A Discussion With Scott Patterson's About His Book Chaos Kings, Part 1

Scott Patterson discusses his book "Chaos Kings," which examines the intersection of financial risk and crisis management through the lens of Nassim Taleb and his partner Mark Spitznagel. The book explores the success of their hedge fund Universa during the 2020 market crash and their prescient warnings about COVID-19. Patterson highlights Taleb's views on risk, the precautionary principle, and the importance of preparing for unpredictable, high-impact events. The conversation delves into Taleb's critique of traditional risk models, emphasizing the need for strategies that account for extreme, fat-tail risks and the lessons learned from past financial crises.

• Scott discusses his book "Chaos Kings" and its connection to his earlier work "The Quants."
• The book explores the concept of risk and chaos through the lens of Nassim Taleb and Mark Spitznagel's work, particularly during the 2020 market crash and COVID-19 pandemic.

"For people who don't know, Nassim and I go way back, running on 17 years now. His ideas were very informative for my first book, 'The Quants,' which was about how all of these quantitative models really blew up in the great financial crisis."

• Scott's relationship with Nassim Taleb influenced his understanding of risk and chaos.

• Scott observed two significant events in 2020: Universa's hedge fund's remarkable performance and Nassim Taleb's early warning about COVID-19.
• Universa achieved astounding returns during the market crash, and Nassim Taleb's paper warned about the risks of COVID-19 early on.

"I noticed that two things happened: one was the hedge fund run by Nassim's longtime partner Mark Spitznagel, Universa, put in these astounding results in the crash... And I also noticed that Nassim and a few of his collaborators in January of 2020 had written a paper warning about the risks of COVID."

• Universa's performance and Taleb's foresight highlighted a unique approach to risk management.

• Nassim Taleb's "Black Swan" theory emphasizes the impact of rare, unpredictable events.
• Taleb clarified that the pandemic was a "White Swan" event, meaning it was predictable based on existing knowledge.

"In the Black Swan, it was described that a pandemic would be worse than previous pandemics and would spread faster due to increased connectivity."

• Taleb's theory underscores the importance of understanding and preparing for rare but impactful events.

• Taleb and his collaborators emphasized the need for early intervention to prevent pandemics.
• They recommended extreme measures such as shutting down borders and isolating affected areas.

"You have to kill a pandemic in the egg, and it's easy to kill in the egg by traditional measures like isolation and quarantine."

• Early intervention is crucial to prevent the exponential spread of pandemics.

• Universa's strategy involves buying insurance-like positions that pay off during major market crashes.
• The strategy is not based on market predictions but on statistical properties and constant portfolio adjustments.

"The principle is there's no timing. The position has to be the same regardless of the environment."

• Universa's approach allows investors to take more risks while being protected against major crashes.

• Some experts, like Aaron Brown, believe Universa's success is due to undisclosed forecasting elements.
• Taleb and Scott clarify that Universa's strategy is purely statistical and not based on predictions.

"Aaron told me that he was convinced these returns are not possible unless the fund is making some sort of prediction... My answer is no, there's no such thing as timing."

• Universa's success is attributed to its unique approach to risk management, not market predictions.

• Taleb emphasizes the importance of execution in risk management, which sets Universa apart from other hedge funds.
• Universa focuses on tail risk metrics and methods that differ from traditional mean-variance approaches.

"Our business is execution... The devil is in the execution."

• Effective execution is crucial for successful risk management.

• Taleb's work emphasizes the importance of avoiding ruin, as it is irreversible.
• Many traditional risk management methodologies fail to account for the risk of ruin.

"If you keep playing this game over and over again, kind of like Russian roulette, you will face ruin."

• Avoiding ruin is a central principle in Taleb's approach to risk management.

• Taleb and his collaborators wrote a paper in January 2020 warning about the systemic risk of pandemics.
• The paper emphasized the need for early intervention and preventive measures to avoid catastrophic outcomes.

"This is a ruin problem, and if you keep playing this game over and over again, you will face ruin."

• The paper highlighted the importance of understanding and addressing systemic risks to prevent disasters.

• Scott's book "Chaos Kings" explores the themes of risk, chaos, and the importance of early intervention and effective execution in risk management.
• The book draws on the work of Nassim Taleb and Mark Spitznagel to provide insights into managing risk in an unpredictable world.

"The strategy isn't a bear fund bet; it's not based on an assumption that there's going to be a crash."

• The book aims to provide a comprehensive understanding of risk management and the principles that guide successful strategies like Universa's.

• Discussion on how COVID-19 highlighted the inadequacies of conventional risk management approaches.
• Emphasis on the need for swift and sweeping action to halt diseases in their tracks due to increased connectivity and nonlinear spreading.
• Fat tail processes have special attributes making conventional risk management approaches inadequate.

"Clearly, we're dealing with an extreme fat tail process owing to an increased connectivity which you had written about in the Black Swan which increases the spreading in a nonlinear way. Fat tail processes have special attributes making conventional risk management approaches inadequate."

• Fat tail processes spread nonlinearly, requiring different risk management strategies.

