Investing principles of the great: Nassim Taleb

We continue the series of articles about famous investors who earned a lot with their investment principles and helped others to increase the welfare. One of them is Nassim Nicholas Taleb, a successful investor whose approach combines mathematics, philosophy and the ability to see simple, but not always obvious things.

Investor and philosopher

Without knowing that Nassim is a philosopher, it seems that he has a gift of foresight. He described his views about the world and investments in books, essays, interviews and lectures. In 1985, Taleb earned several million dollars speculating with futures contracts, and in 1987, when the Dow Jones index reduced by 23% — 40 million. During the stock market crash in 2008, his earnings were already estimated at several hundred million dollars.

Looking at his ideas, it is clear that he has no gift of foresight. Despite his remarkable mathematical skills, which helped him make a career in the investment business, he is no more often right than others. The thing is in his unique philosophy, which he applies to investments and other areas. Back in 2006, Taleb described the instability of the banking system of those days and an inflating bubble in his book “The Black Swan”. There he told how to take advantage of it. Already in 2008, both Taleb and his attentive readers managed to make a profit using the described approach. This made him famous around the world.

Source: Reuters

According to Nassim, the main mistake people make is ignoring the probability of “black swans”. With this term he described an event, which has the following characteristics:

1) In most cases, it is not predictable.

2) When it occurs, it has a tremendous effect.

3) After the event has occurred, it seems totally explainable and predictable.

Some negative examples of such events are the accident at the Fukushima-1 nuclear power plant or the housing bubble in the US, which led to the global financial crisis in 2008. However, there are positive examples too: the invention of the first car, the emergence of the Internet, or any thing that has changed the world. Ordinary people may experience it winning a lottery ticket(1) or observing any other successful combination of circumstances.

“Barbell” for investors

Taleb shows that such seemingly unlikely and unpredictable events can either totally destroy us, or become a source of experience and well-being. For this purpose, it is necessary to understand how to deal with uncertainty and randomness. To explain this, Taleb introduces the concept of “antifragility”. This is the ability of a system to develop and remain stable, owing also to “black swans”. In terms of human behavior, antifragility is when one makes small mistakes, analyzes and learns from them, avoids negative “black swans” (for example, avoids keeping all funds in bank shares before the financial crisis), and catches the positive ones. To become antifragile, it is necessary to adhere to Taleb’s “barbell” strategy.

There are two extremes in life that should be adhered to. First, one should create a solid basis for a safe life. For private investors, this means that there is no need to rush into investments devoting them all the time and money. First, it is necessary to ensure a stable job and income. This will allow to live comfortably, if the investments become unsuccessful. After that, it’s worth studying the financial market (for example, for half an hour on a weekday and 2 hours on the weekend), and invest only in highly reliable financial instruments first. Secondly, one should allocate a small share of funds to venture capital investments, which can lead to either a complete loss or increase the invested funds many times.

So, on one side of the “barbell” there should be a bigger part of the capital invested with minimum risks, and on the other side — a smaller part invested with high risks. Losses from this end of the “barbell” have only a little impact on the current life level. However, if the positive “black swan” occurs — the wealth will increase significantly. Its bigger part will move to the reliable end of the barbell, and its smaller part will stay to risk. At the same time, it is highly recommended not to follow a median strategy. For example, investing half of the capital in high-risk investments, and half — in low-risk ones, or investing all funds in medium-risk securities. If the negative “black swan” occurs, one can lose half or all of the capital.

From 2006 to 2008, Nassim Taleb was gradually buying options(2) for stock market decline and suffering little losses, until the crash increased his fortune several times. On the other end of his “barbell”, he kept income from selling books, giving lectures and passive investments, as in 2005, he closed his hedge fund Empirica Capital, in order to focus on philosophical research activities.

Let’s apply the “antifragility” to P2P lending. Is P2P lending market anti-fragile and resistant to “black swans”? Obviously, yes(3). An investor distributes funds between many borrowers. The probability that all of them will fail to pay out the debt is close to zero, even during crises and turmoils. As the loans are usually short-term, an investor can track the level of defaults and stop reinvesting to analyze the situation, if it starts increasing. Banks are more vulnerable in these terms — their loans are long-term, and they cannot stop the activities, as they have to pay salaries and interest on deposits. The next question is, can any P2P model be more anti-fragile than others? In our opinion, yes. A platform, which works with borrowers (individuals) from different countries is more anti-fragile than the one focusing on business loans in one country. The reason is obvious — if a financial crisis occurs, many firms will be having a hard time. In this case, the long term of loans may prevent the investor from taking measures on time. On the other hand, borrowers from different countries cannot all become insolvent at one time, both because of their geographical location and the short term of the loan. So, the P2P market can be a good way to save money and increase the wealth on the reliable end of the “barbell”. Especially, in times of low or negative rates on traditional investment markets.

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1. The probability of getting rich with the help of a lottery ticket is too little, so don’t even try to catch this swan after reading the article — this is just a good example.

2. An option is a derivative financial instrument, purchasing which you can fix your maximum loss at a certain level, while the upper limit of income is potentially unlimited.

3. It is understood that the platform is reliable and fair.