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of The Black Swan and directed our discussion towards his treatise on asymmetric outcomes-the central theme of the unpublished tome that he brought along with him and referenced throughout our visit.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
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As an investment professional with 30 years in the financial markets, I have witnessed the continual belief in the defective “Buy & Hold” approach promoted by the Wall Street marketing machine. Since the tools or structures necessary to manage risks and returns do not exist in the typical Broker/Advisor world, one can only expect the uninformed public to continue to get the “short end” of the investment equation.
Tom Byrne
I ponder the relevance of The Black Swan Portfolio theory to sustainability (ESG or Triple Bottom Line theories). For instance, we don’t know whether we possess the “solution” to climate change, but the failure of our environment and the depletion of human capital (see http://bit.ly/oGnl6) from our continued unwillingness to take risk (develop, invest in and deploy interim solutions) is imminent.
If you insure against market risk (principal protected funds, equity indexed annuities, AAA insured bonds, FDIC CEDRS CD’s, etc.), then you don’t have to buy into any theories or lose a penny of your profits. Most people take too much risk and think Knightian tenants. (It was Frank H. Knight’s (1921) landmark thesis that put the issue at the very heart of entrepreneurship research. As Blaug (1996: 444) notes, “The beauty of Knight’s argument was to show that the presence of true ‘uncertainty’ about the future might allow entrepreneurs to earn positive profits despite perfect competition, long-run equilibrium and product exhaustion.” Knight identified three types of uncertainty: The first one (now generally accepted as the notion of risk), consists of a future with a known distribution – only the particular draw that will actually occur is unknown; the second one (generally known by the term uncertainty), involves a future whose distribution is unknown, but can be estimated by studying draws over time; and the third one that Knight called true uncertainty (that is now known as Knightian uncertainty), consists of a future whose distribution is not only unknown, but unknowable.