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Black Swan Investment Strategies Don’t Work

February 13, 2013 Leave a comment Go to comments

Nassim Nicholas Taleb is a great writer and his first two popular books, Fooled by Randomness and The Black Swan, exposed a lot of people to new ideas. I’ve seen some people writing about changing their investment strategies based on what he writes because of his background as a successful trader. I would be very cautious about this. Although the books are entertaining and thought-provoking, applying the advice too liberally  may be dangerous.

The main idea that investors seem to latch on to is what he calls the “barbell” investment strategy. Since I’m reading his latest book now I’ve recently been exposed to yet another description of it. The plan is simple: put 90% of your portfolio in the safest assets you can find to eliminate the downside, and then put the remaining 10% in the riskiest assets you can find to get a profit. He claims that other “blended” or “balanced” strategies have hidden risks of great loss and this avoids them.

Ironically many people who end up following this advice are exposing themselves to unexpected negative surprises (black swans). It comes on both sides. First, the safe asset may not be safe. As Taleb wisely and repeatedly points out we assume that the past will repeat itself. The US government has never defaulted on short-dated treasuries… yet. Who knows if they will be safe in the future? But that’s only a minor technicality.

The real danger is in the risky portion of the assets. Many people seem to be building a portfolio where they assume the risky assets will make them a lot of money. This is a bit ironic – “Hey, I have this great high-risk investment that’s guaranteed to make a good return!”. Either they are doing very badly at picking risky assets or, if they do it correctly, they have a very high chance of losing that 10% of their portfolio.

So once that happens the plan has worked. You’ve lost 10% of your assets and the other 90% are safe (we hope) in an investment that is generating minimal returns if any. Now what? If you’re like most investors you expect to earn a higher return than that. So you need to start over, and take 10% of your remaining 90% and put it into risky investments. Do this 5 times in a row and you’ve lost 41% of your portfolio. How’s that for risk-free?

The misconception here lies in applying this to your current portfolio. If you have $100,000 invested and you have determined that you need $1,000,000 to retire comfortably, that means that the amount you cannot afford to put at risk is 90% of that or $900,000. But if you implement this strategy with your portfolio today you will be keeping $90,000 safe, which is far short of your needs, and risking $10,000 which you can’t afford to lose yet.

Your financial life can play out in one of two ways: either you can directly save enough cash to pay for your living expenses when you aren’t working which means your only goal is to avoid losing that while making a minimal return. Or you can’t save that much, which means your only hope of success is to earn a decent investment return. Many people fall into the second category (to break the mold I put myself in the second category but could make the first work). This leads to the great misunderstanding of risk. The biggest risk for them is that they don’t get the investment return they need. If they merely hold on to the cash they have saved, they will have failed.

For that type of person the safest strategy is to create a balanced portfolio that will give them the return they need while minimizing the risk of total loss and the volatility along the way. Once you have enough money then you can switch to a preservation portfolio. So it turns out that the brilliant new black swan strategy is just old common sense: when you have enough already, don’t put it at risk in the pursuit of further gains that you don’t need. And it didn’t even take me a whole book to explain that!

  1. Trevor
    July 14, 2013 at 3:23 pm

    You’re right, but the probability is smaller than the entire non-barbell going to zero, according to Taleb. My suggestion is to then be 100% in maximally safe, inflation protected securities.

    • July 14, 2013 at 6:10 pm

      A barbell strategy has a very high probability of going to 0 if you manage it the wrong way. The correct way would be to quit investing in risky assets once you lose that part. But that strategy doesn’t sound as sexy as the common misunderstanding.

      If you can meet your lifetime financial goals by investing only in government-issued inflation-protected bonds then there is no better way to go. I could do that but I want to try something more fun 🙂

  1. March 18, 2013 at 4:14 am

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