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Episode Summary: The James Altucher Show - Scott Patterson on Traders Making Billions from Unexpected Events
Episode Overview In this episode of The James Altucher Show, host James Altucher interviews Scott Patterson, a Wall Street Journal reporter and author of *Chaos Kings: How Traders Make Billions in the New Age of Crisis*. The discussion focuses on how traders exploit unexpected market events—referred to as "Black Swans" and "Dragon Kings"—to achieve extraordinary profits. Patterson shares insights from his book, detailing the strategies employed by these traders during crises like 9/11, the 2008 financial crisis, and the COVID-19 pandemic.
Key Concepts
Black Swans vs. Dragon Kings
- Black Swans: Coined by Nassim Nicholas Taleb, Black Swans are rare, unpredictable events that have significant impact. The central idea is that people often fail to anticipate these events, and they catch most off guard.
- Dragon Kings: Introduced by Didier Sornette, Dragon Kings are catastrophic events that are statistically rare, but can be predicted. Sornette employs complex mathematical models to identify potential Dragon King events before they occur.
Two Factions of Traders
- Chaos Kings: Traders like Nassim Taleb and Mark Spitznagel who profit during crises by betting on rare events. They take a long-term approach, losing small amounts regularly but banking large returns during crises.
- Quantitative Traders: This group uses complex formulas to detect impending chaos and make predictions based on statistical models. Didier Sornette exemplifies this approach with his analysis of financial markets.
Key Strategies
- Positioning for Crises: Chaos Kings adopt strategies that allow them to profit when the market experiences significant downturns. They often buy out-of-the-money put options that are relatively cheap but can yield massive gains when Black Swan events occur.
- Risk Management: The conversation emphasizes the significance of managing tail risk, which refers to the risk of extreme market movements. Traditional investors often underestimate this risk, leading to significant losses during downturns.
Key Discussions
Historical Context
- The importance of recognizing past crises (e.g., 9/11, 2008 financial crisis) and their impact on market dynamics. Patterson discusses how these events created unique opportunities for specific traders who were well-prepared.
Psychological Aspects of Risk
- The episode dives into human psychology, particularly how loss aversion can dominate decision-making. Traders must learn to accept short-term losses to achieve long-term success, which goes against innate human instincts.
Impact of Emerging Technologies
- Patterson discusses the potential of technology, such as AI, to alter risk prediction models. However, the reliability of such models remains debatable, especially when dealing with unpredictable events.
Noteworthy Quotes
- “The odds of the market going down 40% in a matter of days… would be one in a billion.”
- “You have to go through months, if not years, of losing all the time. That’s why it sort of goes against basic human nature.”
- “Panic early. You’ve got to react as soon as possible.”
Conclusion Scott Patterson’s insights provide a fascinating look into the world of finance, particularly how certain traders thrive on chaos and unpredictability. His book, *Chaos Kings*, not only details the strategies of these traders but also serves as a broader lesson on risk management applicable to various aspects of life. The episode encourages listeners to reflect on their understanding of risk, chaos, and the unpredictable nature of events that can dramatically alter economic landscapes.
Call to Action Listeners are encouraged to explore Patterson's book, *Chaos Kings*, for a deeper understanding of these trading strategies and to reflect on how they might apply similar principles in their own lives.
Written by AI. May contain mistakes. Listen to the episode to check what was said.
Transcript
Automatic transcript. May contain errors.0:00Look, as a manager of people, as an employer, as an entrepreneur, and as even an investor in startups, I can tell you the most important thing for your business is the quality of people. people you hire. The best part is that great candidates are already on LinkedIn. Employees hired through LinkedIn are 30 % more likely to stick around for at least a year compared to those hired through the leading competitor. And I will tell you that the great thing about LinkedIn is that you're not just looking at random people. You're able to see the people who your friends and trusted peers and colleagues who they trust and who they've hired in the past and who they recommend.
0:42And hiring doesn't have to be complicated. Realistically, when you have a business to run, you don't want to spend hours on hiring. You want to hire the right person as quickly as possible. That's why LinkedIn Jobs AI Assistant suggests immediately 25 great big candidates daily so you can invite them to apply and keep things moving. Hire right the first time. Post your job for free at linkedin.com slash Altature, then promote it to use LinkedIn Jobs' new AI assistant, making it easier and faster to find the top candidates. That's linkedin.com slash Altature. Post your job for free. Terms and conditions apply.
1:24This is a fascinating story. Do you know that every time there's a major crisis, 9-11, the 2008 housing crisis, March 2020 with the pandemic, or even in 1987 when the market fell 20 % in the day, every time there's a major fast crisis like that, there's one type of person and basically people who follow this one very, very specific investment strategy that make millions and millions of dollars. And this is the only time they make money. But because no one ever expects a crisis to occur, these people make much more money than they lose during quiet periods. So when nothing's happening, when nothing bad is happening, these people lose a tiny bit of money every month.
2:10But when the crisis happens, they make thousands of percent on their money. And Scott Patterson wrote a book called Chaos Kings, how Wall Street traders make billions in the new age of crisis. He doesn't talk about all Wall Street traders. There's just a handful of people who do this. You have to be a particular type of person. And it's a very particular type of strategy. But we talk about what type of person that is, what type of strategy this is, who these chaos kings are and how much money they make. They make billions in some cases. And how you can apply this sort of philosophy to your own life, whether it's investing or just life.
2:44So here's Scott and I talking about the chaos kings.
2:51this isn't your average business podcast and he's not your average host this is the james altucher show what do you think scott if the lockdown didn't happen would 2020 still have been probably the craziest election we've seen in our lifetimes. Yeah, probably. But I certainly think it catalyzed it, gave it a lot of fuel and energy everywhere. It wasn't just a right-wing. I mean, you had the George Floyd protests right around the corner from the White House where all that happened here at Lafayette Square Park where they ran down those protesters and tear-gassed them. I mean, I think there's no doubt without all of the insanity that came with the pandemic.
