Venture Populist

The Black Swan by Nicholas Nassim Taleb holds its own among the most important investment books ever written. In it, Taleb argues persuasively that any sensible long-term strategy in a world dominated by extreme and unpredictable (black swan) events has to accept, and even embrace, that very unpredictability. It is poignant and timely advice for any investor and a must-read for investment professionals.

I met Taleb for lunch at Bice in NYC one afternoon about three years ago while I was heading Alternative Strategies for an investment management firm. I was interested in exploring the idea to engage Taleb as a sub-advisor for an investment fund that we were contemplating. I found him to be personable, enthusiastic, engaging and surprisingly modest.

I had read and re-read Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life before our meeting and I was looking forward to discussing his contempt for investment managers that sell themselves on their track record…a cynicism that I shared. But Taleb had just finished his final draft manuscript of The Black Swan and directed our discussion towards his treatise on asymmetric outcomes-the central theme of the unpublished tome that he brought along with him and referenced throughout our visit.

The notion of asymmetric outcomes, “I will never know the unknown since by definition it is unknown. However, I can always guess how it may affect me, and I should base my decisions around that”, causes Taleb to advise to seek out (investment) situations “where favorable consequences are much larger than unfavorable ones.”

That is a central tenet of Venture Populism and my advocacy of committing a portion of an investor’s portfolio to private venture-oriented investments. Like Taleb, I believe that effective investment portfolios should contain meaningful (and appropriate) exposure to positive Black Swans-such as private equity investments in emerging ventures and distressed companies.

In posts to come I will expand on this premise and propose a provocative new model for portfolio construction that balances the investor’s need to mitigate the asset-depleting impact of negative black swan events with simultaneous allocations that benefit from the potential of positive Black Swans and asymmetrical outcomes.

Many advisors now concede that Modern Portfolio Theory, traditional asset-allocation and buy-and-hold investing models have failed and investors are looking for improved approaches that preserve capital and manage unexpected risks more effectively without giving up on the prospects for capital appreciation.

The Black Swan is indeed a brilliant and provocative work. As the New York Times review summed, “It concerns the occurrence of the improbable, the power of rare events and the author’s lament that in spite of the empirical record we continue to project into the future as if we were good at it.”

We expect all swans to be white and are shocked when a black swan swims by…the same way that we were lulled into complacency with flawed risk management models and were then shocked when the market fell 50% and erased away trillions of wealth.

Investors and their advisors can build better portfolios that are for the most part insulated from the impact of negative black swan events, yet have simultaneous exposure to asymmetrical risk/return opportunities.

Album:   The Black Swan, Story of The Year, 2008

Popularity: 65% [?]

Broker Model Needs Repair (Financial Post)

“By charging you 1% annually to manage your money, a large portion of your wealth ends up in his or her pocket.”

Financial Advisers Face a Crisis of Confidence (Investment News)

“About 80% of affluent investors — that is, those with more than $500,000 in investible assets — are disgusted with their adviser because their adviser is spooked”

Album:   Read All About It, The Newsboys, 1988

Popularity: 41% [?]

In prior posts I have taken swipes at traditional asset allocation, buy-and-hold investing, the Efficient Frontier, the Efficient Market Hypothesis and Modern Portfolio Theory (MPT).

Sure, I am trying to be provocative, poke a little at advisor complacency and provoke polemic on the comment boards…but I am also sincere. MPT relies entirely on investment history for investment analysis and conclusions. These tired and discredited methods are rubbish…and have cost investors trillions.

It is encouraging to see evidence of advisor post-mortems in progress as some advisors are seeking not to repeat the mistakes of the past. I was also entertained by John C. who cracked on the comment board, “What’s over 50 years old and still considered modern?   MPT”

But pretty pie charts and Powerpoints are not so easily disposed of. As an anonymous critic incites, “The appeal of Modern Portfolio Theory in the investment advising community is its simplicity, graphic presentation value, and most of all, little or no investing judgment or skill is required; just pick, print, present, and hope; chasing efficient frontiers, hoping that investment history will somehow repeat itself, and just waiting for historical updates to generate new efficient frontiers to justify investment change.”

Nevertheless, some advisors are stubbornly standing by their man(tra).

Modern Lovers

Consider these edited comments that I received from Matthew K. in response to the Crisis = Opportunity post;

“MPT works. With the right allocation and systematic rebalancing to maintain percentages as well as in line with client’s goals, there is no lost decade. Markowitz knew what he was doing, and as an academic, he did not stand to profit…When MPT is juxtaposed with Daniel Kahneman’s Nobel Prize winning ideas on heuristics, you see how MPT does add value when used in line with client’s goals…Any classic definition of “Venture” includes the idea of risk taking. Where does that fit in CAPM or the efficient frontier?”

I cannot rebut a hopeless romantic, so let’s engage Matthew K. in a virtual volley with interlaced quotes excerpted from a FT article and a McKinsey interview with the especial epistemologist, Nassim Nicholas Taleb. Taleb is the author of two true investor instant classics and must-reads, Fooled By Randomnes and The Black Swan.

Taleb has a strong opinion on the matter of MPT and modern finance…and he is no modern lover:

MK- MPT works. With the right allocation and systematic rebalancing to maintain percentages as well as in line with client’s goals, there is no lost decade.

