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Edward Chancellor and I met soon after I read his prescient and literarily superb book, Devil Take the Hindmost: A History of Financial Speculation (2000). We have stayed in regular touch, including attending a Berkshire Hathaway annual meeting together. This morning he sent me the following column from Breakingviews which, with his permission, I am including as the first guest post to my blog.

Continue reading “1929 Is More Apt Anniversary Than 1987” →

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.
Continue reading “The Tail Risks Optimizer’s Dilemma: Taleb Vs Spitznagel” →

For both natural and financial disasters, extreme preparation supersedes precise predictions. These are difficult days for value investors. There is a paucity of opportunities offering anything close to a margin of safety capable of sustaining long-term gains. Nearly all metrics agree. Whether you use CAPE, price-to-sales, GDP-to-market cap, or many any other measures, today’s market is dangerously detached from its underlying fundamentals.

Further, volatility of the S&P 500—historic and the VIX—has been so calm for such a prolonged period of time, despite the demonstrably more chaotic political and environmental climates, you could be forgiven for thinking the world was now segmented into distinctly disconnected parallel universes. I believe that economic and market stability is an illusion, a prelude to less tranquil conditions. Continue reading “It’s Time to Revisit Puts” →

The most influential book I’ve ever read on social psychology was, unquestionably, The Crowd: A study of the popular mind by Frenchmen Gustave Le Bon in 1895. Some 30 years ago, while browsing through a used bookstore in Manhattan, I happened across a musty long out-of-print paperback edition. Today you can download the utterly remarkable 143-page Kindle version at no cost from Amazon, an exception to the rule that there is no free lunch.

To be sure, Le Bon’s theories are controversial. On July 27, 2016, The Atlantic published “Donald Trump and the Myth of Mobocracy: How the dubious ideas of a 19th-century Frenchman reverberate in 2016.” Zaretsky, the writer, nuances Le Bon’s thought with recent reevaluations. Still, Le Bon goes a long way in helping to understand the transformative nature of today’s digitally and therefore instantaneously linked, globally dispersed, crowds that make up the world’s capital markets. Continue reading “The Crowd: Social Schizophrenia” →

Gresham’s Law, a principle only vaguely familiar to most today, is a monetary concept that claims “bad money drives out good.” Although named after the 16th-century English financier, Sir Thomas Gresham, its origins can be traced back to the Greek comic dramatist, Aristophanes, in the 5th century BC.

The principle applies to the debasing of coinage, the intentional reduction of precious metal content in a coin during the minting process. Because old and new coins had the same face values despite differences in their metal content, the old were hoarded out of existence. Continue reading “Gresham’s Law & Growing Weeds” →

Privileging analytical functions over intuitive ones played out with real consequences in the 2007 financial crisis. My second book, A Decade of Delusions, dealt directly with whether the crisis was a thoroughly random occurrence, or an unpredictable but foreseeable one—a Grey Swan rather than a Black. Chapter 9, “Contagious Speculation,” published in early 2006 and 2007 and Chapter 10, “The Tipping Point,” written in February 2008 make clear that the coming of a crisis should have been expected.

In testimony before the National Commission on the causes of the financial and economic crisis in the United States, Warren Buffett candidly observed: “very, very few people could appreciate the bubble,” which he called a “mass delusion” shared by “300 million Americans.” Regulators echoed similar refrains. Ben Bernanke, Federal Reserve Chairman since 2006, told the Commission a “perfect storm” had occurred that regulators could not have anticipated. Continue reading “The Financial Crisis Inquiry Report as a Harbinger” →

Previously, I challenged conventional diversification as an investment strategy, given its inability to protect portfolios against Black Swans—catastrophic events that are deemed unforeseeable—and, the more common, Grey Swan—a foreseeable disaster that is considered remote.

The difference between these phenomena, and their presumably equally dire outcomes, are subtle, yet significant. They are random to different degrees, hence their shading. The 1908 Tunguskas event, when a 10 megaton asteroid abruptly terminated its journey through space by leveling 830 square miles in Siberia, was truly random. An earthquake on the San Andreas, is unpredictable, but not so random as to be beyond the scope of imaginability. Continue reading “Intuition & Einstein’s Greatest Ideas” →

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.   Continue reading “The Fallacy of the Golden Mean” →

In the July 7 post (“Risk and Return: Always Positively Correlated?”), I argued that the best returns are actually achieved by avoiding risk. Over the next several weeks the focus will narrow. At the “risk” of losing readers early on, I will explore human attitudes toward risk, generally, before examining how those attitudes magnify our vulnerability to Black Swans—a notion popularized by Nassim Taleb—in the context of portfolio management.

The Small versus Large Conundrum

Human attitudes toward risk are, strangely, typically upside down. They are antithetical to avoiding the very events really worth worrying about. There is ample evidence that we are adverse to the small losses germane to our everyday lives. Perhaps the threat of flooding the first floor prods a homeowner to hire a plumber instead of replacing the upstairs bathroom himself. Although not mandatory unless there’s a lien held against a car, many pay the extra premium for collision insurance to avoid an unexpected repair bill. A more abstract example, both emotional and immediate in the extreme, was the reaction of the S&P futures markets the morning after last November’s election—further evidence that we strive to avoid small loses. Continue reading “Black Swans & Why We Worry About the Wrong Events” →