I looked for this article out on the web, and at the CFA Institute website, and didn’t find it. I asked for permission to use this and no one responded after more than one week. The following was excerpted from an interview with Nassim Taleb by Rhea Wessel in the September/October 2013 issue of the CFA Institute Magazine on pages 40-43. CFA Institute, I consider this fair use. If it is not, let me know, and I will take it down.
Is there an investment strategy that fits with the idea?
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I will get there. Let me make some investment rules in general.
Number 1: I introduced earlier the 1/n rule—be as broad as you can in whatever risky assets you areinvesting in to minimize the risk.
The second trick, or rule, [is to] implement that barbell to reduce your fragility. Because if you see the barbell, then no fragility is in the tail. In other words, if you are “bar- belied,” putting a floor on your losses at 90%, the maximum you could lose is 10%. If the markets go down 20%, you don’t lose twice as much as [you would] if the market went down 10%. You lose much less. That puts you in the antifragile category. [For a third rule] I’d say, look for companies that have optionality.
What is optionality?
Optionality means to have more upside than downside because the company has options. An “option” in this sense acts like a financial option, and a financial option is an instrument of antifragility because you pay a premium and you have all this upside and very little downside.
The companies make more from the upside of something than from the downside. Make sure the optionality is not priced by the market. And of course, go away from companies that have negative optionality.
An optionality that is priced in the market is, for example, buying energy companies and gold companies before a rally in gold. Instead ofinvesting in gold, people invested in companies that made a lot more than gold. But after a while, this got priced in. In other words, if you’re wrong on gold, you do a lot better than those who invested in gold outright. If you’re right on gold, you do a lot better than those who invested in gold.
You have to avoid the lottery-ticket effect of investing in companies that are overpriced because people are looking at the big upside.
So, now we have three rules [1/n, implement the barbell, and pursue optionality].
Let me make one more—never invest in company stocks or strategies that have very low volatility without ascertaining that there’s a floor on the return.
[Consider that] a Sharpe ratio measures return divided by risk, as measured by past variation. You have to be wary of companies that exhibit no volatility yet have a high return, unless they are genuinely low volatility. Most of them are fake low volatility.
What do you mean by “fake low volatility?
You know the funds of Bear Stearns that blew up in the subprime crisis? They were funds that never had a down month. A lot of people who blew up in subprime did not have a down month—ever. And people rushed to invest in them because they were low volatility. And then they blew up.
Typically, I never get close to anything that has no volatility, unless it’s justified, like Treasury bonds. If you go to a balance sheet, you can see why there is low volatility, whether it is genuine. The company can have a barbell. The company can have very, very low leverage. Or you might discover that a company is doing the equivalent of selling remote options, and the company can lose a lot of money in one blow.
Let’s link it to make it more intuitive: In general, I can say that a system that has very, very low volatility is likely to blow up. Take the example of Syria. Syria had no political volatility for 40 years, and look what happened.
Forests that never have fires are likely to be completely eradicated by fires when they happen. Forests that have regular fires are much more stable.
You mentioned the concept of leverage. You could make another investment rule regarding debt?
Yes. You know the rule—what you don’t do is more important than what you do. In natural systems, you need redundancy to make the system work better. People think that redundancies are inefficient. I think they’re the most efficient thing in the world, if you do them right.
Redundancy is bad if you buy the same morning newspaper twice or if you have two subscriptions to the same website. But redundancy is fine if you have a stock of cash in the bank or if you’re a company that needs oil and you have extra oil.
Let’s assume that you have cash in the bank and there’s a big crisis. You have dry powder. It will make you antifragile to have the extra dry powder if nobody else has money. You can buy anything you want. Cash is the opposite of leverage.
In fact, the number one indicator of fragility is leverage. It can be operational or financial. Leverage corresponds to people’s overconfidence about the future.
Most people who have leverage will be completely squeezed in a crisis, and you will have cash.
Whose compensation models do you agree with?
Most investment advisers are not harmed by the downside. The only people who have a good compensation model are hedge fund managers. Typically, when I managed money, I was harmed 50 times more than any of my clients as a percentage of my net worth.
The hedge fund managers I know are typically far more invested than their average client. When that person is on board calling the shots, I sleep like a baby. You don’t get this with fund managers.
Okay, Taleb has offered up six ideas for us to consider regarding risk control. Here they are:
- Barbell – safe & risky
- Positive optionality
- Want a floor – no “fake low volatility”
- Avoid leverage – operational & financial
- Alignment of Interests
Let’s take them one-by-one, but before we do, every risk mitigation scheme has to pass the test: “what would happen if everyone did this?”
This is a fancy way of saying equal-weight everything. In such a scheme, ExxonMobil and Apple get the same weight as Phoenix Companies and American Independence Corp. Nifty idea until too many people follow it. This is an idea that cannot scale. Yes, owning small companies and the debts of small companies have yielded high returns, but if many people do that, it will cease to be true.
Barbell – safe & risky
Yes, owning safe and risky investments is a bright idea — that’s where the 60/40 stocks/bonds came from. You get positive optionality and your downside is clipped. Taleb argues for a lower risk version of this. But again, this can’t scale. Most assets are in-between — they carry moderate risks. What is the risk premium at which you buy moderate risks?
Everyone wants the best of both worlds, but how much are we willing to pay to get it? Options normally carry a cost. When you can get them for free, rejoice. The market is competitive, and there are few places where free options exist.
Want a floor – no “fake low volatility”
Taleb is looking for guarantees, or near-guarantees. He does not trust low volatility investments, and I agree. He wants something that tells him that that floor for the asset price is not too far below the current price. Makes him sound like a value investor.
Avoid leverage – operational & financial
Margin of safety is the credo of all good value investors. That makes us avoid financial leverage, and to a lesser extent operating leverage. As I have stated before, good investing takes moderate risks. Low risks avail little, while high risks take too many losses. Moderate risks have a greater probability that humans can deal with them.
Alignment of Interests
Yes, it is important that management and fund managers have incentives aligned with shareholders. I aim for this and have no argument against this, unless it costs too much to get this.
The Main Point
If something in the markets is a good thing, it will get bought, and the price of it will go up. Free optionality is rare. Assets that offer easy guarantees are also rare.
Thus I think the advice of Nassim Taleb is vacuous, because the methods that he recommends for safety are risk factors which have prices. They are great ideas when they can be executed at no cost. But most of the time, there are costs.
In 2002, we had the “we eat asbestos for lunch” trade. After aversion to asbestos risk, some were willing to take the risk because they thought it was overstated.
Any risk can be overplayed. There are fair levels for taking and avoiding risk. Good investors and businessmen understand this.
By David Merkel, CFA of Aleph Blog