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Recently I’ve had a series of very long posts, so for this one I thought I’d take a break and do something shorter and more straightforward. Of course I start lots of posts with exactly that intention and they still end up being over 3000 words, [If your curious, upon being published, with donation appeal and this message it was 3061 words] but perhaps this will be the exception. I mean how hard can it be to cover all the things you should do with your money plus the stock market and to a lesser extent the entire economy? I guess we’ll find out.
To begin with, long time readers will know that I’m a huge fan of Nassim Nicholas Taleb, who has a lot to say about investing. In particular he recommends a barbell investment strategy, which is to say almost everything ends up at either end of the risk continuum with almost nothing in between. Also the ends are not equal. Taleb recommends that at least 90% of your money should be in things that are super safe, where the risk is well understood and very low. And that 10%, at most, should be in very risky assets with the potential for very high returns.
I could now go on to describe what constitutes something that’s super safe vs. something that’s high risk, and indeed I’ll get to that, but the point of this post is not to give investment advice. Indeed this is explicitly not investment advice, for lots of reasons, but the biggest being that it’s my understanding that I can get in trouble if I say that it is. No, my hope is more to describe how investing is all about using your money to prepare for the future, and consequently a lot depends on what you think the future is going to be like. The reason Taleb recommends the barbell strategy is that he thinks that the future is going to be both unknowable, and volatile.
That last word turns out to be very important. Most people accept that the future is unknowable, but they don’t go on to consider it’s potential volatility. To put it another way they admit that they don’t know which stocks will go up, but they assume that the stock market as a whole will definitely go up over a long enough time horizon and so their strategy is to put all of their money in a diversified stock portfolio. Possibly going so far as to just put it all in an S&P 500 index fund. And to be clear, as investment strategies go, there are worse ones, but it’s important to realize that this strategy only prepares you for one sort of future, one that’s unknowable but mostly boring (low volatility).
To illustrate how things become not boring let’s look at what might be considered the founding event of Taleb’s philosophy: growing up in Lebanon. Here’s how he tells it:
The mosaic of cultures and religions there was deemed an example of coexistence: Christians of all varieties… Moslems… Druzes; and a few Jews. It was taken for granted that people learned to be tolerant there.
By any standard the country called Lebanon…appeared to be a stable paradise;
The Lebanese “paradise” suddenly evaporated, after a few bullets and mortar shells… after close to thirteen centuries of remarkable ethnic coexistence, a Black Swan, coming out of nowhere, transformed the place from heaven to hell. A fierce civil war began.
To put it another way, if you had lived in the Levant at any point during those thirteen centuries, you would have been safe assuming the future was going to be boring. (Understanding of course that historically definitions of what constituted “boring” may have been different.) Had there been a Levantine version of the S&P 500 it would have been fair to say that over the long haul it went up, and people use essentially the same language when discussing the stock market. Until one day, when the things that had been true for centuries suddenly weren’t.
And of course Lebanon has yet to recover, and this is without considering the effects of the recent explosion which has made a bad situation even worse. One assumes that Taleb was powerfully influenced by that experience, and that this included influencing his investment strategy, as well as being one of the things which led him to the idea of a black swan, which he mentioned in the excerpt I quoted.
Hopefully by this point in 2020 we all know what a black swan is (if you don’t I would refer you back to my post, The Ideas of Nassim Nicholas Taleb.) And each part of the 90/10 split relates to different sorts of black swans. Let’s start by examining the 10% side of things. Taleb’s core assumption (which I agree with) might be stated as follows:
We can’t predict the future, but even beyond that people are particularly bad at differentiating between something with a 5% chance of happening and a 1% chance of happening. Everything is a guess, but the guesses are especially bad starting around odds of 1 in 20 and get progressively worse the higher those odds go up.
I mentioned that this tied back to black swans, but Taleb would actually say that what I just described is a grey swan. People can see that it might happen, unlike with black swans, but despite considering it as a possibility, they underestimate its likelihood. (Sound like the recent pandemic?) If you can take the other side of this bet, if someone is willing to give you 1 in 100 odds, but the true odds are 1 in 25 then you can make money on the difference. Unfortunately, even if we accept Taleb’s assumption, and assume that this mismatch happens frequently and that the true odds of grey swans are lower than what the market says they are, that they’re 1 in 25 not 1 in 100, you’re still going to be losing a lot more often than you win on these investments. Which is what makes them high risk, but when you do win, you’re not doubling your money you’re increasing it by 100x, and thus the high return. As you might imagine even if things are as straightforward as I describe, which they’re not, this would still require that you make a lot of these bets. But this is also where we’re directing the 10% of our money, not the 90% meaning in order to make this work we have to make lots of bets with the smallest part of the barbell.
