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     And now a brief history of the “Nobel” Prize in economics, which was established by the Bank of Sweden in honor of Alfred Nobel, who may be, according to his family who wants the prize abolished, now rolling in his grave with disgust. An activist family member calls the prize a public relations coup by economists aiming to put their field on a higher foundation than it deserves. True, the prize has gone to some valuable thinkers, such as the empirical psychologist Daniel Kahneman and the thinking economist Friedrich Hayek. But the committee has gotten into the habit of handing out Nobel Prizes to those who “bring rigor” to the process with pseudo-science and phony mathematics. After the stock market crash, they rewarded two theoreticians, Harry Markowitz and William Sharpe, who build beautifully Platonic models on a Gaussian base, contributing to what is called the Modern Portfolio Theory. Simply, if you remove their Gaussian assumptions and treat prices as scalable, you are left with hot air. […]

     So the Bank of Sweden and the Nobel Academy are largely responsible for giving credence to the use of the Gaussian Modern Portfolio Theory as institutions have found it a great cover-your-behind approach. […]

     Meanwhile, the Modern Portfolio Theory started spreading. I will repeat the following until I am hoarse: it is contagion that determines the fate of a theory in a social science, not its validity.

     I only realized later that Gaussian-trained finance professors were taking over business schools, and therefore MBA programs, and producing close to a hundred thousand students a year in the United States alone, all brainwashed by a phony portfolio theory. No empirical observation could halt the epidemic. It seemed better to teach students a theory based on Gaussian than to teach them no theory at all. […]

     So the Gaussian pervaded our business and scientific cultures, and terms such as sigma, variance, standard deviation, correlation, R square, and the eponymous Sharpe ratio, all directly linked to it, pervaded the lingo. […]

     Things got a lot worse in 1997. The Swedish academy gave another round of Gaussian-based Nobel Prizes to Myron Scholes and Robert C. Merton, who had improved on an old mathematical formula and made it compatible with the existing grand Gaussian financial equilibrium theories—hence acceptance to the economics establishment. The formula was now “usable”. It had a list of long forgotten “precursors,” among whom was mathematician gambler Ed Thorp, who had authored the bestselling Beat the Dealer, about how to get ahead in blackjack, but somehow people believe that Scholes and Merton invented it, when in fact they just made it acceptable. The formula was my bread and butter. […]

     Robert Merton, Jr., and Myron Scholes were founding partners in the large speculative trading firm called Long-Term Capital Management, or LTCM, which I mentioned in Chapter 4. It was a collection of people with top-notch résumés, from the highest ranks of academia. They were considered geniuses. The ideas of portfolio theory inspired their risk management of possible outcomes—thanks to their sophisticated “calculations.” They managed to enlarge the ludic fallacy to industrial proportions.

     Then, during the summer of 1998, a combination of large events, triggered by a Russian financial crisis, took place that lay outside their models. It was a Black Swan. LTCM went bust and almost took down the entire financial system with it, as the exposures were massive. Since their models ruled out the possibility of large deviations, they allowed themselves to take a monstrous amount of risk. The ideas of Merton and Scholes, as well as those of Modern Portfolio Theory, were starting to go bust. The magnitude of losses was spectacular, too spectacular to allow us to ignore the intellectual comedy. Many friends and I thought that the portfolio theorists would suffer the fate of tobacco companies: they were endangering people’s savings and would soon be brought to account for the consequences of their Gaussian-inspired methods.

     None of that happened.

     Instead, MBAs in business schools went on learning portfolio theory. And the option formula went on bearing the name of Black-Scholes-Merton, instead of reverting to its true owners, Louis Bachelier, Ed Thorp, and others.