CONSUELO MACK: Right. You were a derivatives trader, you advised hedge funds.
NASSIM TALEB: Yeah. I was, for 20 years, a derivatives trader. I ran a hedge for hedge funds. But one thing about finance is that there's nowhere in the world where you can understand the mechanism of Black Swans as much as in finance. Because everything that happens in history translates into a financial equivalent. To give you an idea: the first Great War, okay? Everybody in school told us when we were school children that it was very predictable. Because there was tension between the U.K. and Germany, right? And Austria. So natural -- you know what? When you know finance, you look at the bonds. The bonds, Niles Fergusson, the historian, showed that the bonds, the war bonds -- there was something called the war bonds, the war bonds did not know about that war. Okay? So it was really unpredictable because it was not priced in the market.
CONSUELO MACK: What do we, as individuals, need to know about the risk that chance plays in our lives? I mean the role that chance plays in our lives and also what do we need to know about these unpredictable events that have, again, these life-altering consequences?
NASSIM TALEB: The first thing I tell people is, "Most of you would not invest a penny in the stock market if you understood the risks." A lot of people take some risks. Not because of courage. Not because of informed decision-making. They take these risks because of ignorance. A lack of awareness and psychological blindness. Some risk involved in finance. For example, you hear stories of "Hey, the stock market yields eight percent, in the last year or so on versus bonds four percent. Therefore, in their mind, okay, they think that these eight percent are going to come year after year. Okay? Assuming it's right, okay? Assuming the story is right, you still have some randomness around this eight percent. You're going to get more some years, less other years, okay? Most people aren't investing while facing the consequences of not having a steady eight percent return. If they knew the variegation they could have, okay, they would not have invested in stocks. Now let's talk about investments that benefit from Black Swans. Typically, the classes of investment that have effectively -- I ignore these stories about stock market, in general, to look at really, what is it that produces returns in the long run? But producing returns in the long run is securities where you tend to lose smaller when you're wrong, or investment, security investment or ventures. And you can make big if you're right. Now what are these investments? Technology. People pooh-pooh tech. I mean people don't like talk down technology, all right? The technology, right, has, look at wealth, accumulation of wealth. Okay? These businesses seem to be volatile. These businesses seem to generally lead to bankruptcies. But you have a small probability of making a huge amount of money. So the businesses that I like are technology, biotech. I mean, think about it. Biotech doesn't seem to look good. But you have that small probability of a cure for cancer. Now these class of investments typically, they're not liked by the community. But they have been historically, okay, underestimated in their potential.
CONSUELO MACK: For an individual investor who wants to not just invest in their own business, which I know, you think is really is the way that most of us are going to make money is by investing in the stuff that we know...
NASSIM TALEB: Yes.
CONSUELO MACK: But for those of us who want a retirement that's more liquid or whatever, we can't invest in venture capital. It's not opened to us. So what do we do?
NASSIM TALEB: So basically, the first thing is negative advice- invest much less in the markets because you don't understand them. Put 90 percent of your money in treasury bills. And then broad diversify across very short-term treasury bills. This is the money you don't want to lose. Now ...
CONSUELO MACK: Except you're losing it on an inflation basis. You're going to lose money possibly every year.
NASSIM TALEB: It definitely beats losing money and then, okay? So with the remaining ten percent, I'm not going to tell you what risks to take. I'm telling you how, the degree of risk, which specific investment. Invest in as broad, as high a number. Okay? Very diversified. Very speculative things. Very speculative. Very diversified. Hopefully, as many as you can...Because you don't know where the next big idea's going to come from.
CONSUELO MACK: Or the next blockbuster drug. Or the next Internet.
NASSIM TALEB: Exactly. Or the next Google or the next Amazon. You don't know. All right? So you invest in these. Okay? And as many, very speculative, preferably ones you understand a little bit, very, very, very high number of these. Okay. Now what you have is a low-risk portfolio....Nothing bad, or a low- to medium-risk portfolio. All right? But it is much more robust, okay, robust to market crashes.
CONSUELO MACK: Two last questions. Bill Miller, who actually recommended, who runs the Legg Mason Value Trust, one of the legendary investors of this century, and the last century, basically recommended that we read your first book, Fooled By Randomness, which we shared with our viewers on an earlier WealthTrack. He wants to know who you’re reading now that is influencing your thinking.
