In Fooled by Randomness, Nassim Nicholas Taleb teases us with the idea that we can take advantage of black swan events in our life and in our investments. I say tease because he's very short (pardon pun) on specifics in my reading. I want to try to flesh out the ideas as best I can.

Taleb cites a statement made by famous commodity trader/investor Jim Rogers:

"I don't buy options....90 percent of all long options lost money." ~ Jim Rogers

Rogers confused probability with expectation.

By itself, the 90 percent number doesn't give us enough information to make a decision about options. What we need to know is the expected payoff of options. The 90% number describes probability; we want to know the expection, which equals the probablity X payoff.

If the winning 10 percent of options yielded a lot of money, then options might actually carry a VERY good expectation of making money. See chart below:

Option Lost $90%-$1-$0.90
Option Gain $10%$100+$10.00

The chart illustrates the idea. Does the idea exactly match reality? Never. The numbers can't be reliably predicted. So what is one to do?

The best description of my lifelong business in the market is "skewed bets," that is, I try to benefit from rare events, events that do not tend to repeat themselves frequently, but, accordingly, present a large payoff when they occur.

I try to make money infrequently, as infrequently as possible, simply because I believe that rare events are not fairly valued, and that the rarer the event, the more undervalued it will be in price."

~ Nassim Taleb, FBR, p.103

So Taleb actually tries to benefit from the rare events, not avoid them. He does this by placing bets on rare events with a large payoff. He's not very specific on how this is done, but it almost certainly (pun?) involves derivative options.

In the book he illustrated the point by describing a meeting he attended where he was asked the direction of the market. Though he generally doesn't answer such questions, he ultimately said he believed it was going up--that the probability it would go up was high.

But the traders countered that he had placed bets that would only payoff if the market went down (put options on S&P 500); how can you say it's going up yet bet it's going down?

Because of expectation. Yes, at that time, most people thought the market was probably going up. But IF it went down--if that rare event occurred--Taleb's bet would payoff big.

So while he thought the market would probably go up, he placed bets to benefit huge if it went down. That's betting on expectation and not probabilities.

This bet took the form of some long-term derivatives (put options). With such an investment(?), the potential (and likely) losses can be relatively small (the cost of the option) but the payoff potentially huge. The idea is that you expect to lose most of the time, but when you win, you expect to win big.

So as long as your numerous losses are small, and the unexpected event does in fact occur, you can get win big.

There are no guarantees. You could bleed to death (hold lots of expired options) while waiting for the black swan, which is why Taleb stresses to keep most of you money in the safest investments possible (Government securities?).

Only use a small portion of your nest egg for chasing black swans.

So Nassim Taleb's best investment advice is to keep most of your money absolutely safe, but for a small percentage, chase black swans.

So what happens if you follow this idea? You buy out-of-the-money option on a broad basket of stocks (e.g., stock index option). What do you do if the rare event occurs? When do you sell?

Again, you can't predict what will happen. One "option" is to buy options in that insure your rare event position that's paying off. No reason to risk that gain. Keep the option as long as you can and execute near the end of its maturity. Or you can sell the option and buy another with an extended maturity (probably at a premium now). Whatever, the main point is to avoid being the one "holding the bag" should a negative black swan event occur while you're holding the positive black swan option.

Taleb also talks of industries are structured to benefit from black swans, like some publishers, venture capitalists, movie producers, etc. And some industries that structured to be hurt by black swans, like insurance companies.

To take advantage, we'd like our pool of stocks to contain only those industries structured to benefit from black swans.

We don't have to limit ourselves to stocks. Interest rates, currencies, commodities, etc. should all fit the model. In fact, it may be an advantage to invest in less widely reported investments so you can more easily avoid the news/noise about the investments. It's a thought.

Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets by Nassim Nicholas Taleb
The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb

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