Select durable investments

You shouldn’t worry about black-swan events, says Nassim Taleb. You should worry about an investment’s vulnerability to those events – in other words, its fragility.

The author of The Black Swan has a new book, Antifragile: Things That Gain from Disorder, due out this fall. The premise? “Some things love randomness and volatility,” Taleb told an event hosted by the Alternative Investment Management Association in Toronto.

For instance, bones benefit from greater stress; otherwise they lose density.

As the book’s prologue says, “Anti-fragility is beyond resilience or robustness: the resilient resists shocks and stays the same; the antifragile gets better.”

The key for portfolio managers is to find anti-fragile investments, and avoid fragile ones.

What’s fragile?

Take an e-reader and a book. Most people think the e-reader is more robust – it can store thousands of manuscripts; it’s lighter; some are multifunctional.

But pour water on that device, and it’s fried. The book? Leave it by an open window for a few hours, and resume reading.

“Almost anything you make more efficient, you make more fragile,” Taleb explained. “You cannot measure risk, but you can measure fragility.”

Fragile investments are disproportionately harmed by outsized events; the effects can be plotted on a concave (frowning) curve. “You lose more when you’re wrong.”

Anti-fragile investments lose less when you’re wrong, and the effects of shocks can be plotted on a convex (smiling) curve.

To find out if an investment is fragile or anti-fragile, test what happens if the markets drop 10%. Then, simulate a 9% and an 11% drop. If the investment does disproportionately worse with an 11% drop (harm accelerates), it’s fragile. If the impact is less than expected with an 11% drop (harm decelerates), it’s anti-fragile.

Taleb said debt is fragile, equity is robust, and venture capital is anti-fragile. Private debt can be robust, but only if it’s turned into equity. In the U.S., the opposite has happened: private debt has been turned into public debt thanks to bank bailouts.

Read: Taleb: taxpayers should dictate banker salaries

So what to buy? Taleb chooses investments with small downsides and large upsides: penny stocks, distressed assets, and options. “You want investments that clip the left tail.”

Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.