NASSIM TALEB: A phenomenal book called “Serendipity in Medicine” by a gentleman called Meyers. I don't know the exact title. A phenomenal book. I mean, I believe that this is why I don't like theories. I believe that most technological discoveries are accidents. They come so you want to encourage people to do tinkering, tinkering, tinkering. And effectively, that book did a wonderful job at showing how most discoveries, many more discoveries in medicine came by accident than accepted by the medical establishment. That book is a wonderful exercise in showing us how randomness runs discovery.
Thursday, December 13, 2007
Excerpts: Wealthtrack Interview with Jason Zweig
JASON ZWEIG: Well, I think one of the central things I learned from being a guinea pig in these experiments that I couldn't have learned in any other way is the difference between expectation and experience. The human brain, it turns out, is designed to expect events much more intensely than we actually experience them. You hope to make money. That's what we call greed. Greed is an intensely powerful experience. But actually making money rarely feels as good as hoping you will make it feels. Likewise, losing money is something we dread when we think about it in the future, even more than we experience when it actually occurs to us. We're all actually more afraid of losing money than we probably should be. Because it feels terrible, but it never feels quite as bad as you think it will if you're expecting it.
CONSUELO MACK: One of the interesting illustrations where you did not use your brain shows expecting dough, expecting to make money, and it shows the segment of the brain, how it reacts. And then expecting dope, which was actually a cocaine user expecting to score? Or a hit? Whatever it is. What did that show you, number one, and what does it tell you about our brains and our expectations?
JASON ZWEIG: Well, what it shows is what I call the prediction addiction. It's very easy for investors after only a few repetitions of a profitable trade, or a stock where the ticks go up, up, up. The stock is $10.12, then it's $10.14, then it's $10.17- you're a genius. You're actually addicted to your own belief in your predictive ability.
CONSUELO MACK: And your brain shows, I mean, shows an addiction? Right? There's a way ...
JASON ZWEIG: The way we can identify it is very simple. If you compare a brain scan of someone under those circumstances, who’s on a hot streak with a financial investment, against the brain scan of a drug addict expecting to get the next hit from a needle, you can't tell the two brain scans apart. That's very important for people to realize. Because what it tells you is that being right is also dangerous. Because that's when people take the wild risks that come home to roost.
CONSUELO MACK: When is it that you're at most danger?
JASON ZWEIG: One of the really astonishing discoveries to come out of neuroeconomics is that the brain has automatic formation of expectations. So once something happens twice in a row, you will, you shall, believe that it will happen a third time. So if a stock goes up, and then up, it's almost impossible for you not to believe that it's going to go up a third time. And Ben Graham wrote about this many years ago in The Intelligent Investor, when he said that the investing public is incorrigible. It cannot count beyond three. And it's as if Ben actually anticipated this discovery of neuroeconomics. And that's important for people to realize too. You will perceive a trend so fast in the modern Internet, you know, financial television world, where things are broadcast continuously in real time. You see ticks constantly. Our parents could only price their portfolios once a day, maybe once a week. We can do it five, ten times a minute. And that leads us to perceive trends constantly. And most of them are just illusions.
...
CONSUELO MACK: So when do emotions play a constructive role in the investment process?
JASON ZWEIG: Well, emotions can be so helpful if you're able to put them in context. And one of the bits of advice I give in the book is to keep an emotional registry, a kind of diary or journal. And only if you do that can you really learn when you should trust your emotions. Chances are you can't trust them much at all, but you may be able to use them as a perfect guide to what your behavior should be by always doing, in effect, doing the opposite. And that's why Warren Buffet likes to say, "I try to be greedy when other people are fearful, and fearful when other people are greedy." The trick is, it's hard to turn your emotions inside out. You certainly can't turn them off. But what you can do is you can adjust your rules with a little input from your emotion. For example, if your normal target for owning stocks is 70 percent of your portfolio and you feel that the market has gone way up, and you feel that you're euphoric, then you have to signal that you should just, you know, buy a little bit more in bonds. At that moment.
...
