Nassim Taleb, the Titanic, and Hedge Funds

There are two pithy Nassim Taleb quotes in a Heard on the Street piece in tomorrow’s WSJ. The piece is interesting in itself, about the likelihood that hedge funds get caught out by the changing interest rate regime, but Taleb steals the show:

1) “The models minimize the risk,” says Nassim Taleb, an adjunct mathematics professor at the Courant Institute of New York University who also runs a $300 million hedge fund. But, he adds, the models “are backward-looking.” Mr. Taleb says that just before severe declines, most models show that volatility is low. But since nearly everyone uses the same models, the probability that most funds move at the same time and in the same direction is greater. Such a phenomenon can create pile-ups at the exit door, diminishing liquidity and creating difficulties in financial markets.

2) Many hedge-fund investments are relatively new and not fully tested. That is especially the case for various kinds of so-called credit derivatives, which allow investors to take a view on the creditworthiness of individual companies or of groups of companies, depending on their rating. Not long ago, banks were using these credit derivatives to hedge their loan books, buying such instruments to protect against potential defaults. Today, many banks have decided to sell such insurance to others. “That’s like buying insurance on the Titanic from someone on the Titanic,” adds Mr. Taleb.