Nassim Taleb[1] and Mark Spitznagel[2], former partners and collaborators, are the reigning authorities on optimizing portfolio outcomes for when tail risks manifest. Neither, collectively nor independently, has been able to find a workable solution to what I call the “Tail Risk Optimizer’s Dilemma.” In Fooled by Randomness, Taleb lamented his inability to build a career by just betting on black swans. “There simply weren’t enough “tradable opportunities” and the life of a ‘crisis hunter’ tests the patience of even the most stoic.” Fortunately for Taleb, managing money is not currently his day job, but it is Spitznagel’s. Taleb is a best-selling writer, itself a positive swan phenomenon, and can afford to be philosophical. Spitznagel, who must hold a portfolio of equities to justify his fees, cannot. Hypothetically, a Taleb portfolio is beyond robust. Extreme adversity will make it stronger (and concurrently more valuable). Because of the probable drawdown in the value of the risk assets in Spitznagel’s hedge fund portfolios, it’s hard to imagine him doing much more than mitigating those losses. Taleb’s approach is not commercial and Spitznagel’s is a concession to the institutional imperative. As they stand, neither gets us to tail risk optimization—profiting from adversity—which, admittedly, sounds almost offensively negative when compared to profiting from opportunity. It’s often very difficult and seemingly antisocial, but we must discipline ourselves to see the world as it is, not as we wish it to be.
Tail Risk & Portfolio Management
Taleb’s “Barbell Strategy” is a prototypical patience tester. In an attempt to protect portfolios against swan risks and profit handsomely when they occur, a Taleb portfolio is like a barbell. It has assets of quite different types hanging at either end of the bar with nothing in the middle. At one extreme are virtually all of the portfolio’s safe assets (predominately short-term U. S. Treasury securities), representing most of the portfolio’s value, but none of its potential (at least directly). At the other end is very little of the portfolio’s value, but all of its direct potential should a tail event occur. Almost all of the time—and what seems to many like all of the time—the portfolio manager looks like a stooge carrying an umbrella over his head on a cloudless day. From the perspective of an investment manager’s business plan, Taleb’s barbell leaves something to be desired.
Spitznagel argues he does not apply the barbell strategy because the asymmetric, convex payoff derivatives, ex post or ex ante, are simply too expensive. At the same time, he differs with Taleb on the definition of tail risk. “The real black swan problem of stock market busts is not about a remote event that is considered unforeseeable; it is rather about a foreseeable event that is considered remote.”
The Dao of Capital was published in July 2013, in which Spitznagel unwittingly pointed out the difficulty in foreseeing:
“Now more than ever, investors need to recognize the distortion in the system, which has reached near unprecedented proportions. Unhealthy growth of assets that would not exist without the deadly fertilizer of intervention is creating a tinderbox that will, in the not so distant future, erupt in massive wildfire. Given the visible distortion in the equity market we should absolutely expect severe stock market losses to come – quite possibly within the next year or so.… This urgency brings a somber yet critical note of warning to these pages.”
Tail Risks Today
Taleb argues that money must be invested on the basis of preparedness, not in prediction. In preparing today, Taleb reflects on the role of debt in the financial system. He posits that by loading future generations with it, growth in GDP can be obtained very easily. This effectively attempts to growth-game the system. The future economy may collapse upon the need to repay such debt, though. Economic growth with attendant financial fragilities should not be called growth, “something that has not yet been understood by governments.” Time and again, they appear notoriously ill-prepared for financial catastrophes.
Spitznagel sees systemic threat in the beguiling euphoria induced by central banks pumping liquidity. While most economic sectors seem to be enjoying prosperity, at least temporarily, he argues the arrangement is unhealthy. He notes, as few others do, that it is not an increase in savings that accounts for the drop in interest rates. His point is as subtle as it is significant. Additionally, Spitznagel reminds us that though the Fed can print money, it can’t print property and equipment. When physical capacity is underutilized—as it is in the U. S.—cash flow otherwise used for capital spending is redirected toward activities that give only the illusion of growing prosperity. Inflation of per-share earnings and dividends through stock repurchases and rising dividends, ultimately leading to higher stock prices, creates no system-wide gain in prosperity. Moreover, because the price-discovery and price-signaling system is distorted, malinvestment is the immediate result and economic contraction is the inevitable consequence. “Government cannot make a man richer, but it can make him poorer.” Whether one opts for Taleb’s or Spitznagel’s explanation of today’s tail risks, or some combination of the two, the outcomes are indistinguishably unpleasant.
About Spitznagel, Taleb made the following observation: “One thing Mark taught me was that when someone isn’t afraid of losing small amounts of money, they’re almost invincible.” Ironically, it is Taleb’s barbell strategy—which consistently loses money to the extent that premiums paid for derivatives exceed the modest income from U.S. Treasury securities—rather than Spitznagel’s hedged long equity portfolio, that is the true test for invincibility. Taleb’s barbell casts a shadow of slow and constant suffering, not unlike Chinese water torture in which the liquid is slowly dripped on the person’s forehead, that daily challenges mental fortitude.
Enduring the Barbell
In reality, most people are simply not hardwired to endure pain before gain, especially when the duration of the suffering and the magnitude of reward are uncertain. Moreover, most investors find it difficult to remain patient and circumspect as the gravy train to apparent riches pulls out from the station. The loneliness of watching the caboose get smaller as it fades into the distance is more than most can handle. Benjamin Graham quantified those who can stand such isolation at 1 out of 100. For more on that story, click here.
Unfortunately, this human tendency has a doubly negative impact on the investment management industry. The human aversion to pain and desire to join others aboard the train affects clients and investment firms alike. Managers, however, are assumed to be more aware of systemic risks than their clients, or else there would be no reason to employ them. Investment institutions are often risking their own economic survival if they try to optimize their clients’ portfolios for adversity and get off the train before their peers. The optimal scenario would constitute institutions that are unconditionally client-centric and clients who understand and appreciate that value proposition. In a battle between human nature and nirvana, the state of the world would suggest that the former will invariably dominate. Consequently, many firms fail to properly prepare clients and their portfolios are left to suffer the vicissitudes of the market.
The eerie calm in the markets this year, accompanied by the rise in S&P earnings in 2017 (after steadily declining over 7% on a 12-month trailing basis throughout 2015 and 2016), are common to late-cycle bull markets. Ozone level valuations mean little to those riding the gravy train. Until, that is, something happens that reveals nothing but air under the train’s wheels. I am hardwired to believe that long-term wealth building and once-in-a-generation devastating losses are not mutually compatible. Therefore, focusing almost entirely on managing risk at the short-term expense of buy-and-hold gains, despite the unconventionality and risks posed to the manager’s business, is sometimes required. Such seems the prescription for today’s opportunistically defensive investor.
[1] Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets (2001); The Black Swan: Second Edition: The Impact of a Highly Improbable (2010); Antifragile: Things That Gain from Disorder (2012); among others…
[2] The Dao of Capital (2013)