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Surviving in a fat-tail world

According to Nassim Taleb, author of The Black Swan, we are living in a fat-tail world where extreme events are common, while our ability to predict them is nil. 

One thing is for certain: to survive in a fat-tail world, relying on traditional concepts of probability or risk management is pure folly, according to Nassim Taleb. Our models structurally underestimate tail risks. “You can’t measure them and you cannot compute their incidence,” he told a room full of financial analysts in Amsterdam when he visited late last year on the invitation of CFA Society Netherlands. “Worse: fooling yourself into thinking you can measure tail risk will only give you a false sense of security.”

Financial market supervisors and regulators aren’t much help either. Regulators are no more likely to see black swans coming than the next guy, and they are easily misled besides. “No regulator will ever know the risks as well as the trader, and it’s in traders’ interest to hide risks in the tails due to moral hazard. After all, ‘Wall Street’ is richly rewarded when things turn out well, and when things turn out badly the losses are borne by the taxpayers.”

To prevent such excesses we could learn a thing or two from the code of Hammurabi, a Babylonian law code dating back to about 1772 BC, Taleb insists. “King Hammurabi understood exactly how to deal with risk. If a house collapsed, costing the owner his life, then the law dictated the architect be brought to death,” he said. “Hammurabi had the right idea. Not that I have anything against architects.”

In the case of the financial system, the risk of collapse is all too real, as we have seen a few years ago. Taleb believes financial institutions are especially vulnerable to tail risk, not merely because traders are driven by perverse incentives but also because of the sheer size of institutions. “If you throw a mouse, it will continue on its way as if nothing happened. But if you throw an elephant, the animal will break a leg. Scale doesn’t just have advantages; there are drawbacks as well. There’s nothing wrong with being big, but be aware of how fragile you are in times of stress.”

Large-scale, overly efficient and over-optimised systems are more sensitive to shocks than are relatively small, decentralised systems that allow plenty of room for trial and error, Taleb believes. A system in which small mistakes occur frequently is less vulnerable than a system in which huge catastrophic events occur rarely.

Measuring fragility

We live in a world of increasing tail risks – both in terms of frequency and impact – that can be neither measured nor predicted, while slick financial players continue to take risks at others’ expense with impunity. A sobering thought. Given this bleak world view, what is a pension fund with AUM of, say, between €10bn and €15bn to do?

“That is a tough question,” says Taleb. “But there are some things you can do.” It may not be possible to predict the occurrence of a shock, but its impact can be charted. “Fragility can be defined as ‘short volatility’. And short volatility can be measured.”

Short volatility refers to an option position where the holder incurs losses if volatility rises. At the other end of the spectrum, ‘long volatility’ benefits if volatility goes up – a phenomenon Taleb has called ‘anti-fragility’. Anti-fragile systems are not merely robust in the sense of being able to withstand shocks, they actually benefit from shocks – similar to the way muscle strength is built through exercise.

At the behest of the International Monetary Fund Taleb has developed what he calls “a simple, heuristic method” to measure fragility, based on methods to detect hidden exposures to volatility in option trading portfolios. The approach adds an extra dimension to the existing stress tests. According to the IMF Working Paper presenting this method, most stress tests tend to focus on point estimates for a limited number of scenarios, without examining the change in impact if the scenario gets just a tiny bit worse. The method Taleb proposes explicitly takes this ‘change of the change’ into account. For fragility does not depend on the losses incurred after one specific shock, but on the accumulation of losses when the situation aggravates.

The idea is, in fact, very simple: run stress tests with various measure points instead of just one and compare the results. Plot the outcomes in a graph. If the line has a concave curvature, this points to fragility. “It shows that you will be hit disproportionally if the shocks get just a little bit stronger. That is what I call fragility,” he explains. “What makes this testing method attractive is that the accuracy of your measuring tool does not really matter.

An example: it is all right to measure the height of your child with a household measuring tape that is half a centimetre off the mark.” It is not the exact measuring result at a specific point in time that counts; the differences between the measurements are key. All you have to do is put the child against the wall each month, mark its height and write down the number of centimetres. Draw a line through the points of the monthly measurements and as long as it is a straight line, the child is growing steadily. But if the line curves up, the child has a growth spurt. “You are in fact measuring the acceleration.”

In Taleb’s opinion, a pension fund should measure its fragility in the same manner. “Run these kind of stress tests using three stress factors, and repeat for every driver in your portfolio. I admit that is not easy for a sizeable portfolio. It is a lot of work.” Moreover, the method he offers is anything but perfect, but that should not stop us from using it, in his opinion. “After all, life is incremental too, it is bit by bit. At the end of the day, my method is better than what we used to have. This approach may be ‘quick and dirty’, but it does help you to survive.”

Adultery as a strategy

Realising that we are living in a fat-tail world and understanding the fragility of systems can be very useful for investors. Particularly interesting are opportunities that are concave to only one side. “Take air travel, for example. It happens all too often that some incident affects the travel time. But that will always lead to a delay. You never arrive somewhere an hour earlier than planned,” according to Taleb. “Arrival times have a fat tail on only one side. If you inject uncertainty into such a system, the mean will rise.”

You can take advantage of this situation using what Taleb calls a barbell strategy. The idea is to reduce the impact of adverse events, without limiting the upside potential. This is done by combining the extremes (eg, buying long-term and short-term bonds), while avoiding the vulnerable middle. This makes you more shock-proof: “A barbell approach will make yourself less fragile.

“Nature provides us a good example of this – just look at the so-called monogamous animals, like some birds and the human species. In reality they are not very monogamous at all. And for a good reason: it is very sensible for a woman to marry a dull but reliable bookkeeper, while having a bit on the side with a muscled superstar.” The first will be a suitable and reliable husband, while the second will offer top-quality genetic material.

This bipolar approach also applies to portfolio construction: “Marry the accountant. Invest 80% of your portfolio in dull, risk-free assets, but allocate the remaining 20% to aggressive investments. That is much better than investing all your money in average-risk assets. And it leaves you with a far more robust portfolio.”

 

This article originally appeared in I&PE Magazine (Investment & Pensions Europe), the leading monthly publication for institutional investors and those responsible for running pension funds in Europe. It is reproduced with permission. The original article is linked here.

 

 

 


 

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