Nassim Taleb recently weighed in on the matter via his latest book Antifragile. Taleb holds Antifragile as the crowning work of his series on uncertainty, fragility and robustness. It’s a solid read although sporadic. Taleb describes many markets, institutions and processes as fragile as participants fail to consider the impacts of highly improbable events due to their irregularity and uncertain impact.
Taleb defines antifragility as something which benefits from disruption uncertainty, or volatility. He takes great pains to delineate the differences of antifragility and robustness. Robust things are stable in the face of uncertainty while antifragile things benefit from uncertainty.
Investors and markets hate uncertainty. Financial academics quantify risk using volatility (a topic for another day). Fragile systems require meddling to survive as seen during the recent US banking crisis and resulting Federal Reserve Bank intervention. Suffice to say uncertainty, volatility and fragility are topics which financial market participants avoid. Taleb argues fragility is rampant in today’s world and must be dealt with.
How Can Investors Create Antifragile Portfolios?
Financial instruments which benefit from volatility are derivatives – primarily options. Implied future volatility is the one input in option pricing which is not known during pricing. (The other four are defined: strike price, current price, dividends payable, and time until expiration.) Thus, by definition an antifragile portfolio will be long volatility.
Investors could purchase puts or calls on specific investments or own option ETFs such as VXX, VXZ, TBT. Another way to adopt antifragility in portfolios is to purchase companies which benefit from non-market related instability. Energy companies which own significant reserves in politically stable locations may benefit from geopolitical uncertainty. (ConocoPhillips (COP) comes to mind). Yet the connection between these increasing profit and uncertainty or volatility is indirect at best. Other possibilities could be made for businesses that benefit from natural disasters, medical outbreaks, etc. but the arguments would be indirect and weak.
As most investments and businesses decline due to upheaval, a truly antifragile portfolio would be long volatility via buying options. Given the costs inherent with buying options, antifragile portfolios would lose money during periods of market complacency and gain during sharply increasing or decreasing markets. Antifragile markets would perform exceptionally during a few markets (such as 2008) but lose money most years. Given the mathematical nature of compounding returns, this strategy would be challenged over the long term.
If an Antifragile Portfolio Often Loses Money, How Can Investors Leverage Taleb’s Insight?
If a long only portfolio with undiversified investments is fragile to market shocks while a portfolio of long volatility options is antifragile with uncertain (even though positively skewed) outcomes, is there a common middle ground. Yes - the answer is a robust portfolio.
A robust portfolio is constructed to be agnostic to prevailing market conditions which investments that profit from understood and acceptable investment-specific factors. By selecting uncorrelated investments with exposure to different drivers, investors can create a portfolio which has positive expected return regardless of future uncertainty.
A robust portfolio could certainly contain antifragile investments yet could also invest in assets which have a positive expected value most of the time (“fragile” in Taleb’s parlance). Over the long term, a portfolio with robustness will compound geometrically as opposed to either a fragile or an antifragile. I’ll expound on the facets of robust portfolios in a subsequent post.