NNT-We learn from crisis to crisis that MPT has the empirical and scientific validity of astrology, without the aesthetics…In 1990 William Sharpe and Harry Markowitz won the prize three years after the stock market crash of1987, an event that, if anything, completely demolished the laureates’ ideas on portfolio construction….I would ban portfolio theory immediately. It’s what caused the problems…Portfolio theory simply doesn’t work. It uses metrics like variance to describe risk, while most real risk comes from a single observation, so variance is a volatility that doesn’t really describe the risk. It’s very foolish to use variance.

MK-Markowitz knew what he was doing, and as an academic, he did not stand to profit…When MPT is juxtaposed with Daniel Kahneman’s Nobel Prize winning ideas on heuristics, you see how MPT does add value when used in line with client’s goals.

NNT-Academic economists are no more self-serving than other professions. You should blame those in the real world who give them the means to be taken seriously: those awarding that “Nobel” prize… Every time I have questioned these methods I have been abruptly countered with: “they have the Nobel”, which I have found impossible to argue with. There are even practitioner associations such as the International Association of Financial Engineers partaking of the cover-up and promoting this pseudoscience among financial institutions. The knowledge and risk awareness we are accumulating from the current subprime crisis and its aftermath will most certainly not make it to business schools.

Thanks, (virtual) Nassim. I will take the next one.

MK-Any classic definition of “Venture” includes the idea of risk taking. Where does that fit in CAPM or the efficient frontier?

VP-Of course, venture implies risk-taking… they are nearly synonymous. A venture investor is knowingly acknowledging and accepting an implicit and quantifiable serving of risk that is decidedly less than a range of positive (asymmetric return) outcomes. Perhaps investors would have been better served if their notion of the risk that they were assuming in their efficient frontiers was not muted (and implied to be mitigated) by the marketing machinations of MPT. CAPM is a future-oriented model yet it essentially relies on historic data to predict future returns. The Efficient Frontier? I have seen the inputs, I have seen the outputs…and I have seen the results…the efficient devastation of unsuspecting portfolios.

Album:   The Modern Lovers, The Modern Lovers, 1976

Popularity: 57% [?]

In a video interview about the column, Jeff Goldberg, the article’s author, describes garden-variety vendors of investment advice as, “…these Jiffy Lube kind of places. They’ll take your money. They’ll invest it in the same things that everybody else is being invested in.”

Is that a cruel but fair commentary? It is if advisors keep doing what they have been doing yet (insanely) hope for different results…and good luck securing new clients amidst the new prevailing wisdom. Face it, with the exception of advisors that embraced alternative asset classes and/or market timing, the vast majority of advisors portfolios were marked to market in the selloff and their clients have likely lost a generation of investment opportunity that may never be made up.

In prior posts we have posited and proofed the problem;

• Stocks are not worth their risk premia and bonds look downright scary.
• MPT, B&H and traditional asset allocation models have been completely discredited
• Diversification is not easily achieved because in crisis all correlations go to one.

But we also spoke to the solution;

• The vast majority of private wealth in America is the result of participation or investment in private venture….such as business start-ups, venture capital and private equity.
• The HNW investor understands and appreciates the wealth-creating potential of private venture investing (PVI)…in many cases that is how they became wealthy.

Advisors could materially improve their value proposition, their competitiveness and their client’s portfolios by developing PVI competency and integrating the asset class into their practices.

Why I Hired My Advisor

I know too well that this message will be lost on 80% of advisors who view private investments (in start-up or existing businesses, private equity or venture capital) as a new problem, rather than a solution. That’s probably the way it should be as it is likely that only 20% of IAs possess the capacity and the client-base that could support and embrace the asset class.

But every advisor benefits from a discussion that introspectively considers the true value proposition that they provide to their investment client. Invariably, portfolio performance (relative to client objectives) will always be a factor that advisory clients consider when they evaluate their advisors. Advisors should be open to asset classes that have a proven history of being non-correlated to equity markets and providing exceptional relative and absolute returns over intermediate-term market cycles.

The performance of the private investment category is indisputably compelling and speaks for itself. The most recent Thomson Reuters US Private Equity Performance Index data released through 2008 show the “All Venture” category (which includes data from early/seed, and later-stage VC funds) returned 17% over the last 20 years against the 6.1% return of the S&P. Over return periods less than 20 years the performance relative to equity indices has been even more compelling.

Venture Populist seeks to assist advisors (and investors) by advocating the integration of private venture investing into more investor relationships and portfolios and providing a forum and resource for like-minded professionals and investors.

Advisors that allocate to private venture investments claim that they differentiate their practice (from their advisor peers that are pursuing the same HNW clients) and strengthen their advisor-client relationships by increasing the quantity and quality of the advisor-client dialogue.

Private wealth and family office portfolio managers consistently maintain that the majority of their client dialogue (at the portfolio level) is spent discussing private investments. Have you ever noticed your reflection in the glazed pupils of investor’s faces when you discuss Modern Portfolio Theory or the Efficient Market Hypothesis? That’s a monologue. Discussing the prospects of a private investment in a start-up, emerging or established business…with a HNW investor who made his money in business…and you have dialogue. Business people enjoy talking about business. That provides the advisor with an excellent opportunity to engage clients on a different level than advisor-client, vendor-customer, or salesmen-prospect. Rather, as two professionals contemplating a joint business transaction.

In subsequent posts I will speak to additional ways that an advisor’s practice is positively impacted through PVI including;

• Better client retention rates,
• The development of a collaborative client “community” within the practice,
• Incentivizes for clients to refer new clients to the practice, and most importantly,
• The increased potential for improved portfolio performance,

…while radically differentiating his practice from his peers and invigorating the value proposition to the client.

Album:   Private Practice, Dr. Feelgood, 1978

Popularity: 48% [?]