Nassim Taleb – the man behind the term “black swan” – just published a new paper taking aim at Wall Street titled Why It is No Longer a Good Idea to Be in The Investment Industry.Taleb explains how as funds have become more and more concentrated among a growing group of investment managers he calls the “spurious tail,” it has basically become impossible to be successful in the industry by putting in the work.
You just have to get lucky.
The reason for this is that the track records of successful managers are increasingly characterised by huge wins resulting from “spurious performance,” according to Taleb, which has allowed them to “rise to the top for no reasons other than mere luck, with subsequent rationalizations, analyses, explanations, and attributions.”
Those winning managers, in turn, attract more investments to their funds, increasing their allocations based on past performance, making them difficult for other managers to compete with as the winners grow their market share.
Taleb thinks the industry is already past the point of no return. He writes that “an operator starting today, no matter his skill level, and ability to predict prices, will be outcompeted by the spurious tail.”
Photo: superde1uxe via flickr
There are two reasons why Taleb thinks the spurious tail has become an unstoppable juggernaut that has completely changed how things work on Wall Street.The first reason is that the returns generated by the “spurious tail” set are huge. Taleb uses some quick calculus to show how investment returns several – even more than 100 – deviations away from average can now be expected to arise as simply random outcomes under the current industry status quo.
These huge wins are attracting clients to funds who only managed to generate stellar returns in the past by luck. Taleb posits that due to globalization, there is a “winner-take-all” effect driving increasing concentration of investment funds among “top” managers; i.e., the ones who score a big win have an easier time attracting new clients.
And as investments become more concentrated at the top, the deviation from average of expected “spurious tail” returns grows even bigger.
The second reason the spurious tail has become so prominent is that investors operate in a world of “fat tail” risks. That is, the unlikely events that investors previously ignored have become a lot more prevalent lately in today’s investment environment.
The fat tails make the spurious tail – those big wins that can be expected to arise simply by chance – even bigger.
And a bigger spurious tail means those who don’t get lucky with the big wins are going to have an increasingly hard time attracting investments from clients over the ones who do get lucky.
For Taleb, the investment industry is a bad choice if you don’t want to subject your career entirely to random chance. He writes, “This condition affects any business in which prevail (1) some degree of fat-tailed randomness, and (2) winner-take-all effects in allocation. Conclude, if you are starting a career, move away from investment management and performance related lotteries as you will be competing with a swelling future spurious tail. Pick a less commoditized business or a niche where there is a small number of direct competitors. Or, if you stay in trading, become a market-maker.”