Nassim Taleb: At least this seems to be what Nassim Taleb (author of the Black Swan) did in October 1987 (according to this interview). No wonder he has been so focused on writing and speaking about Black Swans (events with ‘small probabilities but huge repercussions’). He earned most of his income from an event stuck way out in the distribution tail – lucky it was a positive Black Swan for him and not a negative one, which it was for many others.
He suggests minimizing exposure to negative Black Swans (including through insurance) and maximizing exposure to positive Black Swans. He regards Banks and Reinsurance companies as being susceptible to negative Black Swan – giving examples of the 1982 banking crisis – where banks lost more than they had made in all previous years (from the article “The eight biggest banks in America had $ 22 bn in capital, and $ 60 bn in loans to South and Central America. They lost everything in one incident.”) On reinsurance companies he gives the example of Lloyd of London. He regards biotech to be susceptible to positive Black Swans – unexpected breakthroughs leading to dramatic increases in company revenue. His current approach to investing (as I understand it) is keep 80 to 90% in t-bills and the remaining 10-20% in the riskiest investments (focusing on those which are more susceptibile to positive Black Swans than negative ones).
Sampling error and broad exposure. He also highlights the risk of sampling error highlighting that in finance, ‘outliers’ (or a few observations) often dominate the mean. He gives the example that about 170 stocks (out of 5000+) account for about 60% of total market capitalization. Some other examples, which I think are useful: 33 stocks accounted for 75% of the return of the S&P500 in 1998. Only a few stocks migrating from a small value portfolio account for most of its return. The point he makes (more eloquently than the above) is that using a small sample of stocks in a portfolio risks missing the few that make the difference (sampling error). He suggests broad diversification (for more detail see Taleb on Black Swans).
Implications for finances and investing (at least my take):
- 1. More stock diversification is better than less in each asset class used in a portfolio (to reduce the sampling error risk of missing those stocks that make the difference).
2. Minimize negative Black Swans through insurance (disability, life, auto, home, umbrella), and through diversification into asset classes that do well when negative Black Swan’s show up (US treasuries seem to do well when Banks collapse, and CCFs seem to do well during other unpredictable events – climatic shocks and wars [although I don’t currently own CCFs]). IMO this will likely reduce the impact of negative Black Swan’s while retaining broad diversification (as in 1 above) .
3. Don’t expect to make 97% of lifetime ''total money made" in one day…[in my, perhaps biased, view this is less replicable than the more incremental approach taken by many of today's successful retirees (many who post here)].
Robert
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