3:43It caused the conspiracy theories the following year with the vaccine. That really bifurcated people. You know, people I know who I thought were pretty normal went off the deep end about the vaccine. And it pushed them into further reaches of conspiracy thinking. I mean, if you remember the Canada truckers, like they, the guy I know was saying the truckers, like what canada is doing to the truckers is just as bad as what putin was doing to protesters in russia protesting the ukrainian war and i thought that you know not that doesn't really compare remotely i mean there was a lot of stuff with the pandemic and it was hard not to politicize it because for instance i was not in favor of for an entire year or however long was shutting down all businesses in the economy because now we're experiencing what we're experiencing now which is this weird economy where somehow things are both good and bad at the same time but we also don't know if they're good and bad like it's it's just a crazy economy right now like none none of the data makes sense yeah it hasn't made sense for a couple years and then you have to also ask the question like is the government really allowed to shut down every business because you know we have a right to our property.
5:06But that makes me sound all of a sudden like a conspiracy theorist. Just stating an opinion now makes you sound crazy, even if it's completely rational to ask if something is constitutional or not. Yeah. I think that, I mean, so much has happened, but I think that for a while at least, a lot of businesses shut down voluntarily. Yeah, which makes sense. The market should decide. You don't want your customers to get sick. We didn't know how this thing was spreading. As you mentioned in the book, Chaos Kings, which we'll talk about in a second, you know, Nassib Taleb was looking at the R0 of how fast the virus was spreading.
5:43And that was cause for concern. Like I stopped my kids from going to school before there was a lockdown. But, you know, then three, four months later, because of the George Floyd and BLM protests were organizing quite innocently of 20, 30 ,000 people, but they were still keeping furniture stores closed which typically have no customers in their store right so there was things happening that were irrational but if you stated an opinion like what i just said you were considered an outlier of some sort either to the left or to the right i don't even know yeah it's hard to keep track of it all it's just a sort of a blur now i know it is that period is where my the idea for my book was born actually.
6:25It was born out of the chaos of 2020. Essentially 2020, like 2008, was one of those moments where what happened should never have happened if you use just basic probabilities and statistics. Like the odds of the market going down 40%, depending on which market you're looking at, in a matter of days, if you use basic statistics, it would be one in a billion. But as the steam to lab has shown over and over again, and as you described in the book chaos kings of all the people who benefit from such statistically impossible moves, these so-called black swan events happen more often than statistics predict, suggesting that you can't use the basic, basic, basic mathematical model of statistics to model the markets, and yet everyone does.
7:10And not just the markets, but elections, incidents in your life, whatever bad thing could happen that you think will never happen often happens. Yeah. But good things too. There's good, there's positive black swans too so oh well give me an example of a positive black swan maybe the internet something that we didn't anticipate at all and then has come around and totally revolutionized our lives and you know there's dark sides to the internet obviously but this is not something that people predicted would happen except you know if you were working at Bell Labs in the 1960s or something. Yeah. But you could say a stock like Amazon has black swan-like characteristics.
7:54It's true. How could a company that continually loses money year after year become one of the biggest companies in the world? So I think that in the market, the negative black swans are more common because you don't see 40 % moves up shareholder because of the leveraging characteristics of crashes. but in our daily lives and with some stocks just last week a solar company went up 25 percent just on one announcement from the irs about a tax credit and this is what it's the biggest solar company in america actually for solar and that's a lot i mean 25 it was like a 25 billion dollar market cap it's interesting though like this is like an evolutionary thing where loss aversion is much more powerful than greed fear is more powerful than greed because yeah you know when you're walking in the jungle and you hear a noise in the one in a thousand chance it could be a lion you don't want to die so you just immediately run whereas if you're more motivated by greed maybe oh this is an animal you could hunt or maybe there's just a fruit tree rustling in the wind but you don't you'd much rather have you know take into account the one in a thousand chance and save your life, then the more likelihood that is just nothing.
9:09Right. Yeah. And what you do in your book is you document the really fascinating stories of the people who specifically bet on extremely low probability events and the killings they made in the pandemic and in 2008 and in 1987. Not because they're glorifying like, oh, yeah, we got a pandemic. Let's make some money. But they bet long in advance that the world was too complacent and relying too much on, oh, the market goes up 1 % a day or down 1 % a day. And very rare that it goes up or down more. I mean, they were betting, these people were betting on huge, significant moves that never happened.
9:51So those bets are priced very low, meaning they could make an enormous amount of money if they happen. And they always seem to happen more than we expect. probably initially they just looked at these instruments and said man that's really cheap you know i could buy this thing for 10 cents you know this derivative contract and no one else wants it and i just keep buying that i think that's what nasim was doing in the 80s and it kept paying off for him so it was the market opportunity first and then he kind of backtracked into the sort of the black swan philosophy of yeah why is this happening and why do i keep making so much money on something that goes from 60 cents to 400 it's not statistically probable and it's fascinating because people will think you're ridiculous until they don't meaning like nobody would have predicted 1987 in the stock market crash in october of that year that the market was that the dow jones would fall 22 in a single day because that would mean like right now Let's say the Dow's at 33 ,000 now.
10:53So that would mean it would have to go down to around almost 26 ,000 tomorrow for it to go down over 20%. And Nassim Taleb was the sort of person who was making bets that in a day, that's what's going to happen to the Dow. When that, on an average daily basis, that is just ludicrous. Yeah, yeah, totally. I mean, I wouldn't say Nassim was necessarily betting on that kind of move but he certainly was positioned to benefit from it i think he was betting on something a little less than that universe is a 20 move in a month but i think their idea is you position yourself for this to happen it happens more often than you think and it's actually pretty cheap to do so and you'll never blow up is the other part of it is is you're not leveraged at all right because you probably don't even use all your cash.
11:45You probably just use a small amount of your cash. So just to kind of summarize to listeners, I will say what we're about to talk about with these Black Swan events is the exact opposite of how someone like Warren Buffett invests. Warren Buffett being the greatest investor in history, there's nothing wrong with how he invests. This is just the exact opposite. it. So Warren Buffett takes big bets on a handful of stocks that he thinks over the long run, over a 20 year period, no matter what happens to the market, these stocks will go up. So Coca-Cola, he's owned for over 40 years. American Express, I don't know if he still owns it, but he owned it forever.
12:27And this is sort of completely the opposite. You make these sorts of investments that lose a little bit of money every month while things are normal. And then the one month out of 100 that things go crazy, these might make you a thousand times your money or whatever, some outsized number that's much greater than the amount that you've steadily been losing while things were normal. Right. And what they discovered, and what Nassim and his partner, Mark Stixnagels, discovered implementing this strategy was that those events, when you go down 40, 50 % are what really matter and what you really need to protect yourself against.
