The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb tops my list of books that have changed the way I think about almost everything. There is no such list, and if I were to write one it would probably just be this book and then nothing else. Other books have taught me things but they’ve never really changed my perception.
This is one of my favorite books. It underlies most of my knowledge about finance and investments. It is an enjoyable read that has many examples and anecdotes to explain a complicated but important subject. Basically, it was pure fun to read. I think I powered through it in a matter of days reading on the train and between (sometimes during) classes at school. I read it a few years ago, but it still occupies a prime position on my bookshelf.
There is a massive amount of information and insight in the book. It is extremely well written and a pleasure to read. Despite jumping anecdotes and moving all around there is this unity in the presentation that makes it feel more like a novel than a nonfiction book. That is what made it so easy to read beginning to end. Normally, I tend to skip through nonfiction books and read them based on my interest.
I’d prefer you to read the book yourself, but it basically discusses those extreme, unpredictable events that have a huge impact, which we always explain after the fact and their increasing frequency in our world. As we move at a faster and faster pace, these black swans become more common. The book also discusses the problems with predictions, and how they often do not account for black swans (aka the unknown unknowns).
Think of the 2008 financial crisis, sure some people saw it coming, and we all know them. Suddenly they achieved the status of a prophet. Some of them got filthy rich predicting the housing bubble bursting, and some of them have risen to prominence. Those same people have made bets that have lost spectacularly (less than they gained but wrong nonetheless), and have been making predictions for years that have not come to pass. You can predict gloom for 100 years and you’ll probably be right for a few decades. If you got lucky and nailed the gloom for the century you might be right more often than not. Now try that for a second century. Predictions are not worth much, and the book really discusses the so-called “expert problem” thoroughly.
The book has affected the way I think about investments. First, we should be looking to profit from black swans. We should position ourselves to capture as many of them as we can even if it means being on both sides of a bet, because the commonplace wins will keep you in the game and the black swans will generate you the large returns. Second, don’t buy into gurus and sages. Use them as sources of information. Make the decisions for yourself. They may know more than you, but once you educate yourself about the broad concepts you very often beat the experts. I’ll discuss both of those points and how they have affected my process in investing and trading.
Here are a few points, all of which I think will become full articles at a later date, but they were all inspired by this book. When the articles are written I will insert links in this review.
First: Capturing Black Swans
Whenever you make an investment choice try to hedge yourself. This may not be something specific like being both long and short, or having calls and puts. What I do is evaluate my positions for their exposure. So if I am extremely long I will buy broad-market puts, like SPY. Obviously, this only protects me from market risk. If I simply chose a stock that is terrible I’d lose in a green market. I am worried more about macroeconomic factors. They show up sometimes without warning. Sometimes it takes on unrelated bankruptcy to send the economy reeling. All we need is a dangerous spike in the yields of Japanese bonds to trigger an economic ice age (this will be another post). I have control of the relatively small choice of a single stock. I can do my research and be comfortable with that. If I lose because I picked long I can live with it, but if it goes red because of extrinsic circumstances I would like to hedge myself. Owning the stock and having SPY puts would mean that I could hold my stock, and make cash by selling the appreciated puts. That sounds great to me. I’d lose the value of the puts if the market turned green, but hopefully that means my stock has made a big move. If I bought those SPY puts and Japan melted down my stock might lose 50% of its value, but those SPY puts would look like they went exponential.
Never commit too much to a single position. Take many small bets and diversify. You are not diversifying for preservation, but to increase your exposure to black swans, while limiting your exposure to a single event destroying your wealth. I could go heavy on one stock, but then that stock controls my fate. I could go light on 10 positions that I chose knowing that each of them has a chance of making an unbelievable move. I choose my position sizing carefully to maximize my gains. Think of odds betting, I might go $1000 on the 2:1 favorite, but there is no reason I shouldn’t drop $250 on the 5:1, and maybe $100 on the 25:1. The profit potential on those would be greatest for the $100 bet, second greatest for $1000 bet, and the $250 would cover the other two bets with some change. If these were the only choices, then clearly its a no-loss situation. Things are never this perfect in real life, though if you would like to research it is called arbitrage betting. Arbitrage is an important term that you should research, and I realize I have another post to make. The point is to lower your exposure to a single position but keep the same overall exposure (i.e. instead of $1000 on one position try $250 on four positions). You would need to see some massive gains to justify that. You are looking for one home run, one that is good but not great, one that is bad but not terrible, and one that is plain awful. In this scenario your upside potential is unbridled so your home run alone returns enough profit to justify the endeavor, and the other moderate winner is icing. This is similar to the venture capital industry, and I will discuss that in another post.
