Nassim Taleb’s 6 tips for embracing risk

Nassim Taleb has two categories for people: those who fall apart during times of crisis, and those who profit from them. The scholar, former options trader and author of some of the most influential books of the last 20 years calls the latter group “antifragile.” They are not just able to survive in a world of unpredictability: they actually thrive on disorder.

“The world is more random than we think,” Taleb explained in a rare interview with MoneySense before a keynote address to chief investment staff from Canada’s biggest pension plans. “You are going to make more mistakes than you ever think you are going to make, and you don’t know where or when.”

Taleb’s message will resonate with investors who endured two major market crashes in a single decade: the tech wreck at the turn of the millennium and the 2008–09 financial crisis. His major works—Fooled by Randomness, The Black Swan and Antifragile—have challenged an investment industry that until recently clung doggedly to the efficient markets hypothesis: the theory that markets are rational, as are the investors that operate within them.

His ideas combine elements from his diverse background. A statistician, risk analyst and Wall Street veteran who spent years trading derivatives, Taleb has learned that humans constantly downplay the impact of random events. And that blind spot continues to overwhelm investors at the worst possible times.

But there is hope—as long as you learn to embrace risk rather than running from it. “It’s not bad news at all if your systems are set up to gain from an increase in disorder over time,“ Taleb explains.

So how can investors put this idea into practice with their own portfolios? Here are Taleb’s six rules for building a profitable and antifragile portfolio:

1. Look for survivors

Slow and steady wins the race, right? Not so according to Taleb, who urges investors to embrace companies who have endured a volatile history. “Try to invest in companies that have had some trouble in their past and have come back from it.” His rationale? Companies that have overcome turmoil are proven members of the antifragile club: they’ve weathered storms and come back stronger.

Taleb says the market is full of companies like this in the wake of the global financial crisis. “We had the 2008 crisis: don’t let it go to waste,” he says. “See which funds or companies didn’t get harmed. These are more valuable.”

Taleb also hints at brewing turmoil in Silicon Valley as the next opportunity to hunt for survivors. “Silicon Valley collapsed and came back and learned a phenomenal lesson,” he says, referring to the dot-com bubble and noting that tech stocks are ripe for another correction. “Hopefully they will have another crisis to learn from, because it will teach them to stop being arrogant. They start getting arrogant every 15 years.”

The trick is to wait until companies start to come back: don’t buy before you see clear signs of recovery.

2. Keep some powder dry

Taleb likes to talk about the benefit of “dry powder”—the ability to jump in and buy when others can’t. That means always keeping a cushion of cash in your portfolio, even when interest rates are low. “The idea here is survival, not performance,” he asserts, adding that it’s particularly important when other investors are flooding into markets. Once these investors have pulled back—after a correction, when prices are low—then it’s time to take that cash and put it back to work.

“Try to stay underinvested particularly when it seems foolish to do so,” Taleb says. “The people I know who made a lot of money in finance are those that kept their powder dry when no one else had any.”

To underscore his point, Taleb points to great American families like the Kennedys who had cash on hand during crises and snapped up assets during some of the darkest days of the U.S. economy, making a fortune in the process.

3. Be vigilant with your investment choices

Most of us fail to give enough thought to the investments we buy. “When people invest on paper they don’t exercise rigor at all,” Taleb says.

He uses an analogy of a baker who runs his business with great vigilance, but doesn’t apply that same care to his investments.“The baker saves $200,000 and then turns around and puts it in a company he knows nothing about. But if he exercised the same vigilance in his investment as he did with his business, he’d be doing it full-time.” Taleb would rather see individuals stay out of the market than invest in things they don’t fully understand.

His rule of thumb is to invest in companies you would do business with. Would you use them as a supplier? Would you let them buy from you on credit? “If you start framing it that way, people will start to be a little more rigorous.”

4. Be even more diversified

Diversification is more important than you think, says Taleb. “If experts tell you to have 30 stocks, have at least four times that,” he explains. During his life as a trader Taleb learned that stock market performance is driven primarily by a relatively small portion of the index—those 100 to 300 companies whose market capitalization dominates. To avoid being too exposed to these market movers, Taleb says it’s important to hold a far broader universe of companies.

5. Remember the Lindy Effect

As people get older their life expectancy decreases. But the opposite is true for some objects and ideas, Taleb says. If a book has been in print for 40 years, he writes in Antifragile, you can expect it to remain on the shelves for another 40 years. “If it survives another decade, then it will be expected to be in print another fifty years.”

This idea is called the Lindy Effect (named for a long-lived New York deli) and Taleb says it applies to companies, too. The longer a business has been around, the more likely it will survive in the future. He points to Lindy-friendly firms such as the old European insurers that have been around for decades with no major changes to their approach or, in some cases, management.

6. Watch for skin in the game

Outsized or misaligned executive pay is a big warning sign of fragility says Taleb, and not just because it fuels income inequality. He says investors should look for companies where upper management has “skin in the game.” That means their compensation should be based on the long-term health of the company, and management should personally face the risk of loss if things go wrong.

“Without skin in the game, the chairman and CEO have more upside if they are right than downside [if they are wrong],” explains Taleb. “Their optimal strategy in that case is to make the books look good and to hide fragilities—because they are being paid based on cosmetic returns and not long-term ones.”