Nassim Nicholas Taleb, Financial Risk, and Black Swans

The February 2 issue of Forbes featured an article on Nassim Nicholas Taleb, the "Oracle of Doom" who wrote the best selling books "Fooled by Randomness" and "The Black Swan: The Impact of the Highly Improbable".

For years, he has been warning that the world is like the titanic - "sailing at night in iceberg-strewn waters, just a few feet from diaster."

Taleb, an options trader, complains that the financial crisis was caused because Wall Street "is in the business of hiding risk, and greatly underestimates the probability of outsize moves."

The name of the book, "Black Swan", comes from the fact that Europeans had only ever seen white swans - until black swans were found in Australia.

Besides Wall Street, Taleb also blames economists who were "overconfident" that their risk control models falsely showed that banks were profitable and in control.

He is a big believer in "fat tails" - or the idea that events predicted with low probability under the standard bell curve, actually occur more frequently.

As an investor, for both his personal account and his hedge fund, Taleb puts most of his money in Treasurys, and uses the rest to bet on volatility with options. He sells options that pay off with moderate volatility, and buys options that pay off with high volatility.

This strategy "has delivered a string of mediocre results interrupted occasionally with spectacular years" like 2008. He told Forbes that he personally took home "in the low eight figures" last year.

Taleb has been criticized for giving general warnings of doom, but no details about what to do. In response, he offers these suggestions for reforming the system:

1. Complex derivatives (like swaps) should be banned because they are tools for hiding risk.

2. There should be a two-tier financial system. Banks that might need to be bailed out someday should be treated like utilities, and only allowed to invest in simple stuff. Hedge funds that invest with private money could so more sophisticated investing, but with the knowledge that they will never be bailed out.