Risk Management For People Afraid of Excel
Pulling off the Barbell Portfolio as popularized by Nassim Taleb
Robbie Knievel is best known for launching himself across the Grand Canyon on a motorcycle.
There were only two safe outcomes. He could call off the stunt and stay on his side of the canyon, or clear the gap and land on the other side. Anything in between meant falling to his death. His survival only existed at the extremes, ruin sat in the middle.
Most people’s view on risk is that this is something you should try to eliminate. Variance is bad, regardless of the reward. They only focus on the gulley, ignoring the reward waiting for them on the other side. Others are degens who only focus on the reward, the other side of the Canyon, ignoring the very real possibility of dying.
Neither approach is always right, but at times they aren’t wrong. There are cases when people should try to limit variability and others when they should embrace chaos. At times it’s optimal to combine both.
This applies to investment portfolios, career choices, and even dating. Countless people have earned a living referencing Daniel Kahneman and Amos Tversy research showing how bad people are at making decisions. Much of it stems from a misunderstanding around risk taking.
It’s less complex than people realize. Famed investors such as Nassim Taleb have been giving away the solution for years. It’s called the barbell. Like Knievel, you want to avoid the middle. Embrace risk when the potential payoff is worthwhile, otherwise take as little as possible. This approach lets you chase the upside without compromising your chance of survival. Keep reading to learn how.
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What is Risk?
Most people’s introduction to risk usually comes from games. Parlor games, board games, wagers that sort of thing. Coin flips are easy enough to grasp. The coin has two sides, which guarantees a binary outcome. Heads or tails, one person wins, one person loses. There’s no skill involved so any player has equal odds.
Outside of these games, life doesn’t work this way. Odds and conditions are rarely known ahead of time and performance can play a role. There’s an expected outcome but if actual results can vary, then there is risk. Some risks you can know in advance, like the odds of the coin flip (known-knowns), others you can be aware of but can’t quantify (known-unknowns), others you can’t even fathom (unknown-unknowns).
In the case of the coin flip, if a stranger wagered you $10,000, a mathematician would say your odds are 50-50. That’s the right way to think about your expected payoff but that 50% probability of losing doesn’t capture all of the risks.
This is a stranger so you don’t know enough about them to determine if they can afford to pay you (default risk). Even if they can, they might decide to break your legs and take the money anyway (counterparty risk). These are harder to calculate.
Risk isn’t inherently good or bad, it’s just an acknowledgement of different outcomes. You can think of risk as the umbrella term containing all of the factors that can influence the result. Something is only risk-free if there is only one possible outcome. Examples include forgetting your wife’s birthday or rooting for the Toronto Maples Leafs; both can only end in disappointment.
When you hear terms such as risk, risky or high-risk, this does not mean these are bad things, rather there is a large range of possible outcomes.
Bad Investors Avoid Risk, Good Investors Consider It
(Not Investment Advice)
A common misconception is that classically trained investors try to eliminate risk.
If that were true they wouldn’t be investors. They would be hoarding money under their mattresses. They try to minimize risks that don’t offer enough upside.
Given the choice between an investment with a guaranteed 10% return or another with a 50% chance of -10% with a 50% chance of a 30% return, over the same time period, the classical investor would take the first one. The second investment provides the same expected return but it exposes the investor to the possibility of losing money, without any additional compensation.
Returns are not created equal. According to finance theory, investors that can generate the highest return per the lowest level of quantifiable risk are superior. Returns that are greater than they should be, per the implied level of risk is called alpha. If as an investor you are not seeking alpha, you are a degen.
A degen doesn’t think in terms of risk versus reward. They just look at reward/upside. Meanwhile a bad investor, only focuses on downside risk i.e.. the potential to lose money, without considering the upside.
Imagine a third investment, one that offered a 99% possibility of a 20% return with a 1% of -10% return. A charlatan investor would focus on the 1% chance of losing money and cost themselves major upside. Both the degen and the classically trained investor take the third investment and hope they don’t get hit with that 1% scenario, otherwise the charlatan will never let them hear the end of it.
That’s the most math you’ll need to do this article I promise.
Upside vs Downside Risk
(Not Military Advice)
The examples I’ve given so far rely on the assumption that risks are knowable and quantifiable in advance. In most cases, they’re not.
As much as classically trained investors like to make their pretty Markowitz efficient frontier charts, this only works looking at historical results. The basis of their planning is to hope the future looks like the past. Sometimes it does, until it doesn’t.
