Betting on The Black Swan: Getting Rich The Impossible Way

Nassim Nicholas Taleb is a trader and a philosopher. His books about the way people think about probability have been obscenely influential, and trading strategies based off of his ideas are becoming an indelible part of the market.

His strategies center around the idea of the “black swan,” an event that’s incredibly unlikely to happen according to the models but has significant power on the market when it does. He made a great deal of money from betting on these events over the last few decades, leveraging what he saw as the mis-pricing of options in order to generate massive returns.

Finding a Black Swan
Taleb defines a black swan event with three attributes: (1) It’s wholly unpredictable given current models, (2) its effect is powerful, and (3) it is incorporated into models after it happens. You can have a better chance of calculating the likelihood of these events than other traders, but Taleb is emphatic on one point, you cannot predict the black swan and you shouldn’t be trying to.

Betting on a black swan isn’t about trying to predict what’s going to happen next year, it’s about finding bets that are mis-priced because nobody has calculated the odds of them properly. Taleb made his money on options that covered all sorts of low probability thresholds that were eventually crossed, most notably during the 1987 stock market crash.

These events may only happen on average once every hundred years, but if you have a hundred of them, you start to average one a year. The payoff is, at the same time, incredibly high because of the extremely low probability. Balancing a portfolio around this idea can be incredibly lucrative, but it’s not for the lighthearted.

You need a strong background in valuing options in order to make this strategy work but, most importantly, you need to know how to build a portfolio. If you’re investing your own money on long term chances, you may run out of cash before anything has a chance of paying off.

Building a black swan portfolio
There’s no case in which an investor should rely entirely on long-odds high-payoff investments to make his money for him, especially when the odds are so long that they’re impossible to calculate. You need to build a portfolio that can offer a steadier stream of income while you wait for the big bets to pay off, assuming they will, or at least one that ensures you don’t lose all your money.

In order to accomplish this, Taleb advises a portfolio in which 80-90% of the money is put in something extremely safe, with Treasuries being the generic instrument, while the rest of the money is invested in out-of-the-money options that carry ridiculous levels of risk.

This portfolio, which he titled the barbell, means that there is a guaranteed floor. You can’t lose your safe money. At the same time there’s huge upside from that once-in-a-hundred year event. If you aren’t familiar with options, however, or you’re not disciplined in your creation of a portfolio, trying to follow this strategy may be enough to wipe you out completely.

Don’t rely on the black swan
It’s been close to thirty years since Taleb discovered the power of so called out-of-the-money options, and many traders have invested in strategies that mirror his in the intervening years. That has risen the price of options covering the kinds of trades he made his name off of.

He was gifted with the 1987 stock market crash as a demonstration of the power of this idea, but he does not believe that strategy would automatically an ordinary investor, simply because there isn’t enough information to price the risks, and therefore, the mean time to happen, properly.

The bottom line is that this strategy takes a lot of work and involves a lot of risk if mismanaged. The original idea was to hold a tiny portion of your money in options for the long term while keeping the rest in something with a lot of safety.

Many investors go for broke investing in what they believe is a Taleb inspired portfolio, forgetting that he was working for an investment bank, and playing with their money, when he invented the strategy.

There’s still money to be made in this area, and there’s still plenty of mispricing of options going on every single day. You have to know when to buy them, however, how to price them, and know how to build a portfolio around them. If not, your returns are going to look downright bad, and you may spend forever waiting for the black swan.