The Black Swan’s Nassim Taleb and the Nobel Committee

October 20th, 2010
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Contributed by: Aswath Damodaran
I just read this article, where Nassim Taleb, who seems to have taken on the mantle of the "anti-theorist" in finance, argues that the Nobel committee should be sued for giving the prize to Harry Markowitz, Bill Sharpe and Merton Miller (`Black Swan' Author Says Investors Should Sue Nobel for Crisis).

Nassim Taleb has written a few books, "Fooled by Randomness" and "The Black Swan", which have brought him acclaim and his warnings seem to have been borne out by the recent crises. (I have put down my thoughts about these books in an earlier post. ) I think he badly misplays his hand by arguing that Markowitz, Sharpe and Miller are to blame for the excesses in financial markets. In fact, let's take each of their contributions to finance and put them to the test:

a. Let's start with Merton Miller, who was the oddest target of all. (Perhaps, the story got the name wrong and Taleb really blamed Bob Merton, not Merton Miller...) Miller and Modigliani argued that great firms acquire that status by taking good investments (that generate higher returns than it costs them to raise capital), and that finessing capital structure or messing with dividend or buyback policy adds little or no value at the margin. Since much of the advice and deal making in Wall Street is directed towards capital structure solutions (recaps, leveraged transactions) and dividend policy (buybacks, special dividends), it would seem to me that what corporate finance departments at investment banks do is in direct violation of what Miller would have propounded.

b. How about Markowitz? The singular contribution to finance that Markowitz made to finance was his recognition that the risk in the investment has to be measured as the risk it adds to a portfolio rather than the risk of it standing alone. In effect, his work is a statistical proof that diversification eliminates a significant portion of risk in investments. It is true that he worked in a simplified world where an investment's worth is measured on only two dimension - the expected return (which is good) and standard deviation (which is bad), but his conclusion that diversification reduces risk would hold with any of the distributions that Taleb claims are more realistic descriptions of investment behavior. The mean-variance framework has been critiqued and adapted from within and without the discipline for forty years, starting with Mandelbrot in the 1960s and continuing through to the behavioral economists today. Perhaps, you can indirectly critique the dependence on the normal distribution for the failure of risk management systems such as VaR, but that is na stretch.

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