13:11The monthly baubles up and down at 5%, those kind of take care of themselves. If you just manage your risk, you don't lever up too much, you will make money on the market. What you need to do, according to them at least, is protect that tail risk, that left side tail risk of a crash. And if you do that, You survive that and you get through it and you end up performing very well. Universes, Spitz and Nagel's hedge fund, backtesting has showed that that has actually worked really well in the past 15 years or so. And this is not how traditional investors think. They want to benefit on the daily grind upwards.
13:51Like a Buffett, there's not a lot of Buffetts out there in the world. So he does very well at it. But they don't think about that tail risk. They sort of just set it aside. even risk managers on Wall Street, you know, the value at risk metric that many banks use and hedge funds use calculates the 95 % probability of a move every day. That 5%, they're just like, no, you don't can worry about that. That's not including some 15 days out of the year when you can see a move bigger than what's in that calculation. And I think that in 2008, that's what a lot of these banks found out is if you're not thinking a lot about and protecting against that 5 % risk, then you could blow up and it's the end of the game.
14:39You're out of the game forever. Yeah. I'm always trying to figure out how to explain this all simply. So imagine when you're a student and you're being graded on the curve. The curve is a basic statistical model where most people sort of aggregate in the middle and a handful of people will get an A plus and another small amount of people will get an F, but most people are around a B or a C. Believe it or not, that's how most hedge funds and investors model the stock market. So what you were just referring to, like how Wall Street models their risk, they're trying to figure out, hey, we own enough things that are uncorrelated with the market and here's the odds of if such and such events happen, here's what our max loss probably will be and what our minimum gain or maximum gain would probably be.
15:29But what Nassim and other really smart investors have shown is that because all of Wall Street believes that basic statistics rule the market, the bets you could make predict a huge move, either up or down, are very underpriced because no one wants those bets. They're like, oh, that's crazy. So Nassim and Mark Spitznagel and other people you mentioned, like Bill Ackman and others you mentioned in the book, real fascinating stories. They find the most underpriced bets they could make to make them super cheaply. They're probably going to lose on those bets. But again, in the long run, I mean, what's Universal's returns?
16:08This is Mark Spitznagel's fund. They've had average annual returns more than 100 % since 2007. And those were audited financial results from Ernst & Young. So they've had phenomenal gains. The hard part of the strategy is that you have to go through months, if not years, of losing all the time. That's why it sort of goes against basic human nature, which, as we were saying, are loss averse. You have to just accept that that's the price. And they like to think of it as an insurance policy. So you're paying your policy. You're fine. Your house isn't going up in fire. And you just accept that that's a payment.
16:50but when the fire comes, you're protected. And not protecting yourself is as if you're, you know, you're living in a flood zone and you have no insurance and you're just acting like everything's fine and you'll never get flooded out. You know, it's not just human nature, it's Wall Street nature also, because in 2006, I had the opportunity, I met with John Paulson's hedge fund, which famously made billions betting against the housing market. They were betting on the black swan happening, which did happen in 2008 as Nassim benefited as well. They laid out the whole thing. And I remember thinking they're, they're right.
17:28The world is just doomed right now. Like I don't, and their main concern was, well, banks survive long enough to pay them the money they owe, which is a common theme, but I couldn't invest with them. They told me on average, they're going to lose 1 % a month. I couldn't expose my investors to that. I was running a fund of hedge funds and that was too big of a loss. for me to take every month if I wanted to keep raising money. Yeah. But they were correct. I wish I had invested them. Now, of course, afterwards, everyone tells me they're invested in them, but I don't believe that. Yeah, no, I remember talking to funded funds back then that were some that were invested in Paulson and were very excited about it.
18:08And that was a perfect example. Nobody thought that could happen. The US housing market does not decline as a whole. Never happened before, although it did actually in the Great Depression. And that's been the universe's experience is that big investors are really reluctant to give them money because to them, it looks like a line item, like this huge cost every quarter, every year. It's a loss, depending on how big their position is,$10,$20 million. And for a fund manager, that's terrible because it hurts your performance. and you're being judged on your annual performance. That's where your bonus comes from.
18:49You're the best. You're sort of losing faith in you. So as successful as their strategy has been, they still have had trouble raising money from institutions like pension funds. As I recount in the book, they did get a major investment from CalPERS starting around 2016, 2017, the big California pension fund, biggest pension fund in America. The CalPERS was very excited about it, but then there was a management change. They looked at those line item losses and said, this is terrible. We got to get out of this thing. It's way too expensive. And they cut their position in January, 2020. Just completely liquidated it.
19:30So, and they, you know, I mean, the calculations are they could have saved their pensioners billions of dollars, two, three billion dollars. Although on Buffett's side of things, if you're a long-term holder, then you don't really care that much about market movements. You're just going to assume that eventually the markets will go back to all-time highs. Stocks will return to their glory. So you might miss out on some gains that you could have made short-term. But in the long run, you kind of have a faith in, okay, biotech's going up in the long run. So I'm going to throw it around to a bunch of biotech stocks.
20:03And eventually, some will succeed and some will fail. And I'll be good. And you do that in every industry. Well, I'd say, I mean, Berkshire Hathaway, which I used to cover for the journal, It's a unique company in many ways. And what people forget is he has a gigantic insurance operation that is constantly, no matter what's going on, is constantly churning out cash. And that gives Buffett this dry powder that he uses when markets collapse, like he did in 2008 with Goldman Sachs and others. um he's sitting there with this pile of cash that he can deploy and buy stocks when they're at their cheapest and that's that not you know not many companies have that structure that's really the engine that drives virtual pathways and insurance cash and a couple of points one is insurance company is almost the opposite of a black swan sort of investing because an insurance company is using basic statistics to model the fact that scott patterson is a man in his 40s or 50s i don't know who uh has never had a car accident before and he's married with two and a half kids and lives in such and such place so they use basic statistics and they determine oh yeah we're going to charge scott 600 a month for his car insurance and we'll pay out two million if he gets into an accident but you could be a black swan you could go crazy one day and just drive into a mall and kill a bunch of people and your insurance is like, you know, goes through the roof.