To pull all of this together the 10% part of a Talebian portfolio is designed to give the investor access to potentially lucrative grey swans. And it’s no more than 10% (and possibly less) because “hunting” these grey swans is hugely risky, and you might lose all the money you spend doing it, so we want to make sure that amount is low. To put it in even more basic terms, you’re trying to prepare for the uncertainty of the future by buying a share in as many uncertain futures as possible.
As an aside, the easiest way I’ve found to make these bets is with options, and that’s how Taleb got his start, as an options trader. I assume that this also informed his entire ideology, because the kind of extreme odds I just discussed aren’t even possible through just purchasing stocks. They are, however, accessible to normal traders and I think essentially all online trading platforms provide the ability to buy and sell options. Once again this is not investment advice, just an explanation of investment instruments.
For a while I felt like I had a handle on all of the above, that is the 10% side of things. The bigger struggle has actually been figuring out how to handle the other side, the remaining 90%. And it’s actually the idea I just mentioned, buying a share in different versions of the future that clarified things for me. That and attending Taleb’s Real World Risk Institute earlier this year, and listening to him for a full week. Even so it took a while to gel. Accordingly, the big reason for doing this post now is that I think I finally have a system for the 90% side as well.
So, you may be asking, if the 10% side is for hunting grey swans, what’s the 90% for? To what are we dedicating the bulk of our wealth? Well, the 10% side is for hunting them, and the 90% side is to keep them from hunting you. And it’s not just the grey swans that are out to get you, the really scary black swans are out there as well. This may seem a little bit paranoid, and it is, but you should be paranoid after the events of the last few months, and probably more than a just a little bit, but if that feels uncomfortably close to being in hardcore guns, gold and spam prepper mode let me frame it differently.
The 10% is dedicated to buying shares of improbable futures, the 90% is dedicated to buying shares of probable futures. To making sure that whatever the future is, that you have a piece of it, that you’ll have a piece of whatever it is that ends up constituting wealth in the future. Allow me to offer up a few examples:
In Taleb’s earlier books he mentioned that he had at least some of his 90% in government treasuries, and in other very secure bonds. I’m not sure if that’s his allocation anymore, particularly when it comes to treasuries, but the reason he did it, and the reason why you might still do it is that treasuries are guaranteed to keep their value in any future where the US Government remains powerful and the dollar remains valuable. Which is to say you’re making a bet on the USA, and treasuries will continue to count as wealth if your bet is correct.
For another example we can return to the S&P 500. There are some people who have most if not all of their wealth (outside of things like their house) in the S&P 500. Which is a bet that in the future the 500 companies who comprise the index will continue to have value. That the wealth of owning a piece of a large company today will continue to constitute wealth in the future. You can see where that seems like a pretty safe bet, and as I said having most of your money in the S&P 500 is not a bad idea. Of course it’s also more volatile, US treasures have never lost 30% of their value in a month, but for some people that’s precisely what makes it attractive. It’s a bet on a future that is both very likely and a bet that generally pays out better than a bet on the treasuries. You want a slice of a future where companies are still important and the stock market always recovers from whatever history throws at it.
For all my talk about buying a piece of the future, thus far what I have described doesn’t look very different from a standard 401k with a little bit of diversification. So let’s talk about cryptocurrency. Is there a conceivable future where crypto is very important? Sure. Is there a future where crypto is dominant? Where the dollar has collapsed and the US has defaulted? Or some other scenario where Bitcoin or another crypto becomes the de facto reserve currency? I’ll admit it seems unlikely, but what does seem clear is that crypto represents one vision of the future, and a future where crypto is the dominant fungible store of value has the potential to be mutually exclusive with the other visions I’ve mentioned. Should this be the case you would certainly want to make sure you had purchased a piece of that future while it was still cheap.
My next example may be the first one you thought of when I started talking about an asset that would hold its value regardless of what the future brought, and that would be gold (and other precious metals). And indeed it is this quality that it’s many hardcore fans (gold bugs) find so appealing. That regardless of what happens the value of gold is never going to go to zero. Further they foresee a future where it’s the only thing that has any value. The point of the 10% is to chase profits, the point of the 90% is to avoid ruin, and if the future arrives and you’re left with nothing that still holds value, then you have definitely not invested correctly. Gold (or other precious metals) would seem to guarantee that you will always possess something of value.
Beyond the examples I’ve already given there are of course many other possibilities. Lots of people would argue that any plan for avoiding ruin and preparing for potential futures would be woefully incomplete if you didn’t own your own home and the property on which it sits. Still others assume that the best defense is a good offense and their goal is to invest in a class of assets that will not only retain its value, but experience tremendous gains in value. As an example you might decide that one vision of the future is one in which big technology companies absorb a huge chunk of the economy. Accordingly you might allocate a significant percentage of your 90% to the FAANG stocks and indeed over the last decade such a bet would have been very lucrative. (Honestly a barbell of gold and FAANG doesn’t seem that crazy right at this moment.)
From all of this the key insight that I want you to take away, and the insight I believe I had that clarified things for me is that investing is not about making money, it’s about buying a piece of the future. And it’s true that increasing your personal holdings of whatever counts as wealth now (US Dollars) is a pretty good way of having wealth in the future, since what’s valuable now has a very good chance of still being valuable, but that if we broaden our analysis accumulating dollars is only a subset of the larger project of buying a piece of the future.
Once you’ve absorbed this lesson there’s still a lot to be done. There are all manner of potential futures and one needs to strike a balance between casting too wide a net (putting any of your 90% into an individual stock would almost certainly qualify) or alternatively crafting a net that’s too narrow. (In particular if there’s any chance that something will end up being the only store of value, see gold and crypto above, you should definitely have some of that thing.) In theory you would allocate your investments according to their likelihood. If you think there’s a 20% chance that t-bills will continue to be the best store of value, a 5% chance that crypto will grow to dominate the world and a 10% chance that we end up with a zombie apocalypse where gold and silver are king, then you would invest your assets in that same way.
But once you’ve made this decision you’ll quickly realize that there are other decisions to be made, because having decided on an allocation and placed your resources accordingly, things are going to start to gain or lose value, and it may be that your 5% stake in crypto has grown to be 8% of your net worth. What do you do then? This is a little bit tricky. If you still think crypto only has a 5% chance of being the dominant store of future value then you should rebalance your portfolio. This has the added advantage of forcing you to sell high and buy low (because you’ll be moving money out of your winners into your losers). But, you should also consider the possibility that the gain or loss is a signal of that future becoming more or less likely. In which case you’ll want to adjust your target percentages, probably not by exactly the amount of the gain or the loss, but by part of it.
Beyond all of this, as you get older your own future changes. Do you want to make sure you have something to pass on to your children? Do you have some sort of bucket list? A trip to Europe you’ve always wanted to take. I should mention at this point that I’ve always found Tim Ferris’ exercise of dreamlining to be useful when deciding how much money you really need.
Finally, while it’s not the primary topic of this post (though it may be one of the major topics of the blog itself) wealth comes in many forms. As one example, it would take an awful lot to make me homeless and that’s without considering any of my assets. Why? Because I have my parents, six brothers and sisters, and a bunch of friends and in-laws who’d be willing to let me move in with them long before I ended up on the street. To travel even farther afield this is also one of the reasons I’ve never entirely understood people who decide not to have kids, I mean talk about a sure fire method to buy a piece of the future!
Hopefully this advice (though definitely not investment advice) has been helpful. I understand that it doesn’t have much to offer in the present moment when the stock market has seemingly gone insane. But hopefully over a long enough time horizon it provides some wisdom, and that the time horizon of its usefulness is longer than much of the other advice that’s out there. In any case, good luck, I think we’re all going to need it.
I feel like there’s never been a more appropriate time but simultaneously a less appropriate time to ask for your money. On the one hand if you’re going to follow this advice don’t you need your money? On the other hand I’ve just demonstrated the great care and wisdom I would exercise if entrusted with your donation…