If you have been investing for over eight years, you know of the storied Lebanese-American statistician, investor and writer Nassim Taleb. His book, “The Black Swan,” has been ranked among the most important books since World War II. For those who have read his complete work on uncertainty, "The Incerto," how many have put his ideas into practice?
Taleb’s work is challenging—difficult both to digest and summarize. Yet when the next financial crisis hits, people will look to thought leaders like Taleb and Peter Bernstein for quick answers.
In this piece, I have highlighted the five core lessons I took away from Taleb's writing. These lessons play a central role in a black swan portfolio:
I will provide a few observations and comments on each of the pillars below.
1. Eliminate risk of ruin
"When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing." - Warren Buffett Â (Trades,Â Portfolio)Â
Part and parcel of Taleb's antifragility philosophy is the need to reduce or eliminate the probability you will lose. Whatever happens in the market, you will need something left to regain some ground.
In Taleb’s construct, there can be no medium risk or medium return investments. Rather, you need two distinct sides, where one is comprised of aggressive, high-risk investments and the other is risk-free.
2. No forecasting
Forecasting is popular and lulls us into a nearly hypnotic state. We begin to accept having numbers, even random ones, is preferable than having no numbers. To illustrate with levity, Taleb uses a graphic of a wizened turkey predicting his flock’s growth:
In his rage against the negative effects of forecasting in "Antifragile," Taleb points to a memorable black swan event in the nuclear industry:
"In the wake of the Fukushima disaster, instead of predicting failure and the probabilities of disaster, these intelligent nuclear firms are now aware that they should instead focus on exposure to failure-making the prediction or nonprediction of failure quite irrelevant. This approach leads to building small enough reactors and embedding them deep enough in the ground with enough layers of protection around them that a failure would not affect us much should it happen."
Buffett joins Taleb in his abhorrence and skepticism of forecasting. Take a look at one of Buffett’s ground rules from his original partnership agreement:
In lockstep, Taleb counsels us to protect against negative events rather than try to predict them. The goal is to stop rare events from having a big impact. The bonus is on you to mitigate your vulnerability: you cannot simply hope to see it coming and take swift action.
3. Diversify aggressively
Taleb encourages investors to diversify beyond their comfort zones, which is a bit different than Buffett’s "putting all your eggs in one basket and then watch it" approach. I favor Taleb’s advice because watching your basket can never protect you from black swan events. By definition, these events cannot be foreseen and a “circle of competence” approach could lay the groundwork for financial ruin. The trade-off is doing somewhat better over time or risking destruction.
4. Skin in the game
The working title of Taleb’s next book is "Skin in the Game," which says something about how important this concept is to him. It is the fifth book of the "Incerto" series ("Skin in the Game: The Logic and Thrills of Risk Taking"). In a paper co-published by George A. Martin, Taleb says:
"Nobody should be in a position to have the upside without sharing the downside, particularly when others may be harmed."
The founders of FRMO Corp. (FRMO, Financial) and Horizon Kinetics arrived at the same conclusion about having “skin in the game.” In 2011, Murray Stahl (Trades, Portfolio) and Steven Bregman published a very interesting essay noting the owner-operator mindset and character are important drivers:
"It is such a powerful determinant of success that even a naively selected set of such companies have produced astonishing results over time (see more below). At owner-operator companies, decisions are made by a principal or owner, as opposed to an agent or hired manager."
The table below was published by Horizon Research Group. It depicts the returns of owner-operated companies in comparison to S&P 500 returns:
It reveals that when operators are also owners and hold common stock, they look for investment opportunities because they have real skin in the game. Common stock turns out to be a force for good (over options) because operators are exposed to the same risks as investors.
5. Seek optionality
"Optionality is the property of asymmetric upside (preferably unlimited) with correspondingly limited downside (preferably tiny)." - Taleb in "Antifragile"
Seeking out optionality is especially important on the aggressive side of a two-pronged portfolio.
Taleb happens to prefer enterprise solutions, using venture capital and backing entrepreneurs. For those who just cannot go there, please pay attention to his other investment ideas.
Optionality is when the upsides outweigh the downsides. Optionality might, at first, seem contradictory to avoiding forecasting and predictions. Are not we trying to guess how businesses will fare in the future?
How Taleb resolves this apparent conundrum is simple: he simply seeks out optionality. According to his thinking, a black swan impact on your holdings must be a possibility to start (so bonds do not figure into this equation, let’s put them aside). On the other hand, stocks simultaneously have a potential downside of 100% and an unlimited upside. If you are aggressive, you can always achieve growth.
Ultimately Taleb’s recommendation is to rank investments based on optionality and look for quantity over quality. Keep your eye on product launches, trials and experiments per dollar invested.
As a point of comparison, music industry research explores how songs become hits (Salganik and Watts 2009). While hit songs all possess a baseline degree of quality, boosting the quality does not increase their likelihood of becoming a hit. It sort of explains mediocrity across all sorts of industries. It can work beautifully in some sectors (computer games anyone?) but beware in other industries where you are being pitched to invest in a “premium” product. The safest bets, according to the principle, are biotech, tech, media, exploration and production and many but not all precious metal royalty companies.
Finally, Taleb promotes aggressive tinkerers (convex tinkering and decentralized experimentation). A case in point is Amazon (AMZN, Financial), which is constantly offering new products, services and features. It has boldly entered new territories and markets. While Amazon seeks optionality and conducts scaling up tests, the competition quakes in their boots. Let’s keep a collective eye on them and others who listen to Taleb’s lessons.
Disclosure: Long FRMO.