent losses might hurt you, but they are not likely to blow you up. Long volatility traders lose money most days of the week. (Learned name: the small sample properties of the Sharpe ratio).
Rule No. 5- The markets will follow the path to hurt the highest number of hedgers. The best hedges are those you alone put on.
Rule No. 6- Never let a day go by without studying the changes in the prices of all available trading instruments. You will build an instinctive inference that is more powerful than conventional statistics.
Rule No. 7- The greatest inferential mistake: “This event never happens in my market.” Most of what never happened before in one market has happened in another. The fact that someone never died before does not make him immortal. (Learned name: Hume’s problem of induction).
Rule No. 8- Never cross a river because it is on average 4 feet deep.
Rule No. 9- Read every book by traders to study where they lost money. You will learn nothing relevant from their profits (the markets adjust). You will learn from their losses.
*Nassim Nicholas Taleb
Nassim Nicholas Taleb is a Lebanese American essayist, scholar and statistician, whose work focuses on problems of randomness, probability and uncertainty. His 2007 book The Black Swan was described in a review by the Sunday Times as one of the twelve most influential books since World War II.
Taleb is a bestselling author and has been a professor at several universities, currently Distinguished Professor of Risk Engineering at New York University Polytechnic School of Engineering. He has also been a practitioner of mathematical finance, a hedge fund manager, a derivatives trader, and is currently a scientific adviser at Universa Investments and the International Monetary Fund.
He criticized the risk management methods used by the finance industry and warned about financial crises, subsequently profiting from the late-2000s financial crisis. He advocates what he calls a “black swan robust” society, meaning a society that can withstand difficult-to-predict events. He proposes “anti-fragility” in systems, that is, an ability to benefit and grow from a certain class of random events, errors, and volatility as well as “convex tinkering” as a method of scientific discovery, by which he means that option-like experimentation outperforms, directed research.