When most people think of risk, they usually just focus on downside risk, like the charlatan investor. This is because people experience more pain from a loss than pleasure from an equivalent gain (this is called prospect theory via Daniel Kahneman).
This is a bad way to think about risk. There are many instances where it makes sense to want to increase the range of outcomes, where higher variance is good. When you are badly behind in Backgammon, to increase your odds of winning, you need to play more aggressively, even if it means exposing your own pieces. Your only chance of catching up is to slow your opponent down by putting their pieces in jail.
Similarly in the case of a military conflict, the larger army has the advantage. If the smaller army tried to challenge them head to head in an open field, their chances of winning are poor. To increase their chances, they should try to fight many small skirmishes. It’s harder for the larger military to plan for and the smaller army doesn’t risk their entire army in any individual battle.
Most risk management advice can be deduced into this. When you are leading/have more to lose, try to reduce variance. Avoid anything that can upend the apple cart. The odds are in your favor so you want to narrow the set of outcomes. It’s only when you are behind or the underdog do you want chaos. Act like the charlatan investor when you are ahead, and behave like the degen when you are behind. Otherwise act like the classically trained investor.
What if there was a way that offered better returns and let you sleep well at night?
How Does The Barbell Work
(Still Not Investment Advice)
Your first goal should be survival. You can’t succeed if you’re out of the game.
The barbell focuses on maximizing your odds of survival, while permitting maximal aggression. These sound contrary but they can be complementary.
Imagine somebody gave you a bank account with a hundred thousand dollars but with one caveat. You can’t access it unless you start a business and it fails. It’s not enough money to live off for the rest of your life, but it’s enough to support you long enough to get back on your feet. Would you be more or less likely to start a business?
The more secure people feel, the more risk they can accept. The barbell portfolio is constructed with two buckets. A low return/safe portion, this could include money market funds/short term bonds, gold, maybe regulated utilities. Looking at long term averages, all lag stock market index funds, but the probability of default is low.
The other part of the portfolio consists of high upside/risk positions. Speculative stocks, Crypto, derivatives, options, angel investments etc. They all offer far greater upside but most individual positions lose money. There is a way higher loss rate.
A classically trained investor would avoid most positions belonging to the high upside/risk bucket, because their models would decide the risk is too high for the expected return. The high default rate and other possible risks offset the upside. Meanwhile they would consider the overallocation to the low risk/upside bucket as a drag on returns. Nowadays the consensus view is to buy index funds and avoiding individual positions all together. Finance Substack is calling this strategy The Retardmaxx Portfolio (not my verbiage).
This is the lowest effort way to invest, but it’s not the best to minimize large drawdowns, or preserve high upside. It’s simply just mid. Anybody who bought Bitcoin between 2009-2019 and held to today would have experienced a >1,000% return. Depending on when you bought NVIDIA, or some high flying names, you could be up by a similar amount. If you just bought and held the S&P 500 over the same time span, you’d be up about 200% but still lived through volatile drawdowns, such as the pandemic. Bitcoin and NVIDIA are highly volatile assets, but who with the benefit of hindsight would not have bought them in 2015? Still, sitting around buying highly speculative assets is not a risk strategy, it’s simply degen behavior.
Nassim Taleb looked like a both a degen and a charlatan for most of his investor career. His approach was not about finding the next Bitcoin or NVIDIA. He would buy protection against rare, violent market crashes. These bets usually lost money. In normal years, they looked like an expensive drag on returns. However, when markets broke, they could pay out spectacularly. More than enough to offset his drag years.
The barbell is not designed to make you look smart every quarter. It’s designed to keep you alive when everyone else discovers their supposedly diversified portfolio was one big bet in disguise. The safe portion protects your ability to keep playing. The risky portion gives you exposure to outcomes that can matter disproportionately.
Most people are overly concerned about looking good on a month to month or year to year basis. They lack the nerve to accept frequent small losses in the short term to win in the long term. This is why most people opt for the middle. It keeps them from looking foolish at the expense of being exceptional. The barbell encourages risk taking by building a strong margin of safety.
There are many ways to build a margin of safety. Low debt, high savings, rich experiences, a strong network etc. These are things you can always fall back on if you get unlucky. The more safety you have, the more aggressive you can be and the more variance you can tolerate. This allows for incredible outcomes, like jumping the Grand Canyon.
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