• Authorities in the US and other places took a conventional risk management approach, which broke down.
• The debate on quarantining and opening economies ignored the public's fear of dying.

"The authorities in charge of the reaction to COVID in the US and a lot of other places did take conventional risk management approaches, and it really broke down."

• Conventional risk management approaches were inadequate for handling the pandemic.

• Historical analysis of wars showed very fat tails, more than finance or other sectors.
• Discussion on the inadequacy of early models due to finite data and the need for adjustments.

"We tested the wars and realized that wars had very fat tails, much more than finance, much more than anything."

• Wars and pandemics exhibit fat tail characteristics, requiring different analytical models.

• Mandelbrot's use of fractal geometry helped refine the understanding of black swans.
• Fractal geometry made black swans appear as gray swans, fitting into statistical models.

"It was sort of a light bulb going off moment for you when you met him and he was describing the use of fractal geometry."

• Fractal geometry provides a statistical framework for understanding and predicting fat tail events.

• Advocates for a risk management approach of panicking early and often.
• Critique of the "wait and see" approach, which is inadequate for fat tail processes.

"The best way to buy an option is if you have absolutely no reason to buy it because if you have any reason to buy an option, it's going to be too late."

• Early action is crucial in risk management for fat tail processes.

• Importance of addressing ruin problems early, using the precautionary principle.
• Differentiation between multiplicative processes and non-multiplicative ones.

"When you have ruin problems, you need to address them early. You need to kill it in the egg; you need to panic early."

• Early intervention is essential to prevent catastrophic outcomes in multiplicative processes.

• Introduction of a refined precautionary principle distinguishing between fat tail and thin tail processes.
• Emphasis on being cautious about higher layers (e.g., humanity) rather than individual risks.

"There's a key distinction between processes that are multiplicative and processes that are not, fat tail versus thin tail."

• The refined precautionary principle focuses on higher-level risks and multiplicative processes.

• Individual risks (e.g., slipping in a bathtub) are different from collective risks (e.g., spreading COVID-19).
• Importance of considering the aggregate risk in decision-making.

"If I drown in my bathtub, my neighbor isn't more likely to drown in her or his bathtub. If I die of COVID, my neighbor is more likely to die of COVID."

• Collective risks require different management strategies compared to individual risks.

• Discussion on how global risks are increasing and overlapping, leading to more cascading events.
• Importance of preparing for black swans and considering precautionary principles in broader societal contexts.

"Risk is increasing and magnifying and overlapping in ways that can create more risk cascades of events."

• Overlapping global risks necessitate comprehensive risk management strategies.

• Emphasis on the need for early action, refined precautionary principles, and understanding fat tail processes in risk management.
• Critique of conventional approaches and the importance of considering both individual and collective risks.

• The U.S. spends a significant amount of money on the military as a form of risk management, not for entertainment.
• The military spending is aimed at mitigating risks, although it sometimes creates more risks.

"You spend a lot of money, we spend this country spends a trillion dollars on the military, that's risk management. The military is not something you spend money on for entertainment."

• The U.S. military sometimes inadvertently increases risks through its actions.

"The U.S. has a tendency to take its military and create more risk sometimes."

• People are willing to insure against risks that make sense to them but not against those that don't make sense, even if they are cheaper and easier to insure for.

"People are willing to insure against a lot of events if it makes sense to them. They're not willing to insure against events that don't make sense to them and these are the ones that are cheapest and easiest to insure for."

• Nature provides humans with redundant systems, like having two kidneys, to mitigate unforeseen risks without needing to predict specific causes.

"Having two kidneys, you don't have to predict what can cause you to lose one of them... There are seven or eight causes we don't really care; we don't have to predict them."

• Optimization on a single variable can lead to hidden risks and inefficiencies.

"If you optimize on one variable, and it's clearly impossible to really optimize on a scalar without making many more assumptions on a non-scalar."

• Pseudo-efficiency, like driving at extreme speeds, can increase risks nonlinearly, making it necessary to find a tolerable level of risk.

"Driving 400 miles per hour seems reasonable going to be faster, but I think miles per hour is much faster than 400 miles per hour never because you're never going to get to destination."

• Simple lifestyle choices can significantly reduce tail risks and increase life expectancy.

"Don't smoke, avoid the sugar, don't join the mafia, don't ride a motorcycle... and your life expectancy is going to increase dramatically."

• The precautionary principle is often misunderstood as being anti-progress, but it is about being cautious with identifiable and cataloged risks.

"There's debate about the precautionary principle... some people say it's too vague, it's paranoid, it's the enemy of progress."

• The precautionary principle allows for relaxation about local problems, focusing on systemic and global risks.

"The precautionary principle lets you relax about local problems... they don't require the same extreme measures of risk avoidance prescribed by the precautionary principle."

• The government's role is to manage risks that individuals or collectives cannot easily handle, like pandemics and wars.

"The job of the state is to do things that only the state and only the state can do."

• Libertarians often misunderstand the role of government in managing public health risks, leading to conflicts during events like the COVID-19 pandemic.

