The black swan investment theory

Humans are hopelessly poor at predicting the future. We underestimate the possible extremes in the range of outcomes. We lull ourselves into false complacency by jumping on every piece of information that confirms our outlook and by ignoring anything that might make us re-think. We let pseudo-experts tell us silly stories that make surface sense of incomprehensible events that should instead unsettle our certainties. Modern portfolio theory, the basis of contemporary finance, is invalid, having its foundations in the sands of "Gaussian" statistics. So Midas reads in Nassim Nicholas Taleb's 2007 bestselling book, The Black Swan – The impact of the highly improbable. The black swan is a rare, Australian bird in whose existence many disbelieved for a long time, and the author uses it as a metaphor for the random events that he thinks significantly affect our world.

Midas would not trouble his readers' repose with Taleb's gleeful attack on conventional wisdom if it did not bring into question how we invest our hard-earned cash, and if he did not see a grain of truth in the author's logic. But if Taleb's right that the risk factors in markets are much greater than the professionals ever let on, Midas feels some responsibility to think the implications through with his reading friends.

Although you have to meander through more than a little irrelevant confirmation bias of Taleb's own to get there, "Black Swan" does briefly propose a strategy for dealing with the highly random world that the author sees us inhabiting. Essentially, he recommends putting 85 to 90 per cent of your assets in the safest thing going. [He nominates US Treasury notes, but then he wrote before the US Treasury put itself on the hook for the mortgage meltdown, thereby, perhaps confirming his thesis that big bad things have a way of happening] He wants you to put the remaining 10 or 15 per cent of your assets in as many Black Swan bets as you can find. That is to say, gamble on situations where you could make a huge bundle if the improbable outcome turns out to happen.

Well, Midas fancies that he is not going to convince you to explore how to put such ideas into practice unless you see grounds for accepting Taleb's critique of conventional market thinking. What does some Lebanese-born mathematician turned options trader know that the Nobelists – whom he vociferously scorns throughout his book – don't? Here's a random list: the Lebanese civil war, the First World War, 9/11, the stock market crash of 1987, the US banking crisis of 1982, the Savings and Loan debacle of 1990, Japan's lost decade of growth in the 1990s, the Long Term Capital Management crisis of 1998, the sub-prime and related crisis of 2007 – 200(?)

Well, you ask, if you're literal-minded (and I hope you are, because one cannot assess an argument's validity without being) surely Nobel prize winners know about the First World War? To which our author would probably respond that they might as well not know of such unexpected events, the way they carry on as if the world treads a highly predictable path at all times. Sure, he'd say, most days are darned dull, but once in a while the Berlin Wall falls. The trick is that, in Taleb's view, more happens on those exceptional days than on all the innumerable dull days put together. Financially speaking, there's evidence of this. Taleb has a chart that shows if you had missed the best 10 days in the market in the last 50 years you would be worth only around half what your brother-in-law, who stayed in those days, had amassed. Classical statistical techniques cannot cope with these few big moves, yet financial theory is erected on the faulty assumption of statistical regularity.

When Midas attended Harvard Business School many moons ago, he found it intuitively impossible to accept the gospel of modern financial theory promulgated there. The idea that the risk of any stock investment is merely how volatile its price is, relative to the market as a whole, was as surreal then as it is now. The big banks that have lost so much of their value in the past year would be classified as low-risk on this basis – small comfort to real-life investors, even those with the diversified portfolio that the beta theory assumes. The interesting part about investing is trying to understand a company's strengths, its market and its competition and then assessing whether it has good earnings growth prospects – or if it risks seeing its business fall off a cliff. Minor differences in volatility over long periods are of no importance.

But the biggest thing Taleb is saying is that a few unexpected events have more impact on one's wealth and life than humdrum conventional advisers care to admit. Holding a basket of blue-chip stocks won't protect you if the market falls out of bed, and doesn't make you enough money to compensate for the risk that it will fall out of bed. Add to that an argument that Taleb does not make, that actually some smart folks have expected several of the big disturbances, and then we're really on to something. The dot.com implosion and the current credit implosion were foreseen by many, though nobody could tell when the crunches would come. Warren Buffett warned publicly in 1999, towards the end of the dot.com madness, that stock investor expectations were totally unrealistic, and the market proved him right soon afterwards.

So if you buy Taleb's thinking, what would following his prescription look like in practice? The safe 90 per cent part of the strategy is easy enough and Midas has been practising that, to his unutterable boredom, for quite a while. In Midas's safety bets he has liked Treasury Inflation Proof Securities, out of concern that inflation was likely to muck up his retirement plans. He's owned a bunch of non-dollar cash to cover against potential dollar devaluation. Arguably, he's done better in thinking through potential safety risks than the high-flying Taleb with his plain old treasuries.

What about finding those large swimming birds of ebony plumage for the risky 10 per cent of your portfolio? A timely find would have been betting on a mortgage meltdown in the US and UK last year, though Midas is not sure it counts as an "improbable" prediction. The few independent observers who could get their voices heard were warning of this for a long while, after all. It would have been disastrous to bet with anything more than a small stake, though, because the timing and depth of the debacle was never knowable in advance.

Betting on Midas's favourite small-capitalisation late-stage biotechnology stocks is a Black Swan strategy, too. And you don't have to take Midas's word for it, since Taleb mentions biotechs in a fairly similar vein. The market is pricing them all to fail, so any successes are improbable high-return events as far as the market is concerned. Midas believes one can pick a few probable winners and beat the odds. He still likes the chances of stocks he mentioned here several months ago: RPRX and ZGEN. The market has not treated them kindly in the interim: it's been a crummy environment for the entire sector, as hedge funds apparently have had to sell off assets to meet margin calls on the sour mortgage bets that were also in their portfolios. But the important thing about these two biotechs is that the clinical data have been coming in strong for RPRX, and there has been no major news for ZGEN's potential drug breakthroughs. The stocks' price moves tell you nothing about the potential for substantial upside.

Can we think of some other radical ideas to bet on as Black Swans? Let's allow our imaginations to wander. What great or ghastly things might happen in the next year or two that we could bet on? War, peace, revolution, famine, huge technology breakthroughs, global recession and protectionist backlash, market meltdowns, an outbreak of hyperinflation, a massive weather disaster… It can feel morally distasteful to speculate on human tragedies in this list, even though your bets don't affect the outcome. Practically, it's not always easy to see how you'd bet on these events, but raising the question is a start. You might decide on buying certain types of commodity futures, put options on property or stock indexes in places most likely to crash, or call options in stocks of tiny alternative energy technology firms. (Come to think of it, speculators have been doing quite a lot of this already. Is Midas not thinking as radically as a true black swanner, or are speculators black swan fans?)

Before you rush off with 10 per cent of your nest egg to look for black swans, please remember that Taleb wants you to spread these bets around and not to expect to win many of them. A few outsized wins are all you can hope for in an investing lifetime. And since your conventionally-minded friends will tell you that you are crazy, you'll need to fortify yourself by ploughing through Taleb's books a few times. Make sure you truly are convinced that the investing game needs to be played in a radically different way than most of us are used to.

Even if you don't go along with all that Taleb suggests, it might repay your effort to test your portfolio for robustness if various disasters or wonders occurred. You could find ways to diversify away from excessive concentration of investments in one region or economic sector.