This is why I like options. The profit potential is huge with a minimum amount of money at risk. You are risking 100% of your investment, and are likely to lose it, but the profit potential can be large depending on your strategy. I use high risk strategies so I tend to bet very small, but I have seen options trades turn $100 into $4000. Take $2000 and split it among some well researched options, and aim for a victory curve like above, one home run, some good, some not too bad, and some with a 100% loss. To show an ideal but possible scenario you could have taken 20 $100 positions and your only winning position was the one that turned $100 to $4000 would still give you $2000 in profit, a 100% return. This is ideal and might not happen, but I think if you spend the time learning how to trade and then researching before you take any positions you’ll never have 20 complete losers. You stay in the game with $2000 per week or per month churning out 20 positions each time, you take all profit off the table, and hopefully you get a couple of the 40x return in the long run. Sure you could realize a nice profit if you are patient enough. The message here is don’t lose 20 positions at once. And refer the point above, make sure you’re poised to be wrong. 10 positions for a green market, and 10 for a red market, and you probably won’t lose them all. However, there is a chance that you will, and you can call that a black swan. More specifically that is a “gray swan,” because you can calculate the chance you’d lose on all 20 positions, so you see it coming but it’s highly improbable not unpredictable. Gray swans are discussed in the book.
Second: Do not fall in love with experts
Experts have so much information and spend so much time analyzing it that they believe they know what will happen. The narrower the focus the better their success rate. However, at predicting large-scale events they are not so good. How many times have you seen a model extend 10 years into the future? Think about our governments who extrapolated (a favorite term among number crunching experts) tax revenue growth based on the current growth levels 10, 20 years into the future. Remember the tech bubble? Extrapolate California’s tax revenues 20 years based on the height of the bubble. Legislators relied on the experts and spent that money in advance thinking they can cover the payments later. Then the bubble burst, then we bounced back and they did it again, then a different bubble burst. You would think they would stop extrapolating so far into the future. You find me someone who can predict the stock market for the next 3 months and I’ll be happy. People predicting gloom were quiet during our recent rallies, and when the rallies became long in the tooth they arrived predicting a decline. I could have a doom prophecy in perpetuity and I would be right eventually. Most experts who predicted big events, like the housing bust, discount the effect of luck on their prediction. In hindsight all the data made sense. The book explains it better than I do.
The point is that hedging, position sizing, and trying to capture extreme moves in either direction is better than relying on experts with all your heart. I always found it funny how those retirement planners would always look for a nice 5% gain on your portfolio per year and call it excellent. Then 2000-2001 or 2008 rolls around and your portfolio is dragged down by 60% (or 40% if you are diversified) and the only justification is that the overall economy is bad. I don’t think 5% a year is good anymore. 1987 Savings and Loan Crisis, 2001 tech bubble burst, and 2008 financial crisis all pretty big declines in the economy, especially investments. 2001 was particularly bad for the stock market but was not a full economic collapse like 2008. As Taleb argues, it seems like unpredictable events with massive implications are becoming more common.
The part about experts is extremely interesting, but other than learning not to rely too heavily on them it is not as relevant as trying to capture the black swans.
This was a fantastic book and a fun read. It taught me to be more rigorous in evaluating my most basic assumptions, and to not trust my assumptions too heavily. It is well written and entertaining. It takes an extremely complicated topic and presents in an understandable way, and it completely changed how I think. I highly recommend picking up a copy of this book.
I don’t think I’ll have a rating system for my reviews. It is enough to say that I recommend it, I don’t need stars.
For your convenience I’ve linked Amazon:
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