"People that you know either naive or purposefully claim to be Libertarians... were claiming that the government was infringing on their freedoms by forcing them to wear a mask."

• Public resistance to health measures like mask mandates often stems from a lack of understanding of second-order effects.

"People would understand the second-order effect that if I have a mask not to protect myself, it reduces the contamination to others."

• Businesses should have the freedom to enforce their own health measures, similar to other personal preferences.

"Costco should be allowed to force you to only shop there if you're dressed in pink with a yellow hat."

• Mark's mentorship under Ever Clip taught him to love losing money and to cut losses immediately, which aligns with the precautionary principle.

"You have to love to lose money and hate to make money. It's against human nature and that's what you have to overcome."

• Older traders know which risks to take and which to avoid, focusing on avoiding ruin.

"Older traders take risks... just those who survived know which risk to take and to not take."

• Warren Buffett exemplifies the precautionary principle by avoiding big losses and being cautious with investments.

"Buffett exerts his precautionary principle in a different way says no if he has any that he says I'd rather miss an opportunity than have a big loss."

• Buffett's smartest moves during the 2008 financial crisis were the trades he didn't make, demonstrating his cautious approach.

"The smartest moves he made in 2008 were the trades that he didn't make."

• Maintaining discipline in trading can be emotionally taxing, especially when dealing with investors who don't understand their own utility functions.

"It can be emotionally taxing to have investors who have no awareness of their own utility function."

• Investors often can't predict their own reactions to small, steady losses, making it challenging to maintain investment strategies.

"People don't know their own can't predict their own reaction to small steady losses."

• Intelligent investors can understand and appreciate risk management strategies, leading to successful investment outcomes.

"If you present it to intelligent people, there are a lot of intelligent people out there."

These notes provide a comprehensive and detailed overview of the key ideas and discussions from the transcript, organized thematically and supported by relevant verbatim quotes.

• Discusses the challenge of understanding and managing risks in financial markets.
• Highlights the difference between observed risk and real risk.
• Emphasizes the importance of recognizing the potential for extreme events beyond historical data.

"The worst case scenario isn't the worst case scenario. The worst observed case is not the worst case."

• Observed worst-case scenarios do not represent the true potential for extreme events.
• Historical data alone is insufficient for predicting future risks.

"Some people never get it. They’re very intelligent, but they never get it."

• Highlights the difficulty some intelligent individuals have in grasping the nature of risk.

• Introduction to Extreme Value Theory (EVT) and its importance in risk management.
• Explains how EVT was developed to prevent catastrophic events like flooding in the Netherlands.

"We since then mathematically here I explained Extreme Value Theory how it was born in the Netherlands because they decided that they didn’t want to drown."

• EVT helps in understanding and preparing for extreme events that surpass historical records.

• Criticizes the naive empiricism approach prevalent in financial markets.
• Discusses the fallacy of relying solely on historical data for risk assessment.

"The tallest person isn’t the tallest person you’ve seen, but they keep coming back and say, 'Oh, the worst performance in the stock market has been 22% in one day.'"

• Emphasizes the importance of understanding that future events can exceed historical extremes.

• Discusses the application of the precautionary principle in the context of climate change.
• Highlights the need for caution due to the uncertainty and unpredictability of climate risks.

"The uncertainty of models and predictions is a reason to be cautious."

• Uncertainty in climate models necessitates a more precautionary approach to mitigate potential risks.

"If there’s uncertainty about the pilot, I get off the plane. Don’t get on the plane."

• Illustrates the practical application of the precautionary principle in decision-making.

• Critiques the risk management practices on Wall Street, particularly the use of Value at Risk (VaR).
• Points out the persistence of flawed risk management methods despite their failures in the 2007-2008 financial crisis.

"They still use the same methods. Value at Risk still. I can’t believe it."

• Highlights the reluctance of financial institutions to abandon ineffective risk management tools.

• Discusses the limitations and overfitting issues of financial models.
• Emphasizes the difference between models in physical sciences and social sciences.

"In finance, you’re not as confident about the parameters. The more you expand your model by adding parameters, the more you become trapped in an inextricable apparatus and relationships."

• Overfitting in financial models can lead to unreliable predictions and risk assessments.

• Explains the concept of dynamic hedging and its role in identifying model limitations.
• Discusses how trading experience informs skepticism of financial models.

"I had a very clear idea which models don’t work and it models with second-order effects not captured by the first-order effect of the model."

• Practical trading experience helps in identifying the shortcomings of theoretical models.

• Describes the speaker's early life and influences, including a love of books and intellectual conversations.
• Highlights the role of Jesuit priests in shaping their intellectual curiosity.

"My early life provided me with a love of books and a lot of conversation with erudite people, particularly the Jesuit priests who used to hang around my father."

• Early exposure to diverse intellectual discussions fostered a deep appreciation for knowledge and critical thinking.

• Plans to discuss the founding of Empira in the next session.
• Acknowledges the importance of continuous learning and skepticism in understanding and managing risks.

"Let’s take a break and then come back to the next session. Thanks a lot, Scott."

• Indicates a pause in the discussion with plans to continue exploring related topics in the future.