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John_Maxwell_IV comments on Mathematicians and the Prevention of Recessions - Less Wrong
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I have an economist friend who predicted the tech bubble, but shorted too early, and ended up losing quite a bit of money in the process. Knowing that chickens are coming home to roost is not enough; you need a good idea of when they're going to arrive, and to have the solvency to be able to stick to your beliefs. (If Keynes's comment--"The market can stay irrational longer than you can stay solvent"-- fits you, then shorting bubbles seems unwise.)
I do believe there were people predicting the bubble would burst before it burst, and some of them were even people who don't predict a bubble bursting every year. It's not clear to me that a handful more mathematicians pointing out impending disaster would significantly shift public opinion, and hoping that the government would act to burst a bubble early rather than keep it inflated seems like an antihistorical hope.
One wonders if they would have seen the minority aspect of the meltdown coming, then. Qualitative reasoning can be as suspect as quantitative reasoning, and it's not clear to me mathematicians are that much less prone to qualitative errors.
A professor in his 40s once told me that the department where he got his PhD had run the numbers, and financial success was inversely correlated with grades / research skills / intellectual ability; the top people got professorships and were middle class, whereas the people who were at the bottom of the class had left academia, and several of them made millions on Wall Street.
I also hear that the supply of physicists as quants is much larger now than it was ~20 years ago, and so it's a respectable living but not a massively profitable one; it's not clear that you could start a competitor to Renaissance today and do nearly as well.
Did your friend think about purchasing put options on a continuous basis? No short squeeze risk and you wouldn't have to worry about timing. I assume the information from your friend's purchases would have been arbitraged in to the price of the underlying asset somehow.
(I'm not a quant and there might be something wrong with this idea.)
The problem is that a put strategy bleeds money on option costs, whereas a short doesn't. (Shorts bleed on dividends, but in a lot of industries that's cheaper). Also, long-term puts deeply out of the money(which you want, to minimize costs and maximize leverage) are an incredibly thin market, which tends to make trading difficult and expensive.
That shouldn't be an inherent problem... there are some strategies that tend to make money most of the time but occasionally go drastically wrong, and this is an example of a strategy that tends to lose money most of the time but occasionally goes drastically right. Just calculate the expected value as usual, right?
It's not a crippling problem. Nassim Taleb, the Black Swan author, ran a hedge fund with precisely that strategy(though his options were omnidirectional - his thesis was that we underestimate all forms of tail risk), and he made a mint in 2008. But it's something that needs to be kept in mind.
My understanding was that his fund was a failure and shut down before 2008, and the only evidence for his claim to have made money in 2008 was his word (with nothing about how well his strategy has performed on net).
Per Wikipedia:
Taleb reportedly became financially independent after the crash of 1987[15] and made a multi-million dollar fortune during the financial crisis that began in 2007, a development which he attributed to the mismatch between statistical distributions used in finance and reality.[36] Universa is a fund which is based on the "black swan" idea and to which Taleb is a principal adviser. Separate funds belonging to Universa made returns of 65% to 115% in October 2008.[20][37]
That said, the fund he founded, one by the name of Empirica, was shut down in 2004, though it was actually producing positive returns at the time. Apparently he was seriously ill, and wanted to become an author full-time as well. However, the "ran" in my above post was incorrect.
There's at least one leprechaun there: citation 36 says nothing at all about whether Taleb made any money during the 2007 crisis, much less whether he realized a net return since 1987 greater than indexing. I've replaced it with a citation-needed.
Eh, maybe it wasn't bleeding too badly, but 2004 wasn't a year anyone should be posting negative returns, and at least one of their funds was shut down for failing so badly:
(Yes, 2001 was a loss. As Tavakoli asks, how the deuce does a 'black swan' fund lose money after 9/11?)
Articles I read phrased it as he 'feared' a recurrence of throat cancer, which honestly sounds a bit like 'our CEO is resigning to spend more time with his family'.
Spitznagel is more of an Austrian than a black-swan guy; since he started in 2007 and apparently managed small amounts like <$100m, some wins are not very strong evidence... I tried to find any estimate of Universa's net return to investors from 2007 to now after fees etc, but I only found a fluffy Wikipedia article claiming "Spitznagel's investment performance ranks as one of the top returns on capital of the financial crisis, as well as over a career" and citing The Dao of Capital - written by Spitznagel. So...
My first quote on Taleb was from memory, and looking into it it seems that my memory was a lot more black-and-white than the facts are. I'd love to get some concrete data on the two fund families, but hedge funds are notoriously hard to pry data out of, so I'm not sure we'll get any.
And in this case, a career is being built partially out of claiming that one of the families was a great success and proves the worth of a notoriously egotistic man's ideas, so the situation is even worse than usual.
If risk/reward profiles that bleed money most of the time but occasionally make it big look inherently less attractive to investors, should we expect those strategies to be underplayed relative to their expected value?
Probably, but it doesn't need to be a pure strategy. A normal portfolio hedged with a bit of crash insurance in the form of deep-OTM puts can be a sensible play in ordinary times. I don't know how many people actually do that, though - judging by the market size, not many.
I'm not sure; I can ask the next time I talk to him (which will be over a month from now).