21:37So insurance companies in general. Yeah. The law of large numbers is it works for insurance companies by and large. That's how they make their money. Interestingly, I mean, the thing I do get in the book is with this, you know, one of the arguments I'm making in the book is that things are getting a little bit more crazy for a lot of different reasons. You know, technology, global connectivity is rising. That's something that we saw in the pandemic and climate change. And climate change particularly is raising havoc within insurance companies because those models are not effective anymore in predicting things like flooding, storms, fires, all that stuff is becoming very difficult and systemic.
22:22They're seeing climate change as becoming a systemic risk. And a systemic risk is almost by definition impossible to price. So the biggest insurance companies in the world are trying to figure out how can we price these things, which are not in the historical record anymore. The hurricanes are worse, and there's just no way to predict it. The paths of the storms change. Storms are accelerating because of the heating of the oceans. They're trying to use AI to model the risk, but things are sometimes changing so fast and even that can't keep up with it. So that's just an area where insurance is getting hard.
23:01Yeah. They're coming up with innovative models to try to deal with it, but it's very tricky. You mentioned AI just briefly, but AI is almost all based on statistics. So it's hard to kind of overcome a bias towards statistics when you're using AI, because AI itself is based on statistical modeling usually. Yeah, it's backwards looking. yeah but they're trying to make it so it learns very quickly or can make predictions that are outside of the law of large numbers but that's hard stuff i mean it's very tricky
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25:06In your book, you kind of mentioned, and this is a very important thing, the big question everybody had after Nassim Taleb wrote The Black Swan is that in general, you can't only predict the unexpected. You can't predict a one in a billion event. Else, if it was that really that predictable, it wouldn't be a one in a billion event. You couldn't say, well, it's about, well, now we're due for a volcano. No one's been able to predict that because it doesn't follow, you know, actually to get into the nitty gritty, it follows sort of a power law distribution of statistics rather than a bell curve, which is the student's grading model.
25:40But without getting into the weeds there, hard to predict but then you mentioned something called the dragon kings which are more like black swans that can be predicted describe those people and what they do and how well they're doing and so on it's a breed of mathematics known as complexity theory but it you know brings in economics physics very high order mathematics the lead practitioner of it that i profile in the book is a French, he calls him an econophysicist, Didier Sornet. He set up shop in Zurich in the mid-2000s to create a financial observatory laboratory where he collects data on hundreds and hundreds of financial instruments and attempts to predict these Dragon King-like events.
26:30And he kind of made up Dragon King to compete with the Black Swan, with Taleb's Black Swan. So it's his own sort of crazy animal, exotic and king-like. The king effect is another mathematical sort of black swan because kings and the countries that they ruled, their wealth far outperforms everybody else in the country. So Didier, he got his start in the 1990s monitoring the physics behind the blowups of these rockets, these French rockets. And he developed a mathematical formula using the power laws that you mentioned to detect the early signs of such a blowout. He eventually started dabbling in stocks and detected similar patterns that you could see in a blowup of a rocket.
27:24What sort of patterns? What was he noticing? Very rapid oscillations up and down in the parameters that he's monitoring. so with stocks you would start to see big movements within the market maybe the market itself isn't moving as rapidly but within it these interior signals indicating some extreme event is on the horizon so like for instance when people were first worried about the pandemic let's say in february 2020 a lot of people heard about it for the first time the stock work was still sort normal was going to all-time highs then but then you start to see weird things like some stocks would have wild oscillations up and down but the market wasn't affected as a whole just like oil crashed to zero or even negative like but it was and it was only after like a bunch of these things were happening that everybody said uh oh and then the bottom fell out yeah yeah in march of 2020 and and that would be the kind of thing that he you know he he would be looking for is the early indications.
28:31So, you know, he's been refining this model over the years and he'll make predictions and then he'll come out, you know, about a commodity or a country's index like China. He's had some successes where he's made very accurate predictions and there does seem to be some utility in it. The problem is making very specific predictions of these events is so hard. getting the timing right, that it's still, in my mind, not a proven methodology for risk management. I'd say it's a useful tool for betting on the market. It may be something that you could use to buy some options. You see a signal and you say, okay, something crazy could happen and you buy some options and it could pay off.
29:22But the job of risk managers on Wall Street is not gambling. It's managing risk and protecting your clients' portfolios. And I think that as of now, these techniques, they're not equipped to do that because it is market timing. It's a form of market timing. And if you try to market time protecting portfolios of billions of dollars, you're going to miss some things. And that's Nassim's argument and Mark Stisnagel's argument is you can't time these things. It's impossible. You will get wiped out. So you need to constantly have that protection on the books. So again, the difference between Nassim's approach of a black swan versus the Dragon King approach of DVR Sarnett is that Nassim every month is finding the cheapest ways to bet that an extreme event will happen.
30:20And then when those expire, when those bets expire, he might make a bet, oh, in a month, the Dow is going to fall 10%, which is an extreme. And he found some cheap ways to make that bet. And so he just keeps doing that regardless of what's in the headlines. Whereas Sarnett is trying to model it so he can more accurately predict when a black swan will occur, and he calls those Dragon Kings. So you might see there's more mentions of a pandemic in the news and stocks are behaving weirdly. So boom, let's do this. Just like Bill Ackman, you mentioned, was doing the same thing in January of 2020. You know, he started to notice, oh, if this Wuhan thing gets worldwide, we're in trouble.
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31:01And so we basically bet on bad things happening. So he was more like a Dragon King guy. Yeah, exactly. And I'd say it's more like speculation, you know, than risk management. you're weighing the odds of something and you're making a bet. Universa, Lusim, and Spitznagel are not making bets, at least not on any short-term horizon. They're making a long-term bet that these things happen frequently, more frequently than people realize. And to protect against that downside, it's worthwhile constantly maintaining that portfolio. So it's a day-to-day thing. These traders are day-to-day buying these far-out-of-the-money put options, is what they're called, to protect the portfolio.
