Tuesday, August 3, 2010

Risky Business

In his 2007 book The Black Swan, author and former Wall Street quantitative trader Nassim Nicholas Taleb writes that life is far more uncertain than most people realize, and they therefore unwittingly take on far more risk than they intend to. Some of those risks are completely unforeseen and carry massive consequences--so massive, in fact, that they can sometimes dwarf the consequences of practically everything else. Taleb calls these unknown catastrophic risks "black swans." But not all black swans are bad; some of them can result in astoundingly good fortune. More generally, Taleb defines a black swan as "a highly improbable event with three principal characteristics: It is unpredictable; it carries a massive impact; and, after the fact, we concoct an explanation that makes it appear less random, and more predictable, than it was."

In one passage in the middle of the book, Taleb observes that knowledge of the existence and prevalence of black swans can actually help us make wiser investment decisions (boldface mine):

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. Or, equivalently, you can have a speculative portfolio and insure it (if possible) against losses of more than, say, 15 percent. You are "clipping" your incomputable risk, the one that is harmful to you. Instead of having medium risk, you have high risk on one side and no risk on the other. The average will be medium risk but constitutes a positive exposure to the Black Swan.

This "barbell strategy" of being simultaneously hyperconservative and hyperaggressive embodies an example of what decision theorists and game theorists call "minimax" and "maximin" rules: (1) minimizing one's maximum possible loss and (b) maximizing one's minimum possible gain. By being hyperconservative with the majority of one's portfolio, one ensures that a massive decrease in the portfolio's value will be avoided (minimax). And by being hyperaggressive with a sliver of the portfolio, one maximizes the gains to be achieved if that sliver happens to do well (maximin). In other words, the biggest of the bad black swans can't hurt you very much, but the biggest of the good black swans can help you quite a bit. Theoretically speaking, this is a solid investing strategy for an environment in which massive uncertainty abounds.

There's just one problem with it. Notice the phrase I highlighted in boldface in the passage above: "...extremely safe instruments, like Treasury bills--as safe a class of instruments as you can manage to find on this planet." Talk about irony; Taleb's entire book is an explication of how and why most people are disturbingly unaware of black swans, yet his confident statement about the safety of Treasury bills betrays a lack of awareness of one of the biggest black swans of our time: The fate of the U.S. federal government and, by extension, anyone holding its debt instruments and using its currency.

One of the biggest financial risks in the U.S. today is default or hyperinflation by the federal government. Its ever-growing mountain of debt, combined with its ever-growing trade deficit, means that for decades, the U.S. has effectively been importing massive quantities of real goods from abroad in exchange for borrowed dollars. We have been able to get away with it thus far only because the dollar enjoys the privileged status of being the official global reserve currency. But when economic reality reasserts itself and our foreign creditors come to their senses, the dollar will be dropped--either immediately or gradually--as the global reserve currency. At that point, the U.S. government will have to choose between (a) default or (b) hyperinflation. Raising taxes by the amount required to eliminate the debt will be unrealistic and therefore not a viable option.

Whether the government chooses default or hyperinflation (my bet is on hyperinflation since it's easier for politicians), Treasury bills will become worthless. In the former case, Treasury holders will not get their principal paid back. In the latter case, they'll get their principal paid back, but only in near-worthless dollars since the money will be printed out of thin air by the Federal Reserve. Yet most people seeking preservation of capital continue to buy Treasury bills like they're the safest financial instrument in the world. Those people are in great financial danger and they don't even know it. Talk about a black swan!

Even if the U.S. default/hyperinflation scenario does not play out within the next few years, investors are still faced with the reality that Treasury bills provide a guaranteed negative real rate of return. In other words, if you invest in Treasury bills, you're guaranteed to lose purchasing power over time. The reason is inflation. If you ignore the "official" government estimate of price increases--the Consumer Price Index (CPI)--and instead look at an unbiased estimate (e.g., from Shadow Government Statistics), you see that overall prices are currently increasing around 8% per year. With Treasury bill yields currently close to zero, this means that money invested in Treasury bills currently have a real (as opposed to nominal) yield close to negative 8%. That's an 8% loss every year. That's not being "hyperconservative"; that's being fleeced.

What has happened over the years is that governments and their central banks have gradually made financial risk-taking unavoidable. "Hyperconservative" investments no longer exist. Years ago, when most developed countries in the world still backed their currencies with gold, simply saving was a safe and effective way to preserve one's wealth. Saved gold--even gold stuffed under one's mattress--would actually grow in purchasing power over time as the economy grew. (Increasing amounts of goods and services + a fixed supply of gold = increased purchasing power per unit of gold.) The discipline of gold rewarded the virtue of thrift. Those days are gone. Now, government policies punish thrift and conservative investment decisions. In order to get a positive real rate of return and defend oneself against the impending financial meltdown of the U.S. government, one is now forced to invest in assets that have historically been referred to as "risky": foreign currencies and stocks, precious metals, commodities, etc.

These days, all investing is risky business. The investors who think they're avoiding risk (including the ones who buy Treasury bills) are just unaware of how vulnerable their portfolios really are.

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