Sornette vs. Taleb Debate

Sornette vs. Taleb Diametrically Opposite Approaches to Risk & Predictability.

10 minutes into the talk I vaguely have any idea what Sornette is talking about, but his June 2013 TED talk (embedded below) is easier to understand.

At 20 minutes into the debate, he mentions how the market can be analyzed as a physical system, versus a statistical system, governed by a type of power law.

This approach of reducing markets to physical systems endowed with ‘laws’ and parameters, analogous to Newton’s laws of motion, is attempted in the Chart to Scalar market formulation which establishes a relationship between the geometry of the stock market and the volume of the buy and sell orders, the later which has a statistical property that can be used for option pricing and analyzing high frequency trading.

This is one of the better TED talks because it’s actionable (you can make lots of money predicting the direction of the markets) and rigorous, compared to the typical TED talk that tends to be vague yet too didactic.

But Taleb and Sornette both ‘wrong’ in that Taleb’s method for profiting from Black Swans no longer works* and Sornette’s 2013 TED video, in which he predicts an imminent stock market crash due to some ‘power law’, is also wrong because two years later the stock market has continued to rally. The problem is you can have these great ideas, but ideas alone won’t make you money, and in the financial markets success is ultimately measured by money. Stock market indexes tend to be very efficient, much more so than individual stocks, which limits the effectiveness of mathematical models at predicting its motion versus, say, predicting the trajectory of a thrown ball after it leaves your hand.

* Taleb’s strategy – which involves investing 90% of one’s assets in extremely safe instruments, such as treasury bills, with the remaining 10% being used to make diversified, speculative bets that have massive payoff potential – works best during periods of high inflation for three reasons: High interest rates makes put options cheaper in accordance to the Black Scholes option pricing formula, stocks crashes have historically occurred during periods of high interest rates (2000, 1987, 1998, 2007, etc), and a high interest rate helps finance the trader’s bankroll for when the market doesn’t crash, which is most of the time. With interest rates still at zero, this strategy is much less effective. 30-year bonds pay more, but are very volatile. Foreign and corporate bonds are also quite volatile and far from risk free.