31:48They expire, they get new ones, and it's a routine. I imagine it's got to be pretty boring, doing that day after day. Then the excitement comes, you get a couple weeks, and you pop a billion dollars. But I've asked them about that. It's got to be tough. you know because traders are paid bonuses based on the profits they made these traders could go years without any profit at all and that's you know that's that's hard do you think it affects their personality because like take Nassim Taleb he and by the way he's been on this podcast he's a good guy you know his books are great I actually wrote about his books I have a chapter just about his books in my latest book but you see him get into all these like really crazy Twitter arguments you know where he just like he just like goes crazy on these arguments and you know does it make him like overly negative because he's constantly betting on worst case scenarios every month day after day like you say he's betting that he's not hoping for the worst case scenarios but he's betting on them and he's done this for like 30 years do you think it like changes your personality or do you think you have to have the personality for that to begin with yeah that's interesting i you know i do get into that a little bit in the book uh where i i recount this Twitter feud that he had with Cliff Asnos, AQR.
33:09Yeah. Over, AQR is very skeptical of tail risk strategies. That played a role in CalPERS deciding to get out of Universa. No, I think it's, you know, it's a character trait of Nassim that kind of bothers his friends the most. That he's out there publicly attacking people using all sorts of names, calling people charlatans and even worse. He's a very pleasant, soft-spoken guy in person. Yeah, he's very nice, very much a gentleman in person, fun to have a drink with. But then you'll see him just completely go after, and he doesn't care who it is. He'll go after Nobel laureates with the same viciousness.
34:00It's hard to say where it comes from. I think part of his character was born on the trading floors of Wall Street in the 80s and 90s when you were expected to be like that. He respects that kind of no bullshit kind of attitude. And I also think it's probably why he was able to do what he did, which is basically, you know, call bullshit on a large part of Wall Street and say that, you know, none of these people should be making any money and they should go out of business because they don't know how to manage money. And when they blow up, they, you know, they take their multimillion-dollar paydays and walk away with it because they didn't have his, you know, he says, skin of the game.
34:51so you know I I wouldn't do what he does I know smart Spitznagel makes it makes him uncomfortable he doesn't even go on Twitter you know so he you know but he also knows that's just Nassim that's who he is and you know you learn to live with it you know it's also a weird thing in that like take an event like 9-11 so obviously they didn't know they were betting that 9-11 would happen, a terrorist attack on the US. But of course, since they were always betting that the market is gonna, there's a small, tiny, one in a billion chance that the market is gonna have this massive crash and they know that it's actually, the odds are wrong.
35:35It's gonna happen more than one in a billion times. They were in the markets for 9-11, so they made a lot of money that day. And I know some hedge funds even, like there was a fund, Viking, I think it was Viking Global, They actually gave their profits to charity after 9-11 because they were betting on a market fall. But because it was that event, they gave the profits back from that day. And tricky. Well, Empirica, that was the original hedge fund that Nassim and Mark launched in 99. They did not make money on 9-11. And the reason is their investors didn't want them to monetize their positions.
36:14they were afraid if you recall I was in New York at the time everybody was afraid there was going to be another attack and this was just the beginning that you know who knew what was going to happen and you have to act quickly with these positions because they expire quickly so they held on to them thinking that another shoe could fall and they'd never made money on it I talk about that in the book And as Mark told me, yeah, we were learning our lesson that you have to really know how to position yourself around these things. And it is sort of the dark side of the strategy is you're making money when other people are in misery, you know, and they don't like that side of it.
37:00But at the same time, they see it as protecting their clients and these hard times who are pension funds or other investors who have real people relying on that money. and they see it as being a benefit. And they're happy if other firms do the same thing. They don't personally think that most trading firms can't do it very effectively. I don't know. I think that what I tried to do was just look at this as a trading strategy and also expand it beyond just the market as a lesson that we can learn in these chaotic times about thinking about risks that we're facing. Because it's a common human trait to think that tomorrow is going to be just like yesterday.
37:50And we really don't have to think about these extremely negative consequences. But we really should try to do that and prepare. And climate is one of the areas that I'm most focused on. It's what at the Wall Street Journal, like covered climate and technology is being developed for it. So it's sort of top of mind for me. But, you know, when I first started thinking about this book, the pandemic had just broken out. And it was shocking to see how poorly America managed that. And we clearly hadn't prepared for it. What do you think we should have done? I think that we should have been better prepared.
38:30We were very low on the ventilators, obviously. We didn't have a lot of the masks. That's one of the reasons why the health officials early on cautioned people not to wear masks because they were worried there would be a shortage and the hospitals wouldn't have access to them. I think that if, as Nassim recommended and as I recounted in the book, he was cautioning extreme precaution in January of 2020. and if he and there's and he wasn't alone you know and they they sent their one page uh note to the white house at the request of the white house i think if there had been an earlier response in the u.s and if we had been better prepared so that's something that needed the groundwork for that needed to be laid years before we would have done better and we wouldn't have stopped it you It was a very contagious disease, but maybe we wouldn't have the most deaths in the world.
39:27And that was one of the things that I was just astounded by in 2020 was, how is it that America, the wealthiest, most technologically advanced country, is also experiencing the most deaths? There's a lot of reasons for that. I mean, we got caught up in all sorts of conspiracy theories. people continued as it spread. And we've seen this in areas where these conspiracy theories were most widely believed in. More people died in those areas. They wouldn't wear masks. I don't know why, but the mask thing has become political. And you see various studies. To me, it seems to make perfect sense. Wearing masks not only protects you from airborne particles, but it keeps the particles from going out of your own mouth and nose.
40:12I think widespread masking early on probably would have helped. Not an expert in epidemiology, so I'm not the right person to ask. But just looking back on it, I just remember the thing that, you know, I think the initial spark for this book was when I saw in March of 2020, when the entire financial world was in complete meltdown, Univerza produces a gain of more than 3 ,000%. At the same time, Nassim Taleb, kind of using a similar approach to extreme events, in January of 2020, co-authors a paper identifying the extreme nature of coronavirus and warning that we really needed to take precautions against this thing, because if we don't, it's so contagious that it presents an extreme risk to the human race.
41:12So these two completely different areas by these two guys who had looked at the world in a very similar way, they came out looking pretty good. Like, you know, university, the world blows up, they make a billion dollars or more. They actually made a couple billion dollars. I mean, there were expert epidemiologists in March of 2020 saying, hold on now, we don't really know. You know, we need to wait and study this thing. And that's the problem that he and others identified was when something that dangerous is coming, you can't really wait around to figure out what the minute properties of it are.
