In economics and finance, a Taleb distribution is a term coined by U.K. economists/journalists Martin Wolf and John Kay to describe a returns profile that appears at times deceptively low-risk with steady returns, but experiences periodically catastrophic drawdowns. It does not describe a statistical probability distribution, and does not have an associated mathematical formula. The term is meant to refer to an investment returns profile in which there is a high probability of a small gain, and a small probability of a very large loss, which more than outweighs the gains. In these situations the expected value is (very much) less than zero, but this fact is camouflaged by the appearance of low risk and steady returns. It is a combination of kurtosis risk and skewness risk: overall returns are dominated by extreme events (kurtosis), which are to the downside (skew). The corresponding situation is also known as the peso problem.
The term describes dangerous or flawed trading strategies. The Taleb distribution is named after Nassim Taleb, based on ideas outlined in his Fooled by Randomness.[1] More detailed and formal discussion of the bets on small probability events is in the academic essay by Taleb, called "Why Did the Crisis of 2008 Happen?" and in the 2004 paper in the Journal of Behavioral Finance called "Why Do We Prefer Asymmetric Payoffs?" in which he writes "agents risking other people’s capital would have the incentive to camouflage the properties by showing a steady income. Intuitively, hedge funds are paid on an annual basis while disasters happen every four or five years, for example. The fund manager does not repay his incentive fee."[2]
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Pursuing a trading strategy with a Taleb distribution yields a high probability of steady returns for a time, but with a near certainty of eventual ruin. This is done consciously by some as a risky trading strategy, while some critics argue that it is done either unconsciously by some, unaware of the hazards ("innocent fraud"), or consciously by others, particularly in hedge funds.
If done consciously, with one's own capital or openly disclosed to investors, this is a risky strategy, but appeals to some: one will want to exit the trade before the rare event happens. This occurs for instance in a speculative bubble, where one purchases an asset in the expectation that it will likely go up, but may plummet, and hopes to sell the asset before the bubble bursts.
This has also been referred to as "picking up pennies in front of a steamroller".[3]
John Kay has likened securities trading to bad driving, as both are characterized by Taleb distributions.[4] Drivers can make many small gains in time by taking risks such as overtaking on the inside and tailgating, however, they are then at risk of experiencing a very large loss in the form of a serious traffic accident. Kay has described Taleb Distributions as the basis of the carry trade and has claimed that along with mark-to-market accounting and other practices, constitute part of what JK Galbraith has called "innocent fraud".[5]
Some critics of the hedge fund industry claim that the compensation structure generate high fees for investment strategies that follow a Taleb distribution, creating moral hazard.[6] In such a scenario, the fund can claim high asset management and performance fees until they suddenly 'blow up', losing the investor significant sums of money and wiping out all the gains to the investor generated in previous periods; however, the fund manager keeps all fees earned prior to the losses being incurred – and ends up enriching himself in the long run because he does not pay for his losses.
Taleb distributions pose several fundamental problems, all possibly leading to risk being overlooked:
More formally, while the risks for a known distribution can be calculated, in practice one does not know the distribution: one is operating under uncertainty, in economics called Knightian uncertainty.
A number of mitigants have been proposed, by Taleb and others. These include: