Showing posts with label antifragile. Show all posts
Showing posts with label antifragile. Show all posts

Mar 1, 2014

Too Big to Tail

At the end of 2012 the author of the famous book The Black Swan and professor of risk engineering at the NYU, Nassim Nicholas Taleb, published his new book Antifragile.

Antifragile is a term Taleb defines to describe things that benefit more (have more upside) from random events or shocks, than they are harmed by (have downside).

In other words, antifragile things are those that benefit from stress and disorder.

Inevitably, this  ' E=MC2 ' book will change the foundations of Risk Management coming decade. Antifragile should be qualified as 'compulsory reading' for all actuaries, CFO's, CEO's and risk or investment managers.

It's impossible to summarize Taleb's Antifragile insights in a single blog, Therefore I'll focus on some examples and the major principles.

Also I would like to point at two more less known and 'mathematical based' text-books(downloadable and in progress) that are related to his popular (non-mathematical) book Antifragile:
  1. Taleb Textbook: Fat Tails Math, Probability and Risk in the Real World
  2. Taleb Textbook: Fat Tails and (Anti)fragility 

What's Investment Risk?
In a presentation ("Actuaris: From Backroom to Boardroom"; Dutch) to over 200 actuarial professionals at 'Actuarieel Podium' on October 1st 2013 in Utrecht, Jos Berkemeijer discussed, questioned and challenged some major actuarial profession principles. One of these actuarial principles is the:

Concept of Investment Risk

Inspired by Taleb's view on investment risk, I asked my audience to rank the next randomly presented stock charts in order of decreasing risk.

Can you manage?

As expected, most actuaries chose Stock Chart I or II as 'most risky'. Apart from a few Taleb-conscious actuaries, all of them chose Chart III as 'least risky'.

And that last choice is indeed the choice we're trained to qualify as least risky. The way we're brought up, is that risk equals volatility, ultimately resulting in a dangerous and wrong conclusion: non-volatility = 'no risk'.

However, according to Taleb, the opposite is true: Chart III represents the most risky stock.


Because the company or investment fund that's behind Stock Chart III doesn't have any real experience with 'managing risk' at all !!

Taleb's Turkey
In another way, Stock Chart II is risky as well. Chart III shows limited risk and exponential growth.
As Isaac Newton already stated: What goes up must come down
Therefore Stock III is a risky investment as well, despite it's limited volatility.

The fact that Chart II Stocks must come down is well illustrated by Taleb's Turkey example   

"A turkey is fed by a butcher.  Every day it is confirmed to the turkey and the turkey’s economics department and the turkey’s risk management department and the turkey’s analytical department that the butcher loves turkeys. And every day brings more confidence to that statement. 
The butcher will keep feeding the turkey until a few days before Thanksgiving. Then comes that day when it is really not a very good idea to be a turkey.

So with the butcher surprising it, the turkey will have a revision of belief—right when its confidence in the statement that the butcher loves turkeys is maximal and “it is very quiet” and soothingly predictable in the life of the turkey.

This example also makes clear that black swans are not just big negative impact events. The events of a black swan event depend on the position of the observer.

Least Risky
At the end we have to conclude that, despite the largest volatility, Stock III is the least risky investment, because the company or investment fund behind this stock chart, has learned to 'deal' with risk.

Dealing with investment risk is just like raising your child. You try to protect your child against life threatening events (defaults), while at the same time you encourage it to take limited (non life threatening) risks, so it may learn to prevent and absorb damages (losses) in order get better in resisting future other risks. 

Or.., to put it in a philosophical way, as defined by rabbi Anthony Glickman:

 “Life is long gamma.”
“Life benefits from volatility and variability”

Antifragile Essentials
Now after this popular intro, let's conclude with some fundamental principles of Taleb:
  1. Antifragile
    An investment portfolio (strategy) can be qualified as 'Antifragile' if it benefits more form shocks (high-impact events or extreme volatility, up to a certain level) than it suffers.

  2. Optionality & Investment Strategy
    • What makes you antifragile?
      Executing a option strategy
    • Traditional investment strategies: 'too much focus'
      Traditional investment strategies (e.g. Mean-Variance optimization, profit maximization or risk budgeting) all have explicit goals ('focus') that make their performance outcomes very parameter and model dependent. Because 'medium' risks can be subjected to huge measurement errors, the often 'medium' or 'moderate' risk attitude of these strategies can become catastrophical.

      Traditional investment strategies are not designed to explicitly cope with Negative Black Swans events. Neither are they designed to profit from 'disorder clusters': volatility, uncertainty, disturbances, randomness and stressors.

      Most important: traditional investment strategies are not set for maximal profiting of Positive Black Swans!
    • Barbell strategy
      The essence of an 'optionality investment strategy' ('barbell strategy') can be formulated as a 'dual attitude' of extreme risk aversion by playing it ultimate safe in some areas (robust to negative Black Swans) and extreme 'risk loving' by taking a lot of small risks in others (open to positive Black Swans), hence achieving antifragility.

      As a consequence this barbell-strategy reduces the downside risk, e.g. the elimination of the risk of ruin. In fact any strategy that removes the risk of ruin is a kind of barbell strategy. It's a strategy of limited loss and large possible outcome.
    • More Data, Better Outcome?
      Quit contrary to what we as actuaries would expect, Taleb explains in his book Antifragile that the more data you get, the less you know what’s going on, and the more iatrogenics (damage from treatment in excess of the benefits) you will cause.

Some risks are simply too small or too big to Tail. Try to approach them in an Antifragile way.....

Although the new insights and theories of Taleb are quit appealing, there's still a lot of work to do to make it work in practice.

Fortunately, you may read Taleb's book Antifagile online, or simply download it.


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