CONSUELO MACK: One other question. What was the biggest surprise for you in Your Money and Your Brain, as far as your experience?
JASON ZWEIG: I think the biggest surprise for me was learning that the brain can make decisions without you being aware of it. I participated in an experiment at Emory University, where my job, my task in the brain scanner, was to try and identify which of two investments would have a higher return. And it was a fiendishly clever experiment. And we can't explain it completely on the air. But to make a long story short, I was attempting, with my conscious brain, to identify the winning pattern. When, all of a sudden, my automatic brain, the very primitive part of the brain that some people call the "reptile brain," identified it without my even realizing it. And I was furiously tapping my left finger on the button press inside the machine. Because this part of my brain had figured out what to do, while the thinking part was completely stymied. And what did it was I got a few hits of sugar water through the pacifier that was stuck in my mouth. And what this tells you is that you can be motivated by the most primitive stimulus, and it can lead you to an automatic decision that you're completely unaware of, and you may never realize it happened to you.
CONSUELO MACK: Was it the right decision?
JASON ZWEIG: In that case it was, yeah. I walked away $40 richer.
CONSUELO MACK: One of the interesting illustrations where you did not use your brain shows expecting dough, expecting to make money, and it shows the segment of the brain, how it reacts. And then expecting dope, which was actually a cocaine user expecting to score? Or a hit? Whatever it is. What did that show you, number one, and what does it tell you about our brains and our expectations?
JASON ZWEIG: Well, what it shows is what I call the prediction addiction. It's very easy for investors after only a few repetitions of a profitable trade, or a stock where the ticks go up, up, up. The stock is $10.12, then it's $10.14, then it's $10.17- you're a genius. You're actually addicted to your own belief in your predictive ability.
CONSUELO MACK: And your brain shows, I mean, shows an addiction? Right? There's a way ...
JASON ZWEIG: The way we can identify it is very simple. If you compare a brain scan of someone under those circumstances, who’s on a hot streak with a financial investment, against the brain scan of a drug addict expecting to get the next hit from a needle, you can't tell the two brain scans apart. That's very important for people to realize. Because what it tells you is that being right is also dangerous. Because that's when people take the wild risks that come home to roost.
CONSUELO MACK: When is it that you're at most danger?
JASON ZWEIG: One of the really astonishing discoveries to come out of neuroeconomics is that the brain has automatic formation of expectations. So once something happens twice in a row, you will, you shall, believe that it will happen a third time. So if a stock goes up, and then up, it's almost impossible for you not to believe that it's going to go up a third time. And Ben Graham wrote about this many years ago in The Intelligent Investor, when he said that the investing public is incorrigible. It cannot count beyond three. And it's as if Ben actually anticipated this discovery of neuroeconomics. And that's important for people to realize too. You will perceive a trend so fast in the modern Internet, you know, financial television world, where things are broadcast continuously in real time. You see ticks constantly. Our parents could only price their portfolios once a day, maybe once a week. We can do it five, ten times a minute. And that leads us to perceive trends constantly. And most of them are just illusions.
...
CONSUELO MACK: So when do emotions play a constructive role in the investment process?
JASON ZWEIG: Well, emotions can be so helpful if you're able to put them in context. And one of the bits of advice I give in the book is to keep an emotional registry, a kind of diary or journal. And only if you do that can you really learn when you should trust your emotions. Chances are you can't trust them much at all, but you may be able to use them as a perfect guide to what your behavior should be by always doing, in effect, doing the opposite. And that's why Warren Buffet likes to say, "I try to be greedy when other people are fearful, and fearful when other people are greedy." The trick is, it's hard to turn your emotions inside out. You certainly can't turn them off. But what you can do is you can adjust your rules with a little input from your emotion. For example, if your normal target for owning stocks is 70 percent of your portfolio and you feel that the market has gone way up, and you feel that you're euphoric, then you have to signal that you should just, you know, buy a little bit more in bonds. At that moment.
...
CONSUELO MACK: One other question. What was the biggest surprise for you in Your Money and Your Brain, as far as your experience?
