Taleb believes we live in Extremistan, a world in which exceptions play a very big role. For example, of the 20,000 fiction books published annually, just five to 25 books account for one-half of book sales and an impressive 98% of profits. Or take the Standard & Poor’s 500 index. The 10 most volatile days account for 50% of the S&P 500’s returns over a 55-year period, according to Taleb. The role of single-day extreme returns is even more pronounced if you look at individual stocks, he noted.
“A lot of people in Washington and in the Federal Reserve didn’t know we live in Extremistan,” said Taleb. Because policymakers—and many financial firms—believed in Mediocristan, “they were making huge bets vs. Extremistan.” As they made those bets, they took comfort in their forecasts and metrics that encouraged them to overlook the possibility of rare events. Forecasts give an illusion of control and metrics like Sharpe ratios don’t work, said Taleb, who lamented how Excel spreadsheets have encouraged people to make projections much further into the future than in the days of paper and pencil.
Banks landed in their current mess because of reassuring forecasts about the very low probability of dire events. He said banks used forecasts of dire events that “will happen every 10,000 or 10 million years, so take the risk,” said Taleb. He figures that people who make long-term forecasts are going to be wrong because they take too narrow a view of what may happen. “The world is not reasonable. The world delivers crazy events,” he said.
Limit Your Risks to Live with Black Swans
Taleb suggested a strategy for living with black swans: limit your exposure to black swans with negative consequences, especially those that offer the potential for unlimited losses and limited profits. “If you don’t know where the risk of rare events is, then don’t leverage yourself,” he added. “If banks had done this, we’d be smiling today.”
Investors who seek a medium-risk portfolio should invest in a barbell portfolio that combines relatively risk-free investments with risky investments suggested Taleb, who said he’s a big believer in diversification. He believes that because we can’t assess risk accurately, it’s hard to say that any investment is truly medium-risk. But you’d be pretty safe saying that a portfolio of 80% Treasuries and 20% high-risk investments is medium risk. Still, when you’re choosing your high-risk investments, stay away from derivatives, he cautioned.
In conclusion, Taleb said, “Think of positive black swans. They’re out there and no one is looking for them.” Medicine has thrived on positive black swans, as the discovery of the side effects of mustard gas on soldiers led to chemotherapy, he said. Although Taleb didn’t speculate about the nature of a positive financial black swan, perhaps the financial world’s equivalent of a new drug treatment will eventually emerge from the current crisis.
Susan Weiner, CFA, is a writer specializing in investment and wealth management. Contact her through http://InvestmentWriting.com.
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