“You find peace by coming to terms with what you don’t know.”
–Nassim Nicholas Taleb
Imagine yourself in a room with 99 other average people. What’s the average weight? If you’re a male, it’s 191 pounds. If you’re a female, it’s 164.3 pounds. What happens to the average weight if you add the world’s heaviest male or female to the room? The heaviest male weighed 1,400 pounds. The heaviest female weighs 643 pounds. For men, the average weight would go up to 203 pounds, a 6.3% increase, and for women, the average weight would go up to 169 pounds, a 2.9% increase.
Now, do the same thing for measuring wealth. The average family net worth is $77,300. Drop Carlos Slim into the room. He’s worth $69 billion. You’ve now increased the average net worth in the room to approximately $683 million, or a roughly 880,000% increase.
This exercise is outlined in the book The Black Swan by Nassim Nicholas Taleb. He discusses how we are very good at averaging things out, but terrible at identifying the extreme outliers. Furthermore, we underestimate the actual probability and magnitude of outliers which will positively or negatively impact us.
Think about how the lottery works. The theme of the lottery is “someone has to win, so why not you?” The lottery officials and the media trot out the winners to make them seem like they’re everyday people and that there are lottery winners everywhere. People fall victim to recency bias and go out and buy lottery tickets with the expectation that it’s going to be them. They think that the chances of winning are actually much better than the mathematics reveal them to be. The blind spot of evaluating black swans shows itself.
Taleb ran a hedge fund through his company Empirica Capital seeking to take advantage of the blind spot that we have for black swans. The idea was to make many small bets on outliers where the magnitude of the outlier would be enormous. His firm invested in call and put options where, according to their calculations, impact of outlier * probability of outlier > price of option.
If you read the book, the strategy seems simple. Michael Lewis tells of a story in The Big Short where a couple of guys pooled all of their money together, approximately $100,000, made two consecutive options purchases based on similar thinking, and became multi-multi millionaires. Suddenly, the idea is reinforced in your head. Two guys, one phone call, one meeting, and boom! Gulfstream, here I come!
I can also set up the World Coin Flipping Championship, invite 1,024 participants to compete for the grand prize (a two headed quarter, perhaps?), and watch them go. At the end of the competition, there will be a champion. Would you bet anything other than even odds on the winner for the next coin flip?
For every story of a big winner we hear, we never hear the stories of the small (and big) losers. They don’t make for good media stories. The public wants to hear about the extremes. Don’t fall into the trap of thinking that you can be the next lottery winner or that you can predict the next black swan derivatives investment. Here are some reasons why you’re not Nassem Nicholas Taleb.
- He had the capital to make a lot of small bets. Every day, Taleb would put several hundred thousand dollars into the market in a series of small bets with tremendous upside if they worked. Then he played a waiting game. He only had to win occasionally for the strategy to work, but he also had to have the capital to withstand wrong bet after wrong bet after wrong bet.
- He had sophisticated math and software to help him identify and make bets. He could screen out millions of different call and put options variations to identify what he thought was a mispriced opportunity.
- He had the system, and therefore, the discipline to stick to his thesis. As he says, “It’s much harder to be the other guy, the guy losing money three hundred and sixty-four days out of three hundred and sixty-five, because you start questioning yourself. Am I ever going to make it back? Am I really right? What if it takes ten years? Will I even be sane ten years from now?”
- He had experience in trading in the markets long before he started his hedge fund. He had immersed himself in data and in experience and knew how to build a system which would identify the opportunities for investments.
- He had the quantity of capital to make a small net gain meaningful. The psychological trauma of watching your fund lose tens to hundreds of thousands of dollars a day while waiting for the fifty million dollar win must be agonizing. So, even if at the end of the year, he’s up 8-10%, it came at the cost of horribly wicked volatility, but he also probably made millions of dollars – life changing money. Could you stomach taking $50,000, doing the same approach in miniature, watch the value go down to, say $2,500, only to be up to $55,000 at the end of the year – a $5,000 gain? If you want or need the extra $5,000 so badly that you’re willing to take that sort of roller coaster ride with your wealth, come up with the ideas which will give you an equivalent pay raise at work or get a second job.
- You can identify opportunities which will have a higher likelihood of payoff. You can take the same approach as Taleb and try to create your own black swans. If you can spend $1,000 to create a small business which eventually pays you something which resembles your current paycheck, you have created your own personal black swan.
If you’re itching to go hunting after black swans, by all means, go for it. However, don’t try to do it in the options market. Instead, create your own black swan and capture all the value you can out of it.