If you haven’t done so already, I strongly recommend purchasing and reading Nassim Taleb’s 2007 bestseller, “The Black Swan: The Impact of the Highly Improbable” (re-released this year in paperback with new material). (I say purchase it because you will undoubtedly want to reference his ideas many times over.) I wrote at some length about Taleb and his black swan concept in my previous blog, and you’ll find a portion of that entry pasted at the end of this article. (The entry in question was originally posted February 1 of this year.) Therefore, I don’t want to spend too much time summing up his ideas again here, so if you need a primer I recommend first skipping to the archived blog post further down the page.
On May 6, many of you will recall that there was a “flash crash” in the markets – the Dow Jones index nosedived almost 1,000 points in the span of approximately 15-20 minutes, only to recover a huge portion of those losses before the trading day was over. About a week later, Bloomberg interviewed Taleb, ostensibly to confront him in regards to a Wall Street Journal hypothesis that it was his black swan investing approach, implemented by a fund he advises (Universa), that caused the crash. You see, on May 6 Universa purchased millions of dollars worth of put options against the major indexes, betting on a collapse in the market within a few months of the purchase date. No doubt flattered at the notion that his ideas move markets so drastically, Taleb responded to the interviewer with one of my favorite quotes of his (which my Twitter followers will recognize): “When a bridge collapses, do you blame the last vehicle that drove over it?”
Taleb was making a subtle point we should all take heed of: the market is unstable to begin with, and he simply recognized this fact and acted upon it. Therefore, while there are many dimensions to the flash crash that are worthy of analysis, this article focuses on applying one of the concepts Taleb introduced in his book regarding the way we should view markets: that is, by applying fractal geometry (fractals). A quick check in Wikipedia shows the definition of fractals to be “a rough or fragmented geometric shape that can be split into parts, each of which is (at least approximately) a reduced-size copy of the whole, a property called self-similarity.” Think of a snowflake – each “branch” on the flake has its own branches, and those branches have their own branches, and so on. If you were to snap off one of the branches, it would appear (roughly) to resemble the larger flake from which it came.
When Taleb discussed this topic in “The Black Swan,” he was essentially offering a method for reducing the uncertainty that may lie in a potential black swan event. A black swan event is difficult or impossible to predict, until afterward when it is viewed as something that should have been knowable (9/11 is an oft-cited example of this). So Taleb explains that by using fractals, we can reduce black swans to gray swans so to speak, by making the impossible at least appear possible, even if we cannot predict it with complete certitude. Let’s look at a retrospective example followed by a more recent example:
Prior to October 1987, the stock market had crashed on several occasions throughout the preceding decades (here I define “crash” as a greater than 10% drop in the market over the course of very few [and perhaps one] trading session). So traders and investors knew the market could fall a great deal over a short timeframe, because there was evidence of it happening previously. However, if you had said to them “the market is going to plummet 22.6% in one trading day,” they would have scoffed at the notion. Such a thing had never happened before. Of course, on October 19, 1987, it did happen. This black swan event caught nearly everyone by surprise (Taleb was an exception; he made a lot of money off of it by betting it was indeed possible). However, viewed fractally, one could have argued that if 22% drops were possible over a given timeframe x, then x might be capable of equaling one trading day.
Let’s come back to the present. On May 6, 2010, the Dow Jones fell nearly 10% in a matter of minutes. Not weeks. Not days. Not one day. But minutes. Now, it’s true that it recovered significantly from that low point before the trading day ended. But we mustn’t allow that fact to cloud the basic truism that the market could plunge by so much, with a rapidity never seen before. Again, this leads us to the fractal concept: if the market could plunge 10% in one day, why can’t it plunge 10% in one minute? Could it plunge 22% in one minute? Or perhaps more? On May 5 had you suggested such a thing, you’d be looked at as crazy; on May 7, realistic.
The bottom line here is, as investors we should consider the power of applying fractals to our hedging strategies, by stepping outside convention and imagining what the possibilities might be based on the evidence at hand. This will undoubtedly remove many of the limits we often self-impose on what’s “possible” in the markets, and allow more creative hedging approaches to flourish.
As promised, below I’ve posted the first half of my February 1 article on black swans. It will provide you with a good summary of the various aspects of the black swan conjecture, as Taleb argues it. (In a future article I'll post the second half, which addresses use of black swan protection protocols within an investment portfolio.) Of course, there’s no substitute for reading the book, but this should give you a general working knowledge.
