Carlos Velásquez · Medium · 7 min read · Photo By: Benjamin Lizardo — Unsplash.com
You completed a detailed cashflow analysis on a company listed as ticker symbol FRGL.
Its intrinsic value is higher than its current market price. The “stickiness” of the company’s product is well known. Podcasters mention the company can someday develop an “economic moat”. Its most recent 10Ks Forms corroborate this narrative.
Being a prudent investor you allocate 1% of your portfolio to FRGL, a starting position you plan to increase to 5% over the next few weeks.
Your portfolio of 20 stocks is diversified yet concentrated. Trailing stop-losses account for the unique volatility associated with each holding.
What can go wrong?
Coronavirus: A Fragility Transmitting Disease
Market volatility rises during the last week of February as Coronavirus cases outside of China start being reported. You vaguely recall something similar happened with SARs some years back yet everything turned out fine.
On February 28th you override your tiered FRGL limit-orders to opportunistically buy the dip! The assets in your portfolio are now fully invested.
But on March 9th the Dow Jones is down 1800 points upon opening. Market volatility rises throughout the week.
You google “market corrections”. Corrections of this magnitude occur approximately every two years. The market usually recovers quickly. You convince yourself not to be too concerned.
Midway into the week of March 16th, however, more than two-thirds of your stop-losses have been triggered, including that of your most recent purchase. A hedge fund in need of liquidity sold a significant block of FRGL shares, causing its price to fall precipitously; the FRGL stop-loss triggered well below your preset price.
Media outlets are starting to forecast bleaker Coronavirus scenarios. Reports that the stock market may experience a more severe drop than in 2008 are now the prevailing narrative.
On Friday March 20th just before the market closes you panic-sell the rest of your holdings, crystalizing your portfolio loss at 30%. It was the market’s worse week in 11 years.
On March 23rd the market hits a new two-year low. A buddy asks, “are you buying the dip?” You don’t respond.
Your gut tells you that the market can drop another 25%, if not more. You’ll buy then.
After all, you’ve learned to be prudent.
A World of Fragility: Use Protection
In Antifragile, Nassim Taleb writes:
“…longer-term predictions are more reliable than short-term ones, given that one can be quite certain that what is Black Swan-prone will be eventually swallowed by history since time augments the probability of such an event.”
During the last 33 years, a period that overlaps the core investing years of 55 to 75 year-olds, at least 11 events have significantly amplified volatility in the financial markets.
- Stock Market Crash (1987)
- Savings & Loan Crisis (1989-1991)
- Iraq Invades Kuwait (1990)
- Japan’s Asset Bubble (1991)
- Asian Financial Crisis (1997)
- Russia’s Monetary Crisis (1998)
- Dot.com crash (2000)
- 9-11 Attacks (2001)
- Global Financial Crisis (2008-2009)
- European Sovereign Debt Crisis (2009-2011)
- COVID-19 (2020)
Not all of these events have been “Black Swan” events, per se.
Perhaps only the Stock Market Crash of 1987, the 9-11 Attacks and the Global Financial Crisis of 2008 were Black Swan events – i.e. unpredictable.
These 11 events, nonetheless, significantly increased volatility in the financial markets. Today, the repercussions of these types of macroeconomic events have the potential to move faster, deeper and more widespread throughout the globally interconnected financial system. The Global Financial Crisis of 2008 and the COVID-19 pandemic are the latest examples.
During these types of macroeconomic events, the resulting intraday volatility reflected in individual stock price movements can be much higher than the volatility depicted in the chart above.
Forecasting: A Compromising Position
In Antifragile, Nassim Taleb continues:
“…On the other hand, typical predictions (not involving the currently fragile) degrade with time; in the presence of nonlinearities, the longer the forecast the worse its accuracy. Your error rate for a ten-year forecast of, say, the sales of a computer plant or the profits of a commodity vendor can be a thousand times that of a one-year projection.”
