Prudently Protecting Portfolios against Black Swans
As we explored last week, most human energies, including those of the investment media, are dedicated toward avoiding relatively inconsequential small losses, meanwhile almost wholly ignoring the risks resulting from Black Swan events. Lamentably, the same is true for most professional investment managers. A globally diversified portfolio composed of numerous securities within the capital structures of varied industries is the standard product offered to investors seeking prudent stewardship of their wealth. This approach avoids overweighed exposure to essentially anything. It offers absolutely no protection, however, against systemic threats such as Black Swans. Therefore, a “prudent” portfolio is nothing of the sort. This is unsurprising given the tendencies outlined in the July 21 post. It does beg the question, though, as to what a prudently constructed portfolio looks like. I have already addressed that question in part with an earlier post on the optionality of cash. Understanding the fallacy of the golden mean, however, adds more to the story.
The Fallacy Explained
In continuing to question the notion that risk minimization requires spreading your assets hither and yon, let’s assume that someone argues vehemently that cyanide is deathly poisonous while another, with equal intensity, claims it is a health-promoting tonic. Does the truth really reside somewhere in the middle? The golden mean is the assumption that truth can only be found as a compromise between two extremes, but there is no middle ground between disinformation and information. It is a fallacy to claim an intersection between two different planes. Consider the fallacy of the golden mean in the context of portfolio construction. Does a diversified portfolio, with assets that become highly correlated when the preference for liquidity predominates, adequately compensate for an existential threat—a fat tail on the dangerous side of a frequency distribution (also known as a Black Swan)? As you may remember, beyond cash and its gilded equivalents, there were no safe havens during the more chaotic episodes of the financial crisis.
The Danger It Poses
Perhaps because many market participants take them at face value, I have written extensively on the prevalence of prediction errors, the subject of one especially perplexing sentence in Alan Greenspan’s latest book, The Map and the Territory: Risk, Human Nature, and the Future of Forecasting: “Even repeated forecasting failure will not deter the unachievable pursuit of prescience, because our nature demands it.” (Italics added)
It seems, then, that “our (capricious?) nature” demands that we do something demonstrably foolish. Predictions are often based on models, which are themselves victims of the increased complexity of the very phenomena whose future they are designed to foretell. For example, the hardy perennial bell curve, academically known as a Gaussian distribution, is incapable of describing an environment in which many distributions have “fat tails.” The tail of the Bell curve slopes gradually down toward zero, but this downplays the actual frequency of tail events which, if we properly accounted for them, should bulge more at the negative extremes. 
Rational wealth protecting investment managers must find better means than forecasts for coping with an always uncertain future. Increasingly, “power law curves” are becoming more appropriate for responsibly girding a portfolio. They better account for Black Swan events. For those readers interested in the more exhaustive explanation, please contact me for a copy of my 2012 essay, “I Cannot Leave the Truth Unknown.”
In such a world, adhering to the golden mean and putting your money in “medium risk” investments—as if we know what medium risk is—yields only the ignominious excuse that at least your money was lost in concert with that of other well-intended people. Medium risk investment strategies are a fallacy and, to me, a euphemism for mediocrity.
I highly recommend Robert Gordon’s tome, The Rise and Fall of American Growth: The U.S. Standard of Living Since the Civil War or the shorthanded version, Gordon’s 12-minute TED talk video. Gordon argues that the dramatic increase in output per person since the Industrial Revolution upended millennia of social and economic order. If you accept Gordon’s prescription for the future—which expects growth nowhere near levels to which we have become accustomed—then you should minimize your exposure to today’s multiple complex man-made systems; they are prone toward disequilibrium and seem always to be in a critical state. The financial system, hijacked by the Federal Reserve Board of Governors, is a case in point, though it likely appears stable to the casual observer, and, seemingly, to willfully blind central bank chairpersons. In this new era the fallacy of the Golden Mean is even more dangerous. Before laying the yoke of Don Quixote upon my shoulders, try my reasoning to see if it fits.
The Unconventional Alternative
Given the relative frequency of Black Swan events and the fallacy of the golden mean, perhaps the best strategy is one both hyper-conservative and hyper-aggressive. Toward that end, invest, say, 95% or more of your assets in extremely safe instruments, like laddered Treasury Bills. That percentage could be lower if you are confident that substitute assets would actually benefit from a Swan event. An example would be a relatively stable business with redundant liquidity that could cheaply add capacity during a slump, or acquire the company’s or a competitor’s shares, whichever is more compelling.
The 5% portion would be committed to extremely speculative bets, as leveraged as possible, like out-of-the-money put options. That way you are not exposed to errors of risk management; no Black Swan can hurt you at all beyond your “floor.” This is something I did in 2007 and 2008. For those interested in delving deeper into this strategy, see an explanation on pages 342-347 in Decade of Delusions. Contact me if you would like a pdf copy.
John Maynard Keynes observed that it is better to fail conventionally than to succeed unconventionally. It seems most people seek the illusion of safety by clustering in the warm, cozy, and friendly center of the bell curve rather than expose themselves to the loneliness and social estrangement out on the fat tails. It is only human to stay within your comfort zone. The algorithms used by eHarmony.com, Pandora, and thousands of other sites that cater to human needs recognize this proclivity. They will not seek to stretch the limits of your comfort zone. The same cannot be said of this strategy!