May 1, 2013

‘Black Swan’ Author Says Market ‘Fragility’ More Important Than Risk

Nassim Taleb argues markets need ‘stressors’ to prevent catastrophic events

Nassim Taleb, a former options trader who coined the term Black Swan in his book of the same name, delivered the lunchtime keynote at IMCA’s annual conference in Seattle on Monday. His presentation touched on the fragile nature of economies and markets and why volatility is a good “stressor” that is critical to minimizing catastrophic events.

“It took me 21 years to figure this out,” Taleb, professor of risk engineering at New York University Polytechnic Institute, began. “Tea cups are fragile. Although they are perfectly sturdy in a normal state, they can’t handle volatility and won’t benefit form a random event like an earthquake.”

The same can be applied to investing, he continued, arguing that fragility is more important than risk when evaluating markets, and noting that options, in particular, are fragile; They can perform perfectly well until volatility is introduced.

He then conducted a simple though experiment: Fragile packages are labeled “handle with care.” But there is no opposite of fragility. For it to be the opposite, the sender would have to beg the post office to mishandle their packages. There is no word in any language for antifragile, he said. Antifragility benefits from disorder and uncertainty.

“Think about air travel. Planes benefit from uncertainty, in that a plane crash will lessen the likelihood of the next crash from happening, in that they analyze what happened and take appropriate action. It is the opposite with banks. If one bank crashes, it increases the chances that the next bank will crash.”

His point was that economies and cultures need stressors, and pointed to a number of examples to prove his point:

  • Alan Greenspan tried to micromanage the economy and remove all risk. He only succeeded in making it worse.
  • Syria had no political variability for 50 years, and “now it is a mess.”
  • Trying to prevent forest fires from happening only results in a buildup of debris that make it that much worse when a fire finally does happen.
  • If a child is locked in a room for 15 years to avoid illness, it will work until he finally takes a ride on the New York subway.

He then defined antifragility as the “acceleration of harm, which eventually leads to Black Swan events.”

“There are 4 million earthquakes each year that are below a 2.0 on the Richter scale. If they were linear in harm, the world would blow up, but the slow release of pressure make them negligible. The same can be said of the investment portfolio, which can adjust for small shocks, but not those that are big.”

In order to prevent catastrophic events like the 2008 crisis from happening, there needs to be “skin in the game.”

“In ancient Pompeii, if a house collapsed and killed the owner, the architect was put to death. It resulted in architects and inspectors that knew everything about the house,” Taleb concluded. “Planes rarely crash with the pilots on board. This is what drives superior performance; it’s a better predictor than all the Nobel/shmobel theories.”

His latest book is "Antifragile: Things That Gain From Disorder."

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