Voices
The philosopher, options-trader, and best-selling author, Nassim Nicholas Taleb, is among the most provocative and original thinkers of our time.
Across many domains, his insights on how we are persistently prone to being ‘fooled by randomness’, blind-sided by ‘the black swan’, and tethered to the ‘fragile’ are central to understanding the world in which we live. They also chime loudly with the mindset of a value investor:
- Luck v Skill / Noise v Signal & Time
I’m sure there are many golfers, tennis-players and football fans reading this today.
For the golfers, consider whether your chance of beating Rory McIlroy is greater after playing a hole, a round, or a tournament?
For the tennis players, whether your chance of beating Rafa Nadal is greater after playing a point, a game, or a set?
For the football fans, whether the chance of Chelsea lying ahead of West Brom in the Premier League table is greater at Halloween, at Christmas, or at the end of the season?
The signal is that McIlroy is a more skilful golfer than you, Nadal a more skilful tennis player and Chelsea – though it pains me to say so – a more skilful team than West Brom. Crucially, the longer the time frame considered, the greater the likelihood of skill trumping luck/of signal trumping noise.
Taleb cites the typically provocative example of Russian roulette, where clearly any tendency to confuse luck with skill will inevitably end with a fatal outcome:
What is true of golf, tennis, football, and Russian roulette is also true of investing. For many, it is the most crucial part of the value investing mindset, as succinctly stated by the great Canadian investor, Peter Cundhill:
‘The most important attribute for success in value investing is patience, patience, and more patience; most investors do not possess this characteristic.’
- The Futility of Prediction
Taleb is probably best known for his conviction that prediction is futile, captured in his memorable parable of the turkey in the run-up to Christmas day.
Every day is a great day for the turkey – he’s got lots to eat, lots to drink, he’s very well looked after. As each day goes by, the turkey becomes more and more convinced that this is the way life should be – he should have lots to eat, he should have lots to drink and he should be very well looked after. But, sometime late on Christmas week – bang – the turkey is dead and heading for the oven.
Tellingly, Warren Buffett also famously ignores prediction, avoids the ‘turkey’ problem, and warns:
‘Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.’
- The Benefit of a Buffer
Taleb also makes a compelling case for the benefit of a buffer, a margin of safety. He argues that any system, entity, or approach that has a buffer/margin of safety has an often critically greater chance of survival and success. The example he gives is that of evolution, conferring two kidneys on the human body, as a buffer against the otherwise fatal consequences of losing one:
The widely lauded value investor, Seth Klarman of Baupost, is such a believer in the importance of a buffer when investing, that he named his major book on the subject ‘Margin of Safety, Risk Averse Investing Strategies for the Thoughtful Investor’ arguing that ‘a margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes.’
- Anti-Fragile – Benefiting from Unpredictability
The next concept of Taleb which resonates powerfully with the mindset of a value investor is the more subtle one of anti-fragility – benefitting from unpredictability.
Anti-fragility is probably best understood by first considering its opposite – the fragile. Taleb uses the example of a china cup sitting on a wooden table at a substantial height above a stone floor. While we have no idea when or why the cup will fall from the table, we do know that when it does it will smash across the unforgiving floor. The cup is fragile – it doesn’t like unpredictability, disorder, or crucially, time.
Taleb defines the anti-fragile as simply the opposite – that which likes unpredictability, disorder, and time. This concept of anti-fragility captures what is arguably the most important Taleb insight of all:
‘Knowing that you cannot predict does not mean that you cannot benefit from unpredictability.’
It is no coincidence that Buffett has been a consistent beneficiary of unpredictability – a consistent beneficiary of anti-fragility:
- After centuries of profitability, the Lloyds insurance ‘names’ go bust – Buffett benefits.
- Hurricane Katrina devastates New Orleans – Buffett benefits.
- The Global Financial Crisis rocks Goldman Sachs and Swiss Re. – Buffett benefits.
- The VHI finally run out of regulatory road – Buffett benefits.
Buffett had no idea that Piper Alpha would explode, that Katrina would devastate, that the global financial crisis would erupt, or that the VHI would suddenly need capital, but he was positioned to benefit from each of these unpredictable events. In Taleb terms, he was anti-fragile.
- Taleb & Pabrai
Finally, it’s important to highlight the echo of Taleb in the approach of the stunningly successful value investor, Mohnish Pabrai.
Pabrai began his career as a technology professional but switched to investing after discovering Warren Buffett in 1994. Since then he has generated an annualised investment return of over 20% and has been the managing partner of the Pabrai Investment Funds since their launch in 1999.
In his disarmingly readable book, The Dhando Investor, Pabrai grounds his investment approach and success in the story of the forced migration of the ethnic Indian population from Uganda to the United States in 1972. Effectively ordered out of Uganda at gunpoint and penniless by the dictator Ide Amin, many of the fleeing migrants achieved remarkable economic success in their new home by following a clearly defined approach to business and investing.
The Dhando approach is a Guajarati concept which roughly translates into seeking exposure to great potential upside with little downside, or as Pabrai memorably puts it in his book, seeking exposures characterised by a Heads I win, Tails I don’t lose much payoff.
The echo of Taleb is clear and powerful. In his 2012 essay, Understanding is a poor substitute for Convexity (Anti-fragility), Taleb provides the telling insight and image:
‘…in complex systems, ones in which we have little visibility of the chains of cause-consequences, tinkering, bricolage, or similar variations of trial and error have been shown to vastly outperform—it is nature’s modus operandi. But tinkering needs to be convex; it is imperative. Take the most opaque of all, cooking, which relies entirely on the heuristics of trial and error, as it has not been possible for us to design a dish directly from chemical equations or reverse-engineer a taste from nutritional labels. We take hummus, add an ingredient, say a spice, taste to see if there is an improvement from the complex interaction, and retain if we like the addition or discard the rest. Critically we have the option, not the obligation to keep the result, which allows us to retain the upper bound and be unaffected by adverse outcomes.’
More Gain than Pain. The performance curves outward, hence looks “convex”. Anywhere where such asymmetry prevails, we can call it convex, otherwise we are in a concave position. The implication is that you are harmed much less by an error (or a variation) than you can benefit from it.
In quoting an old Yiddish proverb, Taleb captures the essence of what can helpfully be thought of as the Dhando approach to antifragility:
‘Provide for the worst; the best can take care of itself.’
To exploit the changing moods of Mr Market, the thoughts of Taleb help illuminate and guide. Resonating strongly with the great value investors, they increase our likelihood of developing the right mindset for success. The focus of the next piece is the significant cost of a particularly flawed mindset: The Dumb Money Effect.
Further reading
A Beginners Guide to Financial Markets: Part 1- The Asset Risk Spectrum
A Beginners Guide to Financial Markets: Part 2 – Diversification & Portfolio Theory
A Beginners Guide to Financial Markets: Part 3 – The Case for Active Investing
A beginners guide to financial markets: Part 4 – the case for value investing