41:50You need to act very quickly. As they say, panic early. You got to, you know, if something is posing a systemic risk, you need to react as soon as possible. And the same thing with investing is you need to invest before. Like Bill Ackman, he panicked. He totally panicked. And that allowed him to buy the instruments before anybody else did.
42:26In the case of Nassim, do you think because he's he's built this muscle over the decades to look for things that you know he he notices the initial rumblings of something that could be exponentially grow exponentially more devastating yeah like a volcano there might be pressure built up inside of a volcano there's no way to predict if it'll erupt but you know the pressure's there but you're relaxed because it might not you know the odds are against it blowing up today and yet the scene would probably stay away from the volcano. Yeah. Just in case. But could you get too risk averse? Yeah, that's always a risk.
43:07I mean, I think that's why experts are always worth consulting. And Nassim didn't write this paper alone. A co-author on the book was Yuneer Bar-Yam, who's the founder of the New England Complexity Institute. He had been an expert in studying the properties of pandemics for decades. He worked with the WHO in Africa during the Ebola crisis. He was somebody who had real world experience managing and examining pandemics. And Nassim had been studying his writings over the years. They were partners on other papers. but it is I think Nassim's an understanding of exponential risk that really allowed him to see how quickly it could spread and he's written about this before saying that we live in an age of connectivity we have more connectivity than ever with airplanes flying all over the world Bariam had written a paper about this in the late 2000s I think and then another one in the mid 2000s called The Transition to Extinction, which is a scary title, where he is arguing that previous pathogens were so deadly that they could break out in a village, but it wouldn't really spread that much because it kills everybody so quickly.
44:31But with this age of connectivity where people travel to cities, they ride in buses and cars together, they get on planes. We're hitting this point where those deadly pathogens are no longer contained like they used to be. They can spread. And we're reaching a point where if we don't manage a risk of this, we're facing something pretty dire. And COVID-19 was a test of the world's ability to manage something like that. It proved to be not as deadly. But millions of people died. And that's, you know it's horrific what happened and and i think that i don't know it feels sort of like we've forgotten about it like i don't and doesn't i don't get the sense that it really was it should have been a wake-up call it feels like it wasn't um for many people we just kind of want to move on yeah i i agree it feels like like you said in the beginning of the podcast it's almost like a big blur like when i think of events that happened in 2019 it feels like they happened last year almost as if I completely like whacked out the three years in between.
45:33But, you know, it, it seems like if you're thinking in that manner, there's lots of potential. I think this is why people are always predicting in the news. This is a black swan event, even though you can't have that many black swan events just by definition. But, you know, there's, there's all sorts of existential risks to humanity. Like there's, there's biotech, which if you could clone some virus and spread it around, you know, potentially, you know, and these are theories about coronavirus, like conspiracy theories about coronavirus, potentially you could wipe out the world in a lab. There's, you know, everybody's talking about AI now in this very conspiratorial way.
46:11That's just ridiculous to me, but who knows? There's, for decades, there's always been the threat of nuclear war. Oh, now, but now if a terrorist group gets nuclear materials, that's a black swan thing that could happen. So it's almost like there's too many black swan possibilities now. How do you invest at all for a positive world? Yeah, well, that's, I mean, that's, you know, one of the things I'm trying to argue. And, you know, people debate that and say things have always been crazy. But there just seems to be some measurable technical developments in the world that are magnifying risks and they interact.
46:53Some people call that the polycrisis and some economists and others say that this is a new crises are getting bigger in all these different regimes and arenas and they're interacting and causing something even bigger than some of the parts in terms of risk. It's one of the things that I agree that you could just become completely paranoid and him a prepper and, you know, go out to Idaho and set up shop in a bunker. And people do that, you know, people are doing that. But I think that that's not very helpful. And I think that it's better to try to think about the risks ahead of time, not get over paranoid.
47:37And that's one of the things that Nassim talks about with this paper that he wrote with Bar-Yam and a few others. Rupert Reed is another person he wrote this paper with called The Precautionary Principle. That is an attempt to, in a way, quantify systemic risk and characterize it in a way that, you know, you say here are the things that we really need to worry about and be very precautious about. And the other stuff is out there, but it's not systemic. it doesn't have these various characteristics that you need to look for so that you apply the precautionary principle. This precautionary principle has been around for decades.
48:19It's fairly well known in Europe where it's encoded in law in some of the countries in international law. And what it prescribes that when a risk is so extreme that it presents a threat to humanity, the people engaging in that activity to prove mathematically or through other means that that risk actually doesn't exist. With COVID, it's an interesting example because there's a very big danger to this, which is like what happened in COVID, either correctly or incorrectly, which is everybody was told you have to stay in your house and shut down your business. So normally, if that happened in a normal year, people would say, are you crazy?
49:03I got to make a living. And you can't tell me to just, it's not like every home is a jail. This country is America or Europe or wherever. It's a free world. But at the same time, the math was there too. I mean, the New York Times was predicting over a hundred million deaths would happen worldwide, which is the other extreme. So you could go either way in terms of the math. Yeah. I think that, you know, with COVID in the beginning, because of the, the are nots that were, people were saying that, you know, how many people, a single person can infect, it was in three to four range. That was, you know, putting it in the highest level of contagious disease ever seen.
49:45And that's one of the things that shrieked out and seen in others is if it's so contagious, you really, it's going to spread exponentially. I think, I'm not sure what it settled on in the R &I. I mean, it was two. Yeah, two or two and a half. So it wasn't quite as contagious. And that might have been because of the precautions. You know, I think that if people did just continue to go on as life as usual, it would have been a lot worse. I think what people were hoping was that this, you know, it just kept on going. I think that the hope was a lockdown of, you know, and it wasn't like, I don't recall it's being, except for in some states, a government mandated lockdown.
50:24It was people doing it on their own. They, you know, I know that's what I did. I saw this thing spreading and just stopped coming into the office. So a lot of people just started doing that. And some people couldn't. And, you know, like the meatpacking companies and those people got really sick. So in places that didn't impose these restrictions, you saw a lot of spread. A lot of people died in very low-income companies and industries. I mean, it's obviously hard, but I think the problem was it was very haphazardly applied. And a lot of people didn't take those precautions. I think the idea was you break the chains and it stops spreading.
