The “Black Swan” Trader Strikes Again

In today’s “two-for-the-price-of-one” recommendation, we pair one of the best distressed debt vehicles available, with a company that offers an inflation hedge through its exposure to higher commodity prices.

How to Use Nassim Taleb’s “Two-For-One” Barbell Strategy

A Sure Bet and a Moonshot (But No “Mushy Middle”)

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Nassim Taleb hates soccer moms.

Trader, philosopher, statistician, and risk maven Taleb – the author of the modern investing classic The Black Swan – doesn’t have a thing against beige minivans or oranges cut into smiles. And a close reading of his multiple writings doesn’t reveal any opposition to young humans exhausting themselves chasing a ball on a grassy field.

But one thing that eats Taleb’s lunch is the pudgy middle… conformity… the boring, moderate approach… and too much order.

The thing is, that’s precisely what soccer moms (and dads, for that matter) strive for: Schedules, timetables, lists, and OCD-on-steroids levels of orderliness. After all, a low-stress family life and randomness aren’t usually compatible.

But what’s good – or easier – for soccer parents isn’t necessarily the best thing for the long-term development of their offspring.

Taleb explains: “Soccer moms try to eliminate the trial and error, the antifragility, from children’s lives, move them away from the ecological and transform them into nerds working on preexisting [soccer-mom-compatible] maps of reality… further, they are now totally untrained to handle ambiguity.” And organized athletic activities aren’t his jam: “…sports tries to put randomness in a box like ones sold in aisle six next to canned tuna — a form of alienation.”

Now, it’s up to the reader whether or not to take parenting advice from the iconic – and iconoclastic – Taleb. He sticks to a “caveman” diet (if a caveman wouldn’t eat it, he won’t), doesn’t use sunscreen, and gets up at 4 am every day. And – while he did raise two children – he’s long declined to acknowledge publicly the existence of a current or former Mrs. Taleb.

But Taleb’s dislike of soccer moms, and their penchant for structure, relates directly to how he addresses risk in investing.

It’s best explained by what he calls the “barbell strategy”.

A barbell, of course, is a cylindrical bar with weights on both ends. It’s also a way to illustrate the notion of how extremes are kept separate — while avoiding the middle.

In investing, Taleb explains, the objective of the barbell is to reduce downside risk, via “the elimination of the risk of ruin.”

This involves structuring a portfolio with the majority of capital in ultra-safe investments – the “sure bets,” as Taleb explains. These are investments where the chance of long-term capital impairment (i.e., the odds of losing money over a 10-year time horizon) is as close to zero as possible.

On the other side of the barbell are the moonshot opportunities, which target substantially higher returns of 5 – 10x or more. But because this kind of upside often comes with substantial risk, they should make up a very small portion of a portfolio… small enough that a total loss wouldn’t matter much. (Our sole “max risk” position has so far been our only major loss.)

Taleb’s barbell approach to capital allocation entails a foundation of durability on the one hand, while still retaining the opportunity for huge upside potential on the other. He describes his barbell strategy this way in The Black Swan:

“If you know that you are vulnerable to prediction errors, and if you accept that most “risk measures” are flawed, because of the Black Swan, then your strategy is to be as hyperconservative and hyperaggressive as you can be instead of being mildly aggressive or conservative. Instead of putting your money in “medium risk” investments (how do you know it is medium risk? by listening to tenure-seeking “experts”?), you need to put a portion, say 85 to 90 percent, in extremely safe instruments, like Treasury bills – as safe a class of instruments as you can manage to find on this planet. The remaining 10 to 15 percent you put in extremely speculative bets, as leveraged as possible (like options), preferably venture capital-style portfolios. That way you do not depend on errors of risk management; no Black Swan can hurt you at all, beyond your “floor,” the nest egg that you have in maximally safe investments.

Part of Taleb’s solution to the predilection of soccer moms for the mushy middle – his family-life equivalent of dangerous, impossible-to-quantify moderate risk – is to give kids enormous leeway to explore on their own, with no limits… and take on “risk” in that way. That is, balance some structured activities, with lots of time to roam, create, read, dream, wander, and wonder.

More broadly in life, Taleb advances the barbell as “any dual strategy comprised of extremes, without the corruption of the middle — somehow they all result in favorable asymmetries.” In other words, he says, “ignore small dangers, invest your energy in protecting… from consequential harm.”

And right now, we are staring down the barrel of “consequential harm” like never before…

As we’ve written before, the markets are on the cusp of an unprecedented Minsky moment. Global central banks spent the last 13 years inflating the greatest debt bubble of all time. Now, those same central banks are popping the bubble, with the most aggressive rate hiking campaign in 40 years. This sets the stage for a deflationary debt collapse in the very near term. The only hope for governments and central banks to avoid this scenario will be to bail out the global financial system with a record flood of newly issued currency.

That’s why every portfolio needs insurance against two possible tail-risk scenarios: a deflationary debt collapse, or runaway devaluation of fiat currencies, including the U.S. dollar. So we’re taking a page from Taleb’s playbook and introducing a barbell approach of our own.

In today’s “two-for-the-price-of-one” recommendation (after all, we love a bargain), we pair one of the best distressed debt vehicles available, with a company that offers a tremendous inflation hedge through its exposure to higher commodity prices.

We should note that our barbell strategy, while inspired by Taleb’s, is not identical to it – he prefers to put the 85% “sure bets” portion of his portfolio into instruments like T-bills, while with our current recommendation we’re a bit more aggressive.

For the heavy 85% of our barbell, we recommend a hyper-conservative investment vehicle overseen by Howard Marks, one of the best risk managers on Wall Street. Marks is the master of playing defense when markets are frothy, and uncovering hidden gems – most notably, low-downside, distressed assets offering a high margin of safety – buried within the rubble of financial collapse.

Barbell Part One: Distressed Debt Investing with Howard Marks