Even the most sophisticated economic models are incapable of providing accurate estimates beyond three to five years (and they certainly cannot predict Black Swan events).
Forecasts shorter than one year can also be questionable. If you ask a CFO for her 2020 cashflow projections she’ll probably need to dig them out of her laptop’s trash bin.
This article opens with an extreme example of hypothetical mistakes made during the most recent market drop by an investor implementing an “intrinsic value” investing strategy using a discount cashflow analysis, leading him to lose money and miss out on a historic stock market recovery.
However, even outside the context of pandemic-driven volatility, many investment strategies can – and often do – lead to undesired results by following forecasts.
In Antifragile, Nassim Taleb adds:
“What is fragile will eventually break; and, luckily, we can easily tell what is fragile.”
Models, from the most basic cashflow calculation to most complex financial ones, are fragile because they cannot reliably predict how complex systems will react to unanticipated changes.
Luckily bad modeling results can be circumvented “via negativa”. That is, by simply avoiding the use of models.
Black Swan-Style
“Positive Black Swan” investments have an asymmetric risk-reward profile. These moonshot investments have a known, and limited, downside but an exponential 10x to 100x or more upside reward potential.
In his book The Black Swan, Nassim Taleb advocates the following barbell portfolio construct:
“…you need to put a portion, say 85 to 90 percent, in extremely safe instruments, like Treasury Bills…the remaining 10 to 15 percent you put in extremely speculative bets. Have as many of these small bets as you can conceivably have. Examples of positive Black Swans are: some segments of publishing, scientific research, and venture capital.”
From a risk-management perspective, you are no worse following Taleb’s “speculative bets” percentage advice relative to setting all your portfolio stop-losses at 10–15% below their purchase price.
If the US monetary system concerns you, consider buying physical gold instead of Treasury Bills or some combination thereof. If you believe in “digital gold”, Bitcoin could be one of your many positive Black Swan bets.
Of the over 15,000 listed companies there are hundreds of small-cap and micro-cap companies with moonshot potential in all sectors of the economy, especially in the biotech (“scientific research”) sector as Taleb notes.
Follow company insiders’ stock purchase activity as an initial filtering heuristic for stocks to bet on. Make many small bets.
Importantly, intrinsic value calculations are not required.
It Helps Being Long…Volatility
In Antifragile, Nassim Taleb is inspired by Duc de la Rochefoucauld when stating:
“Wind extinguishes a candle and energizes fire. Likewise with randomness, uncertainty, chaos: you want to use them, not hide from them. You want to be the fire and wish for the wind.”
A portfolio of 20 stocks that incorporates trailing stop-losses is akin to candles on a cake at a backyard birthday party, entirely exposed to a premature blow-out from a sudden gust of wind. Moonshot investments incorporated in a barbell portfolio strategy are more similar to hot embers in a fire pit, purposely set to be stoked by the wind.
Sweet-toothed partygoers and most traditional investors hope for calmness. Cold campers and investors implementing barbell investment portfolio strategies hope for and benefit from the opposite.
Volatility in the financial markets is inevitable.
Investors should strive to situate their portfolios to benefit from market volatility.
Investors should strive to be Antifragile.
Author also wrote: N. Taleb’s Minority Rule | Your Inner Voice | Bitcoin’s Volatility | Blockchain Stocks | 50 Investment Lessons | Flywheel Effect | Bitcoin: Mental Framework | Crypto Moonshots | 4 Crypto Stocks | Bitcoin: Insurance | Brief History: Money | Spontaneous Order | Ackman’s $2.6B Moonshot | Fragility Inducing Events | Antifragile: Definition | 1% Bitcoin: 99% Cash
twitter.com/C1_Velasquez | carlosvelasquez-5316.medium.com/
Disclaimer: Topics covered herein are for informational purposes. Before acting on investment information consult with a financial professional. This article is intended for people who understand the pro/con impacts of “tail-risk,” “convexity” and asymmetric risk-reward in the context of an investment portfolio.