________
Title: Black Swan Protection Protocol: An Approach for Weathering the Storm
February 1, 2010
In my August 12, 2009 post, I indicated that there was a separate approach I was undertaking for shielding the money I had no desire to lose – I referred to this approach as “black swan protection protocol.” The genesis of this term lies in the writings of Nassim Nicholas Taleb, and specifically, his 2007 best seller The Black Swan: The Impact of the Highly Improbable. Let me state clearly that this blog post does not suffice for conveying the importance and material significance of Taleb’s conjecture. Nonetheless, I was sufficiently motivated by his insights to fashion a rough outline here of how I plan to follow his advice and why.
If you read my July 15 post regarding Taleb’s ideas, the following may sound a bit redundant, but it’s worth exploring before moving into the details of the actual investment approach. The term “black swan” refers to the discovery in the 17th century of the first non-white swans, invalidating centuries of assumption that all swans were white. Thus, when Taleb speaks of black swan events, he is referring to an event which has the following attributes:
1) the event is completely unexpected
2) it is highly impactful
3) it is retrospectively distorted; that is, afterward it is rationalized as if it was or could have been expected
One of the central themes of the book focuses on the following: the concept of two different realms of existence for humans: Mediocristan and Extremistan. An illustration works best for explaining these concepts.
Take 1,000 individuals randomly from society, tabulating their weight and averaging it out. Then take the 1,001st individual, who is the heaviest individual in the world (say roughly 1,000 pounds for the sake of argument). The average weight for these 1,001 individuals will not have changed substantially with the addition of the 1,001st’s weight to the total. This is Mediocristan.
Now take 1,000 individuals randomly from society and tabulate their net worth, then average it out. Take the 1,001st individual, who happens to be the richest individual in the world: Bill Gates, approximate net worth of $80 billion. What will happen to the average net worth? Rise dramatically, obviously. In other words, the addition of just one individual’s net worth changes the entire complexion of the situation instantaneously. This is Extremistan.
Here’s the basic point: human beings do not intrinsically recognize the kind of world we live in; we think we are living in Mediocristan, when we are actually living in Extremistan. In this sense, we underestimate the impact and importance of unforeseen, significant scale events. Evidence that we are living in Extremistan abounds: see 9/11, the 2008 financial collapse, the 1987 market crash, and so on and so forth. Whether it is due to human nature or evolutionary programming (or lack thereof), the simple fact is we do not effectively recognize the role and impact of randomness and black swan style events in our lives.
Taleb does an excellent job of exploring why this is the case in some depth, with one of the prime reasons being what he calls the “Platonic fold.” Essentially, this is the differential between what we know and what we think we know. When we act on what we think we know, rather than grasping the notion that we are treading into territory that we cannot possibly predict or explain adequately, we invite disaster or at the very least, a severe under-appreciation for the consequences or implications of a particular event.
Another key concept Taleb discusses is what he calls the “confirmation bias.” This refers to the fact that, because we do not see an event occur over a period of time, we assume it is not possible (if we can even imagine its possibility to begin with). Taleb uses this great analogy: a turkey is fed and well-cared for by its owner throughout the year, and the turkey comes to believe the owner has its best interest at heart; then, in late November, the turkey is slaughtered by the owner for Thanksgiving. The turkey experienced a confirmation bias, in that every day it was well-treated, it confirmed the notion that the owner had the turkey’s interest at heart. Obviously, this misconception is suddenly clarified, with tragic consequences for the turkey.
The real question becomes, what can we do about these conditions? As Taleb offers in his book, we can only attempt to build a more robust system that is less susceptible to the devastating effects of negative black swans. His prime example of this from a finance perspective resides in the notion that our banking system is severely over-leveraged and, by carrying the amount of debt that we currently have, as well as speculating in complex derivative financial products, simply begging for some catastrophic perturbation to occur to the system.
But the added problem here is that the banking and overall financial system has become increasingly interconnected in a global sense, thus vastly increasing the complexity of the system itself. A problem at one node, or bank, within the system, can quickly propagate throughout the entire system, causing distress to the system and turbulence in the financial markets. This kind of complexity must be countered with a more robust approach to the kinds of financial products and rule sets that are employed by the institutions themselves. In other words, the less complexity, the less the impact of the failure of a banking or financial institution on the overall system.
