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.

Why?

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.

Finally

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.

Enjoy!

Download (PDF) Taleb's Book Antifragile

Taleb Links

- Homepage Taleb

- Taleb on Twitter

- FT Interview Taleb (2013)

- Taleb's Rules

- Convexity, Robustness and Model Error inside the FourthQuadrant

- http://www.fooledbyrandomness.com/

- Understanding is a poor substitute for convexity (Antifragility)

- Why Taleb is wrong

- Financial Times: The Inventory: Nassim Nicholas Taleb

- The difference between long gamma and short gamma

Other Link

- Presentation by Jos Berkemeijer: Actuaris from Backroom to Boardroom

Hypegiaphobia

What's that spell? Hypegiaphobia?

Yes, Hypegiaphobia is the unpronounceable 'short' for:

A fear of responsibility

In a 2008 white paper, called Hypegiaphobia, KPMG stresses the importance that organizations want to be and must be 'in control' of a multitude of risks and therefore make enormous sacrifices to achieve this goal.

CEO, management and employees have to comply to so many simultaneous goals, and the consequences of not being compliant on a single issue are that high, that people fear to take individual responsibility in a organization.

In search of the balance between rules and trust, KPMG calls upon the parties involved to provide more space for individual responsibilities. In the mentioned white paper KPMG answers two key questions:

• Are the high investments in risk management effective and do they really lead to a lower risk profile?
  
  
• Does risk management overshoot its goal and produce undesirable effects, such as reduced entrepreneurial spirit, increasing litigation, a culture of fear and a potentially adverse effect on the competitive position?

Trust Rules
Moreover, in 2009 KPMG extended their view on Hypegiaphobia by publishing a document called 'Trust Rules'.

Guts, vision and trust go hand in hand in a time of increasing litigation.

Unplug
Lately, numerous persons and organizations in the Netherlands have had the guts to “unplug”. Unplug is a new work style by which numerous (compliance) issues are handled in unconventional ways :

• Getting rid of unnecessary rules, of fixed places and times
• Dealing better with knowledge
• Collaborating more
• Taking more personal responsibility

All this with a a single focus: The client.

Principles
To organize trust and to be able to trust, KPMG has formulated (on basis of client interviews) nine principles they call trust rules (mark: the noun has turned into a verb) :

1. Make contact personal
2. Define common goals
3. Set the right example
4. Build trust with sensible rules
5. Share responsibility and trust
6. Stay on course and keep calm, even when things go wrong
7. Rely on informed trust, not on blind trust
8. Be mild on misunderstanding but crush abuse
9. Dare to experiment and learn from experience

Risk
In a document called Signs of Safety, risk is defined as an increasingly defining motif of the social life of western countries.

However, risk is almost always seen as negative, as something that must be avoided.

Killing Black Swans
To put it simply: everyone is worried about been blamed and sued for something. Thus organizations have become increasingly risk-averse to the point of risk-phobia. Elimination of every Black Swan risk at any price, seems the unrealistic and never ending target.

New solutions
The challenge for management, actuaries and accountants is to see and define Risk in terms of a potential big win and investment instead of only a potential big loss. This also means that - as a society - we have to reformulate rules and laws in a way that risks can be taken in such a way that failure, bankruptcy are or catastrophes are not (nearly) completely excluded anymore.

Often economies of scale lead to the rise of international (financial) companies that overshadow individual countries in terms of VAR.
If country governments of such 'inhabited' international enterprises are convinced that an eventual bankruptcy of such a company would create great collateral damage and therefore is not an realistic option, things will have to change. In these cases governments have no other choice than to order by law:

• a limitation of (international) company size
• a limitation of reciprocal contracts between big companies
  

or...

• to demand and allow companies to restructure themselves in such a way that, in case of a catastrophe, only a part of the company goes bankrupt and not the company as a whole
  

In these cases state (re)insurance is not a preferable solution. Pricing this risk would be too expensive or - even worse - not charging for this risk would lead to a situation where management can take every risk they want, because in case of a bankruptcy, the government would back up anyhow.

Risk-Phobia Virus
As actuaries we're extremely vulnerable to the 'risk-phobia virus'.
Let's not get caught by this virus or hide in the bush, but take a calculated risk and go out to present our new solutions that make the difference in tomorrows risky world. Risk..., a never ending issue....

Links: Hypegiaphobia Video , List of phobia's, Dutch nine trust rules
Sources: Signs of Safety