The financial world has little use for averages. Concepts like extrapolation, correlation, and diversification, according to Nassim Nicholas Taleb, are not only misleading but dangerous. At best, they lead to lower-than-possible returns. “Modern portfolio theory is bullshit,” says the Black Swan author and risk expert.
Taleb was in the Netherlands this month at the invitation of Bluemetric, which marked its tenth anniversary. A former derivatives trader and hedge fund manager, the Lebanese-American made his fortune in the 1980s and 1990s before turning to scientific research and writing. In 2007, he rose to global prominence with The Black Swan, a book about unpredictable events with massive consequences that occur far more often than standard models suggest.
According to the Bookey app, some three million copies have been sold worldwide, and Wikipedia lists translations in 32 languages. A few years ago, The Sunday Times ranked The Black Swan among the twelve most influential books published since World War II.
Now in his sixties, Taleb continues to apply his ideas in the financial world. He serves as scientific advisor to Universa Investments, a hedge fund that designs protection strategies for institutional clients, including pension funds.
“It’s about covering tail risks, which are far greater, longer-lasting, and fatter than anything predicted by a normal distribution,” Taleb explains in an interview with Investment Officer. “We should abandon the normal distribution altogether. The fact that it’s still used in risk models is a chronic problem in the industry. It’s really bad.”
IO: What exactly is wrong with those models?
Taleb: “The problem is that we try to apply a method from the ‘real world’ to finance. But they’re two completely different environments. For example, if you’re measuring the average height of people in a room, you only need 30 or 40 samples to get a reliable figure. Adding more people won’t change the result much.
“But if you want to calculate average wealth, it’s a different story. You won’t know it until you know everyone’s wealth. The very last person could still dramatically change the outcome. What if the final person is Elon Musk?”
So why did the finance world adopt the normal distribution?
“It took me a while to understand, but it comes down to incentives. Rational behavior is not the norm in finance because people do not have ‘skin in the game.’ Most financial professionals do not personally bear the consequences of their decisions.
“Take a banker who issues a loan to a company. If the company defaults, it is not the banker’s problem. He has probably moved on by the time the loan matures.
“But asset owners do suffer the consequences. People who have personal exposure behave more rationally. A person would not buy a house without insurance if they knew they could not afford the protection. But in finance, we do just that. We buy the house and skip the insurance because it is seen as too costly.”
Yet you wrote an entire book on this issue. Clearly others also see the lack of accountability as a problem.
“Absolutely. Hedge fund managers usually have their own money at risk. That sharpens their focus on protecting the portfolio from anything that might go wrong.”
Because it is inevitable something will go wrong?
“I do not want to sell fear, but pretending that nothing bad will happen is worse. Nobody knows what is coming. I am not an investment advisor. I cannot tell you which stocks to buy. I have no idea. What I can say is that you must manage uncertainty.
“You need to build a floor into your portfolio to prevent total destruction during extreme events. In fact, you can design it so that your portfolio gets stronger when those events hit.
“Diversification does not help in these scenarios. Forget about correlations; they do not hold up. Averages become meaningless, and extrapolation is useless. Diversification often just dilutes upside potential. I see more value in a portfolio heavily weighted toward equities, with strong protection against catastrophic downside scenarios.”
Was Covid-19 a black swan? What about the war in Ukraine or Trump’s election?
“Let me begin by saying that whether something qualifies as a black swan depends on perspective. What is a black swan for the butcher is not one for the turkey.
“But no, the Covid-19 pandemic was not a black swan. That was a white swan. Everyone could see it coming. I even wrote in 2007 that I saw the risk of a strange, acute virus spreading globally.
“The Russian invasion of Ukraine was not a surprise either. I was in Kyiv at the invitation of President Zelensky at the time. I had been there before, and during that visit I noticed the lack of home repairs, no painting, no renovations. People sensed something was coming.”
And Trump?
“Trump’s election might be considered a black swan. His behavior definitely was. Take the way he announced trade tariffs. It was a huge shock. The market reaction to that was entirely predictable. But what happens next, no one knows.
“That said, there is something positive to say about Trump. He listens to markets. That is a good thing. If he steps down tomorrow for health reasons, we will get Vance, and that is a problem. He says he understands markets, but he does not. He lacks Trump’s instincts. That would be a bigger issue.”
This article originally appeared in Dutch on Investmentofficer.nl.