Again, I implore readers of this blog to read the book in order to gain a full appreciation of why Taleb’s conjecture is so critical to the health of one’s financial portfolio. There is simply no substitute for his insights.
On May 6, many of you will recall that there was a “flash crash” in the markets – the Dow Jones index nosedived almost 1,000 points in the span of approximately 15-20 minutes, only to recover a huge portion of those losses before the trading day was over. About a week later, Bloomberg interviewed Taleb, ostensibly to confront him in regards to a Wall Street Journal hypothesis that it was his black swan investing approach, implemented by a fund he advises (Universa), that caused the crash. You see, on May 6 Universa purchased millions of dollars worth of put options against the major indexes, betting on a collapse in the market within a few months of the purchase date. No doubt flattered at the notion that his ideas move markets so drastically, Taleb responded to the interviewer with one of my favorite quotes of his (which my Twitter followers will recognize): “When a bridge collapses, do you blame the last vehicle that drove over it?”
Taleb was making a subtle point we should all take heed of: the market is unstable to begin with, and he simply recognized this fact and acted upon it. Therefore, while there are many dimensions to the flash crash that are worthy of analysis, this article focuses on applying one of the concepts Taleb introduced in his book regarding the way we should view markets: that is, by applying fractal geometry (fractals). A quick check in Wikipedia shows the definition of fractals to be “a rough or fragmented geometric shape that can be split into parts, each of which is (at least approximately) a reduced-size copy of the whole, a property called self-similarity.” Think of a snowflake – each “branch” on the flake has its own branches, and those branches have their own branches, and so on. If you were to snap off one of the branches, it would appear (roughly) to resemble the larger flake from which it came.
When Taleb discussed this topic in “The Black Swan,” he was essentially offering a method for reducing the uncertainty that may lie in a potential black swan event. A black swan event is difficult or impossible to predict, until afterward when it is viewed as something that should have been knowable (9/11 is an oft-cited example of this). So Taleb explains that by using fractals, we can reduce black swans to gray swans so to speak, by making the impossible at least appear possible, even if we cannot predict it with complete certitude. Let’s look at a retrospective example followed by a more recent example:
Prior to October 1987, the stock market had crashed on several occasions throughout the preceding decades (here I define “crash” as a greater than 10% drop in the market over the course of very few [and perhaps one] trading session). So traders and investors knew the market could fall a great deal over a short timeframe, because there was evidence of it happening previously. However, if you had said to them “the market is going to plummet 22.6% in one trading day,” they would have scoffed at the notion. Such a thing had never happened before. Of course, on October 19, 1987, it did happen. This black swan event caught nearly everyone by surprise (Taleb was an exception; he made a lot of money off of it by betting it was indeed possible). However, viewed fractally, one could have argued that if 22% drops were possible over a given timeframe x, then x might be capable of equaling one trading day.
Let’s come back to the present. On May 6, 2010, the Dow Jones fell nearly 10% in a matter of minutes. Not weeks. Not days. Not one day. But minutes. Now, it’s true that it recovered significantly from that low point before the trading day ended. But we mustn’t allow that fact to cloud the basic truism that the market could plunge by so much, with a rapidity never seen before. Again, this leads us to the fractal concept: if the market could plunge 10% in one day, why can’t it plunge 10% in one minute? Could it plunge 22% in one minute? Or perhaps more? On May 5 had you suggested such a thing, you’d be looked at as crazy; on May 7, realistic.
The bottom line here is, as investors we should consider the power of applying fractals to our hedging strategies, by stepping outside convention and imagining what the possibilities might be based on the evidence at hand. This will undoubtedly remove many of the limits we often self-impose on what’s “possible” in the markets, and allow more creative hedging approaches to flourish.
As promised, below I’ve posted the first half of my February 1 article on black swans. It will provide you with a good summary of the various aspects of the black swan conjecture, as Taleb argues it. (In a future article I'll post the second half, which addresses use of black swan protection protocols within an investment portfolio.) Of course, there’s no substitute for reading the book, but this should give you a general working knowledge.