51:07And it proved it proved it would be very hard to contain. I mean, you know, China, case in point, they tried to do that, impose these. And this was two years into the pandemic, forcing people to stay locked up in their houses, which is not something I, you know, or I don't, you know, Nassim would advocate. And it didn't work because it's, you know, there's too many people moving around and it continues to spread. And you also crash your economy. so yeah it's it's hard stuff it's hard stuff you know but i from what i remember back then and the idea was a very short lockdown period that keeps it from spreading but that just that didn't work and a lot of people didn't didn't do it yeah i mean that the idea would be since the virus lives for two weeks after it gets to someone you know two weeks give or take the idea would be hey if we all just stay inside for two weeks the whole virus is gone around the world and yeah but that never really happened.
52:07I mean, it was just a few weeks ago they declared the virus emergency over. It's like three years later. I know. And again, I'm not being critical. Like you said, some epidemiologists said, oh, no, don't worry. I mean, and they're smart people. Just like in the housing crisis in 2008, there were very smart people saying, this is going to be fine. This is all going to work out fine. There were hedge funds who studied these things all day long because they don't want to lose people's money and they want to make money. And they were investing in housing stocks and bonds and insurance companies and so on.
52:43While other people were saying, no, no, no, it's everything's going to crash and burn. So it's like equally intelligent people on opposite sides of the coin. I'm just wondering what makes the difference between these people? Because they're like equal in every other respect on paper. And yet one sees the catastrophe and the other doesn't, maybe the ones who see the catastrophe, the reason they're still around is because they see catastrophes everywhere, but they've learned how to manage the risk of seeing those catastrophes as opposed to just flaming out on the first bad prediction. Yeah. I mean, I think that, you know, the way that Nassim and Mark Snesnegel would look at it is if you're relying on predicting the catastrophe, you're going to blow up.
53:27You can't do it consistently. And you know, look at John Paulson. I mean, he made a great bet, but then he made terrible investments in the years following that, gold and some other things. I mean, as you know, managing risk on Wall Street is very difficult. And I think that they have developed a pretty effective model for getting through these things. And one of the key parts of the universe's strategy is that no one will give all their money to universities. You know, that would be a crazy thing to do. What they recommend is you put in a tiny percent of your portfolio, say 3%, and the rest you put in stocks and, you know, the S &P 500.
54:13And so you get to benefit from the upside in the many years that the market goes up. And then when you get a crash, you've got that tail risk protected. And you get a nice infusion of cash when everybody else is cash poor. But this is not a speculative strategy. It's a formula for investing and getting through these extreme periods. And I think that insurance is really what's the important part of it. It's a good way to think about it, insurance. And just to get a little bit more into the weeds, they're buying a kind of option most people aren't even aware of people know about and this is too much into the weeds but people know about calls they're not really as aware of puts which is uh sort of the option equivalent of short selling and because of that puts tend to be not priced accurately because they're not as liquid a market and particularly like again because people have model things using basic statistics the one in a billion type of puts are priced very cheap so it's a form of arbitrage.
55:16So in Nassim's model, the prices of these things are too cheap compared to what his model shows they should be, because the risks are actually higher than people think. And so if they were priced accurately, he wouldn't make any money on them, but they're priced inaccurately. And he's discovered that. So he's able to make this bet every month. And then in the long run, sooner or later, he's going to make way more money than he's lost because of the inaccurate pricing. It's a form of arbitrage. And he's done very well with Now, Didier Sonnet, what are the dragon kings that are on the horizon that he's watching out for right now?
55:50He's sort of got this long-term prediction that society is heading towards collapse. So he would recommend buying a lot of puts. He's dating that in the next coming decades, but it's something that's been born out of some complexity theory. uh joseph tainter is one of the original thinkers that that uh have made similar predictions and didier's built his predictions on that and which is the fundamental idea of it is that we're getting too complicated society getting too complicated for a variety of reasons and we can't manage that complexity anymore things are running out of control and ai would be one of them uh that you know energy crisis climate crisis and because of that we're going to run into um systemic issues like food insecurity water crises war things that combine to create a collapse i mean i feel though like like stuff like food insecurity or food shortages that's been predicted ever since 1830 you know, with Althusian.
56:56Yeah. So it's, it's, it's hard to, to not, there's a fine line between being a crackpot and taking something seriously on the flip side though. I mean, if you go back, let's say 60 years to the sixties, you know, Gordon Moore, the, who were at the time was the CEO of Intel. He was, he said famously Moore's law that computers were going to double in power every 18 months, roughly what he said. It's an exponentially growing industry. And there weren't really other exponentially growing industries. But now because computers have grown exponentially, he was correct, that's created the exponential growth of many other industries that use computers to model themselves.
57:36So like biotech or AI or robotics or automated driving or whatever. So it could be the same thing maybe on the risk side that maybe as Nassim says with the connectivity of everything, plus, again, computer power, you know, growing exponentially, maybe that exponentially increases the number of black swan events that will occur. Like between 1987 and 2008, it was like 20 years, but now we're starting to have more craziness all the time, it seems. Yeah, I think it seems like things are getting a little wobbly, but I don't want to be pessimistic about it. I mean, I think that there's a lot of potential positive.
58:15We talked about positive black swans. I'm, as I said, in this climate space and looking very closely at the technologies that are being developed by all sorts of brilliant people. And it's exploding. I mean, it's literally exploding in terms of the money coming into it. You know, the sharpest minds of the universities are going into these technologies now. And the potential for very cheap energy that's going to be available around the world in the coming decades is very hard to get your mind around what that could do. because if we get off of the volatility of fossil fuels, which will devastate some countries, there are petrostates, the benefits that we could get from widespread, very cheap energy that can be put anywhere on a Pacific island or in sub-Saharan Africa is really remarkable.
59:10And I think it has potential for transforming society, but there's a lot of things in the way, standing in the way of that happening, political mostly entrenched interests very rich uh industries that are benefiting from the status quo but that's one thing that i you know the climate debate can be extremely depressing depending on who you listen to but there's a lot of really fascinating things going on and society is mobilizing in all sorts of ways to to try to make this happen uh finances you know that's I come at it from the financial perspective, talk to people in charge of billions of dollars that think this is the, this is the big thing for them.
