Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 18

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.





Leave a Comment:



7 truths of volatility, but are they friends or foes?

Five factors driving the great Australian recovery

Investors face their own Breaking Bad moment


Most viewed in recent weeks

Lessons when a fund manager of the year is down 25%

Every successful fund manager suffers periods of underperformance, and investors who jump from fund to fund chasing results are likely to do badly. Selecting a manager is a long-term decision but what else?

2022 election survey results: disillusion and disappointment

In almost 1,000 responses, our readers differ in voting intentions versus polling of the general population, but they have little doubt who will win and there is widespread disappointment with our politics.

Now you can earn 5% on bonds but stay with quality

Conservative investors who want the greater capital security of bonds can now lock in 5% but they should stay at the higher end of credit quality. Rises in rates and defaults mean it's not as easy as it looks.

30 ETFs in one ecosystem but is there a favourite?

In the last decade, ETFs have become a mainstay of many portfolios, with broad market access to most asset types, as well as a wide array of sectors and themes. Is there a favourite of a CEO who oversees 30 funds?

Betting markets as election predictors

Believe it or not, betting agencies are in the business of making money, not predicting outcomes. Is there anything we can learn from the current odds on the election results?

Welcome to Firstlinks Election Edition 458

At around 10.30pm on Saturday night, Scott Morrison called Anthony Albanese to concede defeat in the 2022 election. As voting continued the next day, it became likely that Labor would reach the magic number of 76 seats to form a majority government.   

  • 19 May 2022

Latest Updates


'It’s your money' schemes transfer super from young to old

With the Coalition losing the 2022 election, its policy to allow young people to access super goes back on the shelf. But lowering the downsizer age to 55 was supported by Labor. Check the merits of both policies.

Investment strategies

Rising recession risk and what it means for your portfolio

In this environment, safe-haven assets like Government bonds act as a diversifier given the uncorrelated nature to equities during periods of risk-off, while offering a yield above term deposit rates.

Investment strategies

‘Multidiscipline’: the secret of Bezos' and Buffett’s wild success

A key attribute of great investors is the ability to abstract away the specifics of a particular domain, leaving only the important underlying principles upon which great investments can be made.


Keep mandatory super pension drawdowns halved

The Transfer Balance Cap limits the tax concessions available in super pension funds, removing the need for large, compulsory drawdowns. Plus there are no requirements to draw money out of an accumulation fund.


Confession season is upon us: What’s next for equity markets

Companies tend to pre-position weak results ahead of 30 June, leading to earnings downgrades. The next two months will be critical for investors as a shift from ‘great expectations’ to ‘clear explanations’ gets underway.


Australia, the Lucky Country again?

We may have been extremely unlucky with the unforgiving weather plaguing the East Coast of Australia this year. However, on the economic front we are by many measures in a strong position relative to the rest of the world.

Exchange traded products

LIC discounts widening with the market sell-off

Discounts on LICs and LITs vary with market conditions, and many prominent managers have seen the value of their assets fall as well as discount widen. There may be opportunities for gains if discounts narrow.



© 2022 Morningstar, Inc. All rights reserved.

The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.