I really like Frank Martin’s take on Nassim Taleb’s concept of Antifragility. Published with permission (thanks Gary), the following excerpt is from the Martin Capital Management 2013 annual report. Italics are Martin's emphasis, underlinings are mine.
Decision Making Without Forecasts and the Role of Optionality
As Nassim Taleb proposes, disavowing forecasts is the beginning of coping—from an enlightened perspective—with an unpredictable future. As is apparent, forecasting is not neutral, and it is not without consequences for risk takers who rely on mostly erroneous prognostications. Reiterating for emphasis, the problem lies first in the fallibility of trying to outsmart the inscrutably complex future, second in the unwillingness of forecasters to fess up to a history of wide-of-the-mark predictions before launching without remorse into the next mistake, and finally, in our yearning as humans for some explanation of the future irrespective of the explanation’s reliability. Taleb, primarily in his book Antifragile: Things That Gain from Disorder, recommends a radical approach to avoiding the fallout from forecasting errors.
Let’s start with his appellation “antifragile.” Although a ubiquitous property of every system in nature that has survived, the idea that things gain from disorder is not widely understood in man-made systems like financial economics. Robust may be the antonym of fragile, just like positive and negative are opposites, but antifragile, being neither, is not typically a conscious part of our decision making. By understanding the difference between fragility and antifragility, we can build a guide to decision making in financial markets that does not depend on forecasts. Every natural organism or system that still exists has survived without ever relying on forecasts. Nature is full of adaptive, non-predictive systems. If nature doesn’t need forecasting, why do we?
The future is filled with uncertainty, unpredictability, randomness, opacity, and incomplete understanding. If anyone envisions the future with more clarity than that, please lend me your crystal ball.
It is far easier to figure out if something is fragile than to predict the occurrence of an event that will harm it. Fragility can be measured, but uncertainty cannot. Consider two investors. One is fully invested, perhaps even leveraged, whereas the second has plenty of “cash in the bank.” The first, with no redundancies or backup systems, is at the whim of the unexpected. That investor is fragile. The second need not know, or even worry about, which among many unpredictable future events may cause potential harm.
It is critical to understand the difference in approach to the above scenario. The mainstream response to risk management is the near universal portfolio construct, the medium-risk approach of diversifying over a broad universe of “uncorrelated” assets.
An antifragile portfolio is focused on minimizing the downside, rather than increasing the upside, and reducing the exposure to random, catastrophic risks. The concept of path dependence, the inability to reverse damage once things begin to fail, is unfamiliar to most of us. Look at JPMorgan’s recent travails. In a demonstration of static thinking, the banking giant’s powers-that-be believe that generating profits is their principal mission, with survival and risk control secondary considerations. As I’m sure is obvious, that applies to most investors in the markets today. It appears they (JPMorgan Chase and investors in general) have missed the “strong logical precedence of survival over success.” In Buffett’s uncompromising logic, “To win, first you must not lose.”
Following path-dependent reasoning to its logical application, one is hard-pressed to separate halting growth in the economy from risks of relapse into recession—or financial returns averaging 18% over the last five years from risks of terminal losses. If the risk of a portfolio strategy is a catastrophic meltdown, potential returns are totally inconsequential. Taleb tells the story of the manager of a university endowment fund who boasted 20% returns or so but who clearly did not realize that those returns were the result of assuming undisclosed or unknown fragilities. Along came 2008, and those returns were wiped out and the university endangered.
In what we believe to be a high-risk investment environment, our antifragile portfolio construct is bimodal by design. Although it is anything but conventional, its logic has an intuitive appeal. It’s the same construct we employed prior to the financial crisis. Rather than a central mode—the typical portfolio construct mentioned above—it has two distinct modes. It was only after reading the second edition of Black Swan in early 2008 that I learned Taleb advocates the strategy and gave it a name: barbell. The bulk of a barbell portfolio is invested in short-term U.S. Treasury securities, and that portion is deemed antifragile. How it gains from disorder will be addressed momentarily. On the other extreme, one makes small commitments with potentially large asymmetrical payoffs, should “tail events” (which you think possible but unpredictable) occur. Thus, antifragility involves extreme risk aversion on one side and extreme risk acceptance on the other.
The advantages over the medium-risk standard portfolio construct are several: First, risk of ruin is nearly eliminated. Someone with 100% in so-called medium risk securities is exposed to a risk of ruin from miscomputation of risks. Recall the universal portfolio construct above and the attempt to populate it with “uncorrelated” assets (depending on the external stimulus, some go up when others go down). Unfortunately, in financial crises correlations approach 1. Statistically, that means that in a panic almost everything collapses in value, except for high-quality liquidity. Whether a portfolio is 60/40 with equities or debt being the larger, the comfort of medium risk may be an illusion in the face of extreme economic, valuation, credit, or duration risk—or more likely, a combination of several of these.
As promised, an explanation of non-predictive decision making would not be complete without returning to the antifragile properties of the liquid or “safe” side of the barbell. These assets are not merely robust; when exposed to random shocks, they actually gain strength through optionality. He who possesses optionality has the “right but not the obligation” to purchase or sell an asset, whereas the counterparty, the seller, has the “obligation but not the right.” Optionality, while more expensive in a zero-interest-rate environment, still comes at a comparatively small price for the privilege, with limited loss and large possible outcome. The option is the agent of antifragility. Optionality thrives on volatility. Optionality gives you freedom, the freedom to choose among future alternatives not yet made apparent. Your only downside is if you pay too much for the option, the “cost to carry,” over time.
Clustering in the presumably safe middle ground does meet an important human need to belong and perhaps avoid individual accountability by submitting to the anonymity of the crowd. It’s as much a mistake to confuse fence straddling with safety and risk minimization as it was to buy an index fund in October 2007. Diversification became “di-worse-ification,” putting one squarely in the path of the steamroller of market risk. If safety is enduring a 57% top-to-bottom decline in the S&P 500 from October 7, 2007, through March 9, 2009, perhaps “safety” is not the right word!
Analogously, in the broader social context, real growth in society may not come from increasing the ranks in the middle, but from increasing the number of people in the “tails.” As Taleb states, It takes a very small number of risk takers crazy enough to have an idea of their own, those endowed with that very rare ability called imagination, that rare quality called courage, to make things happen.
Men like Steve Jobs, Warren Buffett, Seth Klarman …and Nassim Nicholas Taleb come immediately to mind.
Such a radical departure from the popular buy-and-hold strategy is necessary only when the longer-term (e.g., 7–10 years is often used) expected returns from financial assets are near zero, as they are in our judgment today. Prices are at levels from which downside surprises are far more likely than upside ones. Overlaid on those risks is an environment characterized above as one of “fat tails.” In the financial markets, two negatives, overvaluation and the fat tails, don’t multiply to become a positive. Rather, they add up to a double negative. Should both negatives occur, exacerbated by feedback loops, this report will have served its purpose. It will be falling prices that reveal true investment brilliance, not rising prices as we have today.
Excerpt from the Martin Capital Management 2013 Annual Report. Printed with permission.
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