C&B Notes

Learning to Love Volatility

Nassim Taleb has written a new book that is, in many ways, a description of what works in a world (and markets) that inevitably encounter black swan events.  One of our takeaways is that society should focus less on trying to predict or manage/smooth outlying events, but rather should create and employ frameworks that best navigate them.  We believe that Graham’s insistence on a margin of safety — the heart of value investing — is one of these frameworks.  An unlevered portfolio that consists solely of securities that trade at discounts to their underlying intrinsic values (from our October 2006 letter) provides the opportunity to avoid permanent impairments of capital even when unavoidable mistakes (April 2010) and volatility occur.  And a portfolio — either through cash holdings or the sale of liquid securities — that is able to increase its investments when others are heading for the exits (April 2009) fully meets Taleb’s definition of “antifragile”: something that can gain and strengthen from disorder.

In economic life and history more generally, just about everything of consequence comes from black swans; ordinary events have paltry effects in the long term.  Still, through some mental bias, people think in hindsight that they “sort of” considered the possibility of such events; this gives them confidence in continuing to formulate predictions.  But our tools for forecasting and risk measurement cannot begin to capture black swans.  Indeed, our faith in these tools make it more likely that we will continue to take dangerous, uninformed risks.

Some made the mistake of thinking that I hoped to see us develop better methods for predicting black swans.  Others asked if we should just give up and throw our hands in the air: If we could not measure the risks of potential blowups, what were we to do?  The answer is simple: We should try to create institutions that won’t fall apart when we encounter black swans — or that might even gain from these unexpected events.

Fragility is the quality of things that are vulnerable to volatility.  Take the coffee cup on your desk: It wants peace and quiet because it incurs more harm than benefit from random events.  The opposite of fragile, therefore, isn’t robust or sturdy or resilient — things with these qualities are simply difficult to break.

To deal with black swans, we instead need things that gain from volatility, variability, stress and disorder.  My (admittedly inelegant) term for this crucial quality is “antifragile.”  The only existing expression remotely close to the concept of antifragility is what we derivatives traders call “long gamma,” to describe financial packages that benefit from market volatility.  Crucially, both fragility and antifragility are measurable.

Herewith are five policy rules that can help us to establish antifragility as a principle of our socioeconomic life.

    1. Think of the economy as being more like a cat than a washing machine…
    2. Favor businesses that benefit from their own mistakes, not those whose mistakes percolate into the system…
    3. Small is beautiful, but it is also efficient…
    4. Trial and error beats academic knowledge…
    5. Decision makers must have skin in the game
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