June 11th, 2018

by Brian Stoffel
April 3, 2018
The Motley Fool

Stoffel: I read recently that you gave an interview -- I think it was on Bloomberg -- where you talk about where your own skin is in the game. One thing you wrote is that it is not rational to be long stocks without having some sort of hedge against stocks. That's because their valuations are so high, because there are tail risks...?

Taleb: No -- even if the valuations were low. If the market delivers a crazy valuation, it can deliver a crazy valuation in any direction.

Stoffel: So, for your normal person who works as a plumber or an electrician, what is a good hedge against stocks? Just cash?

Taleb: Well, the point is as follows: if your assets are $100 and you allocate $50 to stocks, then you are ergodic -- assuming those $50 are allocated to stocks, you don't want to decrease them at any point in time.
Let me explain the foundation of the problem: All of these analysts who look at you and the stock market assume that if you invest in the stock market, you'll replicate the performance of the stock market. The problem is, if you ever have an "uncle point" -- where you have to liquidate -- then your return will not be the stock market's. It will be the returns to your "uncle point" -- which is negative.
In other words: The market can have a positive expected return, and you have a negative expected return.
It's very similar to Russian roulette. Russian roulette is a very simple example. If you play Russian roulette with a positive expected return of 80% -- or, whatever it is, five out of six?

Stoffel: I haven't played, so I'm not sure [laughter].

Taleb: [laughter] You can't cheat to be dead. So it's the same thing with casinos. If you gamble in a casino at a roulette table, even if you have a positive expectation, you're guaranteed -- eventually, at some point -- to go bankrupt ... even though you had a positive expectation.

Stoffel: And that's the difference between ensemble [average] and time [average], correct?

Taleb: Exactly. Because probability over time depends on what happened right before. Whereas probability of the ensemble doesn't have to worry about what happened before it. So you have that discrepancy...when you invest.
So as an investor you need to think about it in these terms: no investor knows what's going to happen to him or her in the future. You don't know -- I mean, the market may deliver whatever people claim it will deliver. But if you have a drop in the market that may force you to liquidate -- particularly a drop in the market that may correlate with your loss of business elsewhere -- then, automatically, your returns will be the returns from today until that drop in the market. It de-correlates from the market.
And this is not well understood by finance people... unless you trade. I know a lot of people, for example, when I was short bonds. When I'm short bonds, people think that, hey, typically I will lose money if the market rallies. And the opposite actually happens.
I tend to make money when the market rallies although I'm short. Because -- typically -- you pick your points -- maybe you're only short for 30% of the year, not the whole year -- so you're dynamically hedged. And you pick your points, and you go in and out.
So I noticed over time -- for example -- my best returns from markets are the opposite of what the market has done. So negative correlation. That's simply because I'm long the markets, typically. And I like to buy after dips -- just buy after dips... even in a bear market. And of course, get out after the market recovers. Even in bear markets, you can make money.
This is well understood by traders. Traders say the direction of the market doesn't matter much. It's your techniques that matter.
But for investors, the same applies, unless this is an amount of money that you will never liquidate, and you transmit across generations.
What I've been doing is saying: If you have an investment -- as an institutional investor, forget the individual investor -- and you don't have a tail-hedge protection, then your returns are virtually going to be zero -- over the long run.

Stoffel: Because it's the same as playing Russian roulette...

Taleb: Exactly. If you have tail-hedge protection, then your return will be higher than the market. Because ... you can get more aggressive during the times when people sell.
This is not well understood. My strategies have been to overload with tail options ... and not because you get a good payoff if the market collapses. It's because it allows you to buy when nobody has dry powder.

Stoffel: It's basically the same for an individual investor as having a huge chunk of cash sitting on the sidelines that they can use to buy stocks low. Is that correct?

Taleb: Yes, but the problem is for the individual investor if you miss the rally. You see, I have a larger exposure to the rally -- and my exposure increases via options on the way down. I don't recommend individual investors use options.
The risk of having a lot of cash is that if the market rallies -- for the individual investor, it doesn't work well -- you have all this cash, you missed on a big move. 

Stoffel: And you never know when your time is going to come. So you're losing to inflation as well.

Taleb: Exactly. So the idea -- the wisest and most appropriate approach -- is to let the institutional investors have the tail hedges themselves.
Or to do what I call the barbell: to have a smaller amount allocated to the most volatile things, rather than a larger amount allocated to medium-volatile things. There are techniques around it.
It took me 28 years to figure out the flaws in the models proposed by so-called academics -- people without skin in the game.
Stoffel: Like the Scholes model?

Taleb: No -- the Scholes model is for fat tails.
They're all connected, but there's one central thing: Even if you're not using the Gaussian distribution, you're still long. And it's analyzing things as one step rather than analyzing life as a series of steps.
Ironically, that's my first book: Dynamic Hedging. That's my first activity -- dynamic hedging. When you look at the activity, you're trying to figure out, "What's the smartest approach I can have given the opacity of things?"