JASON ZWEIG: I think the biggest surprise for me was learning that the brain can make decisions without you being aware of it. I participated in an experiment at Emory University, where my job, my task in the brain scanner, was to try and identify which of two investments would have a higher return. And it was a fiendishly clever experiment. And we can't explain it completely on the air. But to make a long story short, I was attempting, with my conscious brain, to identify the winning pattern. When, all of a sudden, my automatic brain, the very primitive part of the brain that some people call the "reptile brain," identified it without my even realizing it. And I was furiously tapping my left finger on the button press inside the machine. Because this part of my brain had figured out what to do, while the thinking part was completely stymied. And what did it was I got a few hits of sugar water through the pacifier that was stuck in my mouth. And what this tells you is that you can be motivated by the most primitive stimulus, and it can lead you to an automatic decision that you're completely unaware of, and you may never realize it happened to you.
CONSUELO MACK: Was it the right decision?
JASON ZWEIG: In that case it was, yeah. I walked away $40 richer.
Tuesday, December 11, 2007
Managed futures fund
We've taken a position in Rydex Managed Futures, a mutual fund that is long-short (except can't short energy) commodities futures contracts. It tracks the S&P Diversified Trends Indicator (SPDTI) and it's 50/50 split between commodities futures and currency futures. Top three commodities are energy (18.75%), grain (11.5%), and precious metals (5.25%). Top currencies are US Treasuries (15%), EUR (13%), JPY (12%).
The fund launched in March 2007 and we invested in July.
A big reason I'm interested in the SPDTI index can be seen in the table below.
Relatively high Sharpe ratio, negative correlation to S&P 500, and relatively high rates of return (see chart below).
Also, commodity futures have the benefit of rolling return, which over the long-term should translate into a non-zero yield. Investing in commodity companies doesn't capture the rolling return, since companies are on the opposite side of the contract. In that sense, commodities companies are indirectly paying the roll premium, while the investor futures receives it.
The Rydex fund invests partially through structured notes, which are intended for the retail and small institutional investor market from what I understand. While there is overhead associated with the structure, it's required given the size of the fund.
The trading strategy is to long if the current price inputs are higher than the exponential average of the prior 7 price inputs. Short is the opposite condition. If energies are giving a short signal, the fund zeroes the energy position (no short).
Fees are a little heavy (1.65% for H-Class - turns out to be 1.77% so far this year, according to their website), but worth it for the diversity it offers the portfolio in terms of negative correlation.
As of Sep 30, 2007 the fund has about $161MM in net assets, consisting of $11.5MM in long currencies (in the form of various currency and US treasury ETFs), $48.2MM in commodity structured notes, $101MM in repo agreements, $4MM in lending collateral (to back their short positions), and $2.9MM in short positions (iShares Silver Trust, CurrencyShares Australian Dollar Trust), Streettracks Gold Trust, and PowerShares DB Base Metals Fund).
The fund launched in March 2007 and we invested in July.
A big reason I'm interested in the SPDTI index can be seen in the table below.
Relatively high Sharpe ratio, negative correlation to S&P 500, and relatively high rates of return (see chart below).
Also, commodity futures have the benefit of rolling return, which over the long-term should translate into a non-zero yield. Investing in commodity companies doesn't capture the rolling return, since companies are on the opposite side of the contract. In that sense, commodities companies are indirectly paying the roll premium, while the investor futures receives it.
The Rydex fund invests partially through structured notes, which are intended for the retail and small institutional investor market from what I understand. While there is overhead associated with the structure, it's required given the size of the fund.
The trading strategy is to long if the current price inputs are higher than the exponential average of the prior 7 price inputs. Short is the opposite condition. If energies are giving a short signal, the fund zeroes the energy position (no short).
Fees are a little heavy (1.65% for H-Class - turns out to be 1.77% so far this year, according to their website), but worth it for the diversity it offers the portfolio in terms of negative correlation.
As of Sep 30, 2007 the fund has about $161MM in net assets, consisting of $11.5MM in long currencies (in the form of various currency and US treasury ETFs), $48.2MM in commodity structured notes, $101MM in repo agreements, $4MM in lending collateral (to back their short positions), and $2.9MM in short positions (iShares Silver Trust, CurrencyShares Australian Dollar Trust), Streettracks Gold Trust, and PowerShares DB Base Metals Fund).
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