59:52You know, even big oil companies are getting into it. Oh yeah. The money in it. And they want to protect their downside, you know, like Exxon works on getting energy out of, you know, seaweed and algae. Like they're doing all sorts of, you know, things that normally they wouldn't care about. They're getting into carbon capture. Yeah. In a big way. I mean, that's it's not really very well known, but it's happening. Carbon capture, by the way, is a huge, huge business opportunity for the simple reason that everyone's going to be required to be involved in it at some point without really fully explaining what it is right now.
1:00:27But but the other thing is, too, you always make money when something's mispriced. And because the government basically sets the prices on these carbon credits, it's permanently mispriced because it's the government. It's not letting the market do it. It's just the government doesn't really know. It's like, that's, that's like the old Soviet union putting the, making the price of eggs, you know, a ruble. They don't really know what the market says the price is. They're just setting a price. And so it's always wrong. Yeah. And so it's a very interesting industry right now for that, for that reason.
1:00:58But, um, I have to say your book was very inspirational to me, Chaos Kings, just because, you know, you, you, you don't just explain like what this is. you really describe the backgrounds and personalities and stories of the people making major amounts of money in this area. And you really go into detail on their trading philosophies. One could read this book and potentially emulate these trading philosophies. It reminded me in a weird way, it's a completely different style of book, but it reminded me of the book written, I think it was around 1999, Market Wizards by Jack Swager. Yeah. And yeah, I talked to Jack for Yeah, and the reason I say that is after I read that book, I wanted to be a day trader.
1:01:40And after reading your book, I wanted to invest in Black Swan strategies and come up with my own formulas and so on. So it got me thinking and it was inspirational that way. But it's useful to know for any investor out there or anybody just interested in risk in your own life, it's just an invaluable book to see what the theories are, how it's related to chaos theory. you know it's really benefited the people who subscribe to these types of philosophies and i just highly encourage people to read it uh chaos kings how wall street traders make billions in the new age of crisis good subtitle usually i hate subtitles and it's by by scott patterson i've had so many subtitles i forgot which we landed on but yeah it's yeah and and scott patterson you also wrote uh about high-speed traders you wrote the book dark pools which got everybody terrified of all this like secret high high frequency trading that's happening that's going to bring down the markets i remember having those discussions when your first book came out and or that but i don't know if that was your first but uh no yeah yeah the quants was my first one oh yeah i remember that one too you talk this guy i played used to play poker with from and he was a lot of Peter Muller.
1:02:55Yeah, Peter Muller. Yeah, very good Scrabble player also. And he was, he was. And does the high speed trading still happen? Like, is that still an issue? Oh, yeah. It's, it's, I haven't really delved into it in detail recently, but it's, it's bigger than ever. It dominates. It's going to continue to dominate. It's spread around the world at this point. When I wrote that book, it was really the U.S. and some in Europe, but now it's just this global connected grid of traders using lasers and the fastest computers you can imagine. I would think it's like a race to the bottom. Ultimately, you can't go fast enough.
1:03:36These people were jacking right into the exchange and, like you say, using very sophisticated technology. There's only so close you can get to the exchange before you're all jamming into each other. Maybe it's spread around because you have to find new markets that aren't sophisticated to do this. I knew PhDs whose sole job was to shave off like two microseconds from a latency in a trading machine. Wow. So yeah, it was crazy stuff. Scott Patterson, thank you so much. It's such interesting stuff. I really am a fan and I've read your books. This book is great. And I'm always interested in the work of Nassim Taleb.
1:04:13and finally I got a chance through your book. I didn't really know his biography, his story all the way back and how he initially made his first money and so on, like in the crash in 1987. He was basically, his father was basically born out of crisis in some way. And it's so interesting. But thank you so much for coming on the show. Yeah, thank you, James. This is great.
1:04:42Thank you.
From the publisher
Join us as we delve into the captivating world of Wall Street's most unexpected profits. In this episode, we interview Scott Patterson, acclaimed Wall Street Journal reporter and author of the fascinating book, Chaos Kings: How Traders Make Billions in the New Age of Crisis.Drawing upon his extensive research and insider knowledge, Scott reveals the secrets of how traders manage to transform unprecedented events, such as the 'Black Swan' and 'Dragon King' phenomena into extraordinary profit-making opportunities.One faction, led by Nassim Nicholas Taleb, bestselling author of The Black Swan, believes humans can never see the big disaster coming. In their view, while inevitable, extreme events-so-called Black Swans-will always catch us by surprise. In 2007, Taleb's longtime collaborator, Mark Spitznagel, launched the Universa hedge fund, which would make billions protecting investors against unforeseen chaos in the market.A second faction, which relies on complex formulas, believes looming chaos can be detected. Chief among these risk prognosticators is Didier Sornette, a colorful French mathematician who enjoys riding his motorcycle at speeds over 170 miles per hour. When Sornette looks out from what he calls his Financial Crisis Observatory in Zurich, Switzerland, what he sees are "Dragon Kings"-punishing events that are unlikely to occur but have probabilities that can be predicted...and defended against.Patterson reveals the intricate strategies employed by these traders, who possess an uncanny ability to navigate and capitalize on market upheavals. From analyzing the impact of unforeseen events to the psychology of risk-taking, he and James shed light on the inner workings of betting on high-stakes world events.Throughout the interview, we explore the thrilling stories and characters that make up the fabric of Wall Street's most profitable moments. Scott Patterson's journalistic expertise and intimate understanding of the financial landscape give listeners a unique perspective on the elusive world of traders who have mastered the art of profiting from chaos.-----------What to write and publish a book in 30 days? Go to JamesAltucherShow.com/writing to join James' writing intensive!What do YOU think of the show? Head to JamesAltucherShow.com/listeners and fill out a short survey that will help us better tailor the podcast to our audience!Are you interested in getting direct answers from James about your question on a podcast? Go to JamesAltucherShow.com/AskAltucher and send in your questions to be answered on the air!------------Visit Notepd.com to read our idea lists & sign up to create your own!My new book Skip the Line is out! Make sure you get a copy wherever books are sold!Join the You Should Run for President 2.0 Facebook Group, where we discuss why you should run for President.I write about all my podcasts! Check out the full post and learn what I learned at jamesaltucher.com/podcast.------------Thank you so much for listening! If you like this episode, please rate, review, and subscribe to "The James Altucher Show" wherever you get your podcasts: Apple PodcastsStitcheriHeart RadioSpotifyFollow me on Social Media:YouTubeTwitterFacebook
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