________
Title: Black Swan Protection Protocol: An Approach for Weathering the Storm
February 1, 2010
In my August 12, 2009 post, I indicated that there was a separate approach I was undertaking for shielding the money I had no desire to lose – I referred to this approach as “black swan protection protocol.” The genesis of this term lies in the writings of Nassim Nicholas Taleb, and specifically, his 2007 best seller The Black Swan: The Impact of the Highly Improbable. Let me state clearly that this blog post does not suffice for conveying the importance and material significance of Taleb’s conjecture. Nonetheless, I was sufficiently motivated by his insights to fashion a rough outline here of how I plan to follow his advice and why.
If you read my July 15 post regarding Taleb’s ideas, the following may sound a bit redundant, but it’s worth exploring before moving into the details of the actual investment approach. The term “black swan” refers to the discovery in the 17th century of the first non-white swans, invalidating centuries of assumption that all swans were white. Thus, when Taleb speaks of black swan events, he is referring to an event which has the following attributes:
1) the event is completely unexpected
2) it is highly impactful
3) it is retrospectively distorted; that is, afterward it is rationalized as if it was or could have been expected
One of the central themes of the book focuses on the following: the concept of two different realms of existence for humans: Mediocristan and Extremistan. An illustration works best for explaining these concepts.
Take 1,000 individuals randomly from society, tabulating their weight and averaging it out. Then take the 1,001st individual, who is the heaviest individual in the world (say roughly 1,000 pounds for the sake of argument). The average weight for these 1,001 individuals will not have changed substantially with the addition of the 1,001st’s weight to the total. This is Mediocristan.
Now take 1,000 individuals randomly from society and tabulate their net worth, then average it out. Take the 1,001st individual, who happens to be the richest individual in the world: Bill Gates, approximate net worth of $80 billion. What will happen to the average net worth? Rise dramatically, obviously. In other words, the addition of just one individual’s net worth changes the entire complexion of the situation instantaneously. This is Extremistan.
Here’s the basic point: human beings do not intrinsically recognize the kind of world we live in; we think we are living in Mediocristan, when we are actually living in Extremistan. In this sense, we underestimate the impact and importance of unforeseen, significant scale events. Evidence that we are living in Extremistan abounds: see 9/11, the 2008 financial collapse, the 1987 market crash, and so on and so forth. Whether it is due to human nature or evolutionary programming (or lack thereof), the simple fact is we do not effectively recognize the role and impact of randomness and black swan style events in our lives.
Taleb does an excellent job of exploring why this is the case in some depth, with one of the prime reasons being what he calls the “Platonic fold.” Essentially, this is the differential between what we know and what we think we know. When we act on what we think we know, rather than grasping the notion that we are treading into territory that we cannot possibly predict or explain adequately, we invite disaster or at the very least, a severe under-appreciation for the consequences or implications of a particular event.
Another key concept Taleb discusses is what he calls the “confirmation bias.” This refers to the fact that, because we do not see an event occur over a period of time, we assume it is not possible (if we can even imagine its possibility to begin with). Taleb uses this great analogy: a turkey is fed and well-cared for by its owner throughout the year, and the turkey comes to believe the owner has its best interest at heart; then, in late November, the turkey is slaughtered by the owner for Thanksgiving. The turkey experienced a confirmation bias, in that every day it was well-treated, it confirmed the notion that the owner had the turkey’s interest at heart. Obviously, this misconception is suddenly clarified, with tragic consequences for the turkey.
The real question becomes, what can we do about these conditions? As Taleb offers in his book, we can only attempt to build a more robust system that is less susceptible to the devastating effects of negative black swans. His prime example of this from a finance perspective resides in the notion that our banking system is severely over-leveraged and, by carrying the amount of debt that we currently have, as well as speculating in complex derivative financial products, simply begging for some catastrophic perturbation to occur to the system.
But the added problem here is that the banking and overall financial system has become increasingly interconnected in a global sense, thus vastly increasing the complexity of the system itself. A problem at one node, or bank, within the system, can quickly propagate throughout the entire system, causing distress to the system and turbulence in the financial markets. This kind of complexity must be countered with a more robust approach to the kinds of financial products and rule sets that are employed by the institutions themselves. In other words, the less complexity, the less the impact of the failure of a banking or financial institution on the overall system.
Again, I implore readers of this blog to read the book in order to gain a full appreciation of why Taleb’s conjecture is so critical to the health of one’s financial portfolio. There is simply no substitute for his insights.
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