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In my last post, we were introduced to the concept of the Black Swan, which is a highly impactful event outside the realm of normal expectations, and can only be explained in hindsight.

The author of the book from where this idea originates, Nassim Nicholas Taleb, professes that humanity ignores Black Swans to devastating consequences, especially in the financial world. He cites numerous stock market crashes and financial meltdowns that have erased billions of dollar in value. Humans gravitate towards high risk, low volatility investments, like blue chip stocks, while under the illusion that they are low risk.

Index investing is lauded by the personal finance community as the best way to save for retirement. If so, then why did every index portfolio lose half of its value after because of 2008? Yes, the argument for asset allocation can be made, erroneously, but it still does not reconcile the confusion of risk and volatility and does nothing for younger, less financially “conservative” investors. Index investing is highly susceptible to volatility and negative Black Swans, yet are trumpeted by those who have little actual knowledge about financial risk. Holding equity investments in a world governed by Black Swans gives investors the illusion of a good investment. It is the classic case of not seeing the forest (massive financial risk because of Black Swans) through the trees (lower MERs).

Taleb suggests an alternative form of investing to that of the index investor. Rather than being susceptible to Black Swans and market volatility, he suggests an investment strategy which thrives off of volatility and risk. One possible asset allocation would be:

• 90% to be put in the lowest risk investment possible, such as US Treasury Bills
• 10% to be put in Options

Options allow an investor to thrive off of positive or negative Black Swans by buying a call or a put, depending on the asset. Options magnify gains while guaranteeing a maximum loss in case the options are not in the money. In periods of low volatility, which will be much more often than not, the investor will merely lose the risk premium. When a Black Swan occurs, the gains from the option will dwarf any losses from the payment of risk premiums prior to the Black Swan. Essentially, the 90% conservatively invested capital merely funds the opportunity to benefit from positive or negative Black Swans.

Taleb explains this concept and the justification for it much more thoroughly in his book The Black Swan: The Impact of the Highly Improbable. He also suggests firing your financial advisor, as they actually know little about investing and risk, as evidenced by their investment recommendations and their ignorance of Black Swans. Food for thought.

Taleb puts forth a very credible argument for abandoning index investing and embracing the concept and implications of the Black Swan. While this may provoke criticism from the personal finance community, please read the book first. It will be infinitely more interesting, thought-provoking, and useful than the latest post from your favourite PF blog (including mine, wait a second, no one would say that about mine, truthfully) or the newest article in Money Sense.

Feel free to email me your thoughts at eddie@summaticus.com.

Tell everyone, yo!