In the world of finance, averages are useless. Concepts like extrapolation, correlation, and diversification do little more than invite disaster—or, at the very least, significantly lower returns than are otherwise achievable. “Modern portfolio theory is bullshit,” declared Nassim Taleb, the legendary author of “The Black Swan”.
Taleb made a brief stop in the Netherlands this week at the invitation of Bluemetric, which was celebrating its ten-year anniversary. A former derivatives trader and hedge fund manager, the Lebanese-American made his fortune in the 1980s and 1990s before shifting his focus to scientific research and writing. In 2007, he rose to global prominence with the publication of “The Black Swan”, a book about unpredictable, high-impact events that occur far more frequently than standard distributions would suggest. According to the BooKey app, around three million copies of The Black Swan have been sold worldwide, and Wikipedia reports that it has been translated into 32 languages. The Sunday Times even ranked it among the twelve most influential books published since World War II.
Nassim Nicholas Taleb (born 1960) still actively applies his theories as an investor and serves as a scientific advisor to Universa Investments, a hedge fund that provides tail-risk protection strategies to clients such as pension funds. “It’s all about hedging against tail risks, which are much larger, longer, and fatter than what a normal distribution assumes,” Taleb explained in an interview with Investment Officer. He recommends discarding the idea of the normal distribution altogether. “The fact that it’s still used in risk models is a chronic problem in the investment industry. It’s really bad.”
Investment Officer: What exactly is wrong with those models?
Taleb: “The fundamental error is that we’re trying to apply a method from the ‘real world’ to the financial world. But they’re two entirely different environments. Imagine a room full of people, and you want to estimate their average height. After thirty or forty measurements, you’ll have a pretty accurate number. Additional measurements won’t change much. Even adding a hundred more people won’t shift the average significantly.
But now imagine you want to estimate the average wealth in that room. You won’t know until you’ve measured everyone—because the last person could be Elon Musk and completely skew the result.”
So how did we ever come to believe that a normal distribution applies to financial risk?
“It took me some time to understand this, but it comes down to incentives for rational behavior. Rational behavior is not the norm in finance, which is why risks are not ‘normally’ distributed. Why? Because people don’t have ‘skin in the game.’ Most of the financial sector is run by individuals who do not bear the financial consequences of their actions. Take, for example, the banker who issues a loan to a company. If that company defaults, it doesn’t affect him personally. Chances are, he won’t even be working at the bank by the time the loan matures.”
So who does bear the consequences?
“The asset owners. Look at people who do have a personal stake in their actions—they tend to behave far more rationally. A person who’s considering buying a house but knows they can’t afford homeowner’s insurance likely won’t go through with the purchase. In finance, we do exactly that: we buy the house and skip the insurance because we think it’s too expensive.”
Still, there are many who recognize the problem of lacking ‘skin in the game,’ as you discuss in your book.
“Absolutely. Hedge fund managers typically have their own capital on the line, which sharpens their focus on protecting the assets they manage from downside risk.”
Because more trouble is always just around the corner?
“I’m not trying to sell doom or scare people. But pretending that everything will always be fine, or that we can foresee all possible scenarios, is dangerous. Because we can’t. No one can. I’m not a financial advisor—I can’t tell you which stocks to buy. I have no idea. The point is that you need to manage uncertainty. Build a floor into your portfolio so that your wealth isn’t wiped out during extreme events. In fact, you can structure your protection so that your portfolio actually strengthens during such scenarios.”
“By the way, diversification is not a hedge in this context. And forget correlations—they break down when you need them most. Averages become meaningless, and extrapolation loses all relevance. Diversification is even a waste of upside potential. Modern Portfolio Theory—MPT—is bullshit. The best opportunities lie in equity-heavy portfolios with robust protection against catastrophic downside scenarios.”
COVID, the Russian invasion of Ukraine, the election of Donald Trump—were these the ‘Black Swan’ events of recent years?
“Let me start by saying that the applicability of that label depends heavily on perspective. What’s a Black Swan for the butcher might not be one for the turkey. But the COVID pandemic wasn’t a Black Swan. That was a white one—everyone could see it coming. (In fact, Taleb wrote in 2007: “I see the risks of a very strange acute virus spreading throughout the planet.”)
“The Russian invasion wasn’t a total surprise either. I happened to be in Kyiv at the time, invited by President Zelensky. I had been there before, and this time I noticed something—there were no construction projects, no renovations, no painting going on. People were bracing for something. They could feel it coming.”
And Donald Trump?
“Trump’s election? Possibly a Black Swan. His behavior, though—definitely a Black Swan. Take how he announced the trade tariffs: a massive shock. But the market reaction was actually quite predictable. There was no surprise in how financial markets responded. What happens next, however—we simply don’t know.”
“There is something positive to say about Trump: he listens to the markets. That’s a blessing in disguise. Because if he were to step down tomorrow for medical reasons, we’d be looking at Vance. And Vance has no clue how markets work. He says he does, but he doesn’t—and he certainly lacks Trump’s instinct. That would be a much bigger problem.”