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Saturday 3 November 2012

Barbell strategy (2)

Read? Barbell strategy

Nassim Nicholas Taleb (pictured), principal of Universa Investments and famed author of “The Black Swan”, delivered a keynote speech on some useful properties of barbells at Gaim International 2012. Noting that the opposite of fragile is “antifragile”, Taleb explained that barbells – a type of investment strategy that sits on both ends of the yield curve for example in bonds – possess this antifragile characteristic, enabling them to benefit from crises.

Barbells, then, have the capacity to turn something that’s robust into something antifragile.

If you have a lot of upside and a lot of downside in a portfolio (left tail distribution) it’s still fragile said Taleb, noting that antifragility has a big right tail distribution with big upside and little downside. Constructing a barbell, said Taleb, involves “clipping the left tail”.

In terms of strategy, said Taleb, instead of investing in medium-risk securities you invest 80 per cent of money in zero risk securities (left side of the barbell) and 20 per cent in maximum risk securities (right side of the barbell). “The linear correlation is vastly superior to medium-risk securities,” said Taleb. “Barbells put you in a situation where error and uncertainty help.”

The reason barbells are important is because today we’re building systems that are vulnerable to model errors. After all, small changes in the standard deviation of tails can blow things up. You want to be protected from any concentration of risk in the left tail and replace that with barbells said Taleb.

“Anything that has a right tail increases with variance and these portfolios gain from variance: we call that the barbell theory,” said Taleb. He said that uncertainty should be welcomed because that’s what nature itself is built on. Evolution is based on things failing and being replaced by stronger equivalents.


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