Tailgating, or, the Taleb Distribution

I am often on the prowl for metaphors to explain things in finance law to students, and I liked this discussion today (January 20, Comment) by the Financial Times’s John Kay on the distribution of returns described in Fooled by Randomness and The Black Swan:

Some people have described the process as picking up dimes in front of a steamroller. A more vulgar account refers to a creature that “eats like a bird and shits like an elephant”. There is a more academic description: a strategy based on writing options that are substantially out of the money. But the analogy I prefer is tailgating, the practice of driving close to the bumper of the car in front at high speed.

However described, it is the same thing: a distribution of returns that produces frequent small profits punctuated by occasional very large losses. A high proportion of trading – and business – strategies in financial markets have this tailgating characteristic. I call it the Taleb distribution, after the author of Fooled by Randomness (an earlier, and better, book than the more widely read Black Swan), which gives numerous instances.

Kay makes the important point, in passing, that important parts of the financial instruments deployed in the credit crisis were not a function of not understanding the “tailgating” phenomenon:

The issue was not just that these distributions displayed Taleb characteristics: these market activities were devised with Taleb characteristics in mind.

Kay goes on to add that governments yesterday as well as today appear to creating responses that are once again premised on the tailgating distribution.

Governments themselves have become infected by tailgating behaviour. Some officials think that government guarantees of private sector liabilities don’t cost anything, because they probably won’t be called on. Others tell you that governments will make a profit on their injections of emergency funds into financial institutions. These are precise analogues of the tailgater who congratulates himself on his skilful driving. The nature of guarantees and capital injections is that they often cost you nothing, but when they do cost you they cost you loads. The taxpayers who are paying for Icelandic banks and Fannie Mae have discovered that, but the wider lesson has not been grasped. Tailgating gets you to your destination faster – except when it doesn’t.

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