Black Swan Protection Protocol: An Approach for Weathering the Storm (continued)

In my August 12, 2009 post, I indicated that there was a separate approach I was undertaking for shielding the money I had no desire to lose – I referred to this approach as “black swan protection protocol.” The genesis of this term lies in the writings of Nassim Nicholas Taleb, and specifically, his 2007 best seller The Black Swan: The Impact of the Highly Improbable. Let me state clearly that this blog post does not suffice for conveying the importance and material significance of Taleb’s conjecture. Nonetheless, I was sufficiently motivated by his insights to fashion a rough outline here of how I plan to follow his advice and why.

If you read my July 15 post regarding Taleb’s ideas, the following may sound a bit redundant, but it’s worth exploring before moving into the details of the actual investment approach. The term “black swan” refers to the discovery in the 17th century of the first non-white swans, invalidating centuries of assumption that all swans were white. Thus, when Taleb speaks of black swan events, he is referring to an event which has the following attributes:

1) the event is completely unexpected
2) it is highly impactful
3) it is retrospectively distorted; that is, afterward it is rationalized as if it was or could have been expected

(IF YOU PREFER TO SKIP TO THE ACTUAL IMPLEMENTATION APPROACH FOR BLACK SWAN PROTOCOL, SCROLL DOWN SEVERAL PARAGRAPHS.)

One of the central themes of the book focuses on the following: the concept of two different realms of existence for humans: Mediocristan and Extremistan. An illustration works best for explaining these concepts.

Take 1,000 individuals randomly from society, tabulating their weight and averaging it out. Then take the 1,001st individual, who is the heaviest individual in the world (say roughly 1,000 pounds for the sake of argument). The average weight for these 1,001 individuals will not have changed substantially with the addition of the 1,001st’s weight to the total. This is Mediocristan.

Now take 1,000 individuals randomly from society and tabulate their net worth, then average it out. Take the 1,001st individual, who happens to be the richest individual in the world: Bill Gates, approximate net worth of $80 billion. What will happen to the average net worth? Rise dramatically, obviously. In other words, the addition of just one individual’s net worth changes the entire complexion of the situation instantaneously. This is Extremistan.

Here’s the basic point: human beings do not intrinsically recognize the kind of world we live in; we think we are living in Mediocristan, when we are actually living in Extremistan. In this sense, we underestimate the impact and importance of unforeseen, significant scale events. Evidence that we are living in Extremistan abounds: see 9/11, the 2008 financial collapse, the 1987 market crash, and so on and so forth. Whether it is due to human nature or evolutionary programming (or lack thereof), the simple fact is we do not effectively recognize the role and impact of randomness and black swan style events in our lives.

Taleb does an excellent job of exploring why this is the case in some depth, with one of the prime reasons being what he calls the “Platonic fold.” Essentially, this is the differential between what we know and what we think we know. When we act on what we think we know, rather than grasping the notion that we are treading into territory that we cannot possibly predict or explain adequately, we invite disaster or at the very least, a severe under-appreciation for the consequences or implications of a particular event.

Another key concept Taleb discusses is what he calls the “confirmation bias.” This refers to the fact that, because we do not see an event occur over a period of time, we assume it is not possible (if we can even imagine its possibility to begin with). Taleb uses this great analogy: a turkey is fed and well-cared for by its owner throughout the year, and the turkey comes to believe the owner has its best interest at heart; then, in late November, the turkey is slaughtered by the owner for Thanksgiving. The turkey experienced a confirmation bias, in that every day it was well-treated, it confirmed the notion that the owner had the turkey’s interest at heart. Obviously, this misconception is suddenly clarified, with tragic consequences for the turkey.

The real question becomes, what can we do about these conditions? As Taleb offers in his book, we can only attempt to build a more robust system that is less susceptible to the devastating effects of negative black swans. His prime example of this from a finance perspective resides in the notion that our banking system is severely over-leveraged and, by carrying the amount of debt that we currently have, as well as speculating in complex derivative financial products, simply begging for some catastrophic perturbation to occur to the system.

But the added problem here is that the banking and overall financial system has become increasingly interconnected in a global sense, thus vastly increasing the complexity of the system itself. A problem at one node, or bank, within the system, can quickly propagate throughout the entire system, causing distress to the system and turbulence in the financial markets. This kind of complexity must be countered with a more robust approach to the kinds of financial products and rule sets that are employed by the institutions themselves. In other words, the less complexity, the less the impact of the failure of a banking or financial institution on the overall system.

Again, I implore readers of this blog to read the book in order to gain a full appreciation of why Taleb’s conjecture is so critical to the health of one’s financial portfolio. There is simply no substitute for his insights.

(BELOW THIS POINT I BEGIN TO EXPLAIN THE THEORETICAL FINANCIAL APPROACH FOR EMPLOYING BLACK SWAN PROTOCOL.)

In deploying black swan protection protocol for my portfolio, I begin by identifying the money I have that I do not wish to subject to the risks of the marketplace; in other words, money I absolutely do not want to lose. Next, I identify the amount of money that I want to deploy for the active component of the black swan protection protocol (I’ll explain what this component is momentarily). These two figures comprise the bookends of what Taleb calls the barbell strategy: extreme conservatism at one end, extreme risk taking at the other.

On the conservative end, taking the amount of money I cannot afford to lose, I invest it into the safest securities available: CDs, money market accounts, and other savings vehicles (as safe as these can be given the overall tenability of the financial system). (One possibility here that Taleb mentions, though I would not personally choose, is the Treasury bond. Bonds will be the basis for the third and final financial bubble that is forming right before our eyes; however, to avoid digressing, I will save that topic for another post.) By investing in these extremely conservative positions, I have achieved the primary objective of capital preservation. While I will very well be subjected to purchasing power erosion due to inflation, that’s where the other end of the barbell approach comes into play, as we will examine now.

The central instrument behind the extreme risk end of the barbell strategy, and where the potential for significant gains resides, is the option. Investopedia describes options as follows: “A financial derivative that represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).” It is crucial here to note that, in general, the further away the date of the option, the more expensive the option will be. For example, if I bought an option in February 2010 that assumed Microsoft’s stock price would rise $2 by April 2010, this option would be less costly to me than if I bought an identical option with an expiration of February 2011. This is due to the fact that the underlying contract price has more time to fluctuate. (As a side note, for terminology sake, the options that are further out on the calendar can be referred to as “long-dated.”) Conversely, the more far-fetched the outcome implied by the option (the further it is "out of the money"), the less expensive it will be. For example, if I bought an option in February 2010 that assumed Microsoft’s stock price would rise $22 by April 2010, this option would be less costly to me than if I bought an option assuming the price would rise by $2. (Option prices are calculated using an esoteric, opaque formula called Black Scholes, but the above pricing assumptions will suffice for this post.)

Thus, on the riskier end of the barbell, I would begin accumulating various options, including short-dated, long-dated and out of the money options, that positioned me for extreme events. For example, as of the date of this blog post, the Dow is around 10000. So I might buy options for this time next year (Feb 2011) indicating that the Dow would be at 9000, 8000, 7000, 6000, and 5000. Another example would be as follows: given my firm belief that the dollar will continue to be devalued through the reckless money-printing of the US government, I would purchase options for 2010 and perhaps 2011 assuming that gold prices would reach $2000, $3000, and even $4000 per ounce.

You might be reading the above examples and thinking that these are extremely untenable investment choices…and you might very well be right. But that is the point. The options I described above – which I must reiterate are only examples for the sake of illustration – would do one of two things: if they do not materialize for me, I’ve lost a couple of hundred dollars; if they do materialize, I’ve made tens or perhaps hundreds of thousands. As I continue to analyze the market and macroeconomic trends, identifying these kinds of potential black swan events, I continue purchasing the options I believe may materialize and rolling them forward further into the calendar years. For example, in 2010 I’d be buying 2011, 2012, and 2013 options; in 2011 I’d buy 2012, 2013 and 2014 options, and so on and so forth.

What’s created through this barbell approach is a method for preserving the bulk of your capital (say 80-90% on average) through conservative investments, and a method for realizing enormous gains through black swan protocol, with about 10-20% of the portfolio dedicated towards option purchases. The 3-10% a year lost to inflation in the conservative category is made up by the triple digit percentage gains in the second. Using the real world example of Taleb’s fund, portfolios would have lost some real value to inflation throughout the mid-2000’s, until 2008 when they gained 50-110% during the financial collapse. Thus, if you’d given that kind of fund $1,000,000 in 2005 (assuming 5% inflation), you might have dropped to $950,000 real value in 2006, $902,500 real value in 2007, then risen to anywhere between $1.35M and $1.8M at the conclusion of 2008. Your overall return after 3 years would be between 35% and 80%.

Again, the approach outlined here is basic in nature, and should be carefully considered for one’s tolerance toward enduring steady but relatively small losses with the anticipation of infrequent yet sizable gains. In addition, the use of options as investments requires some education and understanding, or the help of a financial adviser or broker. But in essence, the black swan protection protocol is in many respects the perfect hedge to a more traditional approach involving the purchase and holding of stocks, bonds, and other securities. After the 2008 financial crisis, it is fair to say that such traditional investments do not necessarily equate to safe investments.