What the Most Epic Battle in History Taught Me about Trading Derivatives:

Hannibal, Rome, & Risk-Taking- Or the perception of impossibility and its consequences.

I believe in heuristics, not predictions. I’ll take ancient wisdom over self-help books. It’s simple logic: old ideas have been tested (and stressed) by time; just like natural selection. In finance (and life) risk is in the tails, NOT the intervals of a Gaussian distribution (the bell curve). The average cold never killed anybody. I’ll embed this idea and how it pertains to trading with a quick narrative of an ancient general, Hannibal.

Hannibal and his kind took different versions of risks than I am used to.

Two ancient superpowers are at war for the entire world (which in 218 BC means the Mediterranean & the Levant). For history’s sake, it’s known as the Second Punic War (essentially the ancient WWII). This guy Hannibal wants to attack Rome for killing his father and embarrassing the other great empire, Carthage, in the First Punic War. Rome prepares by sending their best troops south to Sicily. They position their portfolio to prepare for what’s expected. The experts of Rome readied for what seemed probable intuitively, not statistically (mathematics were not this evolved yet, but the logic is timeless). Sun Tzu (who came 300 years before Hannibal touched a sword) sums up predictions like this: do not be concerned with whether the enemy might attack, but are you ready to receive them?

It’s not about: “will the market crash soon?”, but are you ready if it does? JP Morgan correctly predicted the ‘08 crisis, they just weren’t ready for the magnitude.

Another example of NOT following Sun Tzu’s time-tested principle is shown by Israeli politicians in the Six-Day War, who famously denied the probability of war to soothe public anxiety. Military experts thought Egypt would be crazy to attack without a strong air force. This is thinking intuitively. This thinking got lots of people killed.

Thinking intuitively and not statistically can be a severe error in trading. But more on war:

I would much rather make this trek today

Hannibal takes his army of cavalry, infantry, and elephants (yes, elephants: Mother Nature’s armored personnel carrier) north from Spain to the Alps (to save any Googling, this is very far from Sicily, where the Roman army is, and Uber isn’t in Italy yet.)

At this time in history, NO ONE ELSE IN THE WORLD THOUGHT AN ARMY COULD CROSS THE ALPS.

This is key. He defies conventional wisdom, something taken for certain by many smart and informed people, and Hannibal risks his success on what no one expects. He positions himself to benefit enormously (surprise the superior Roman army) from a perceived improbable event (his army crossing the Alps). This tactic is as fit for the ancient world as it is today (think of betting against the housing market before ‘08, or expecting the Latin-American debt crisis, or Enron’s collapse, or Long Term Capital Management failing, or me not making a free-throw etc.)

The thing is, it can take huge nuts to live like this. We like certainty and we think intuitively (read Daniel Kahneman if interested in the psychology of not fooling yourself). Tail-hedging leverages the gap between Gaussian predictions and the extremely volatile real world. This introduces exposure to the highly unexpected (yes, think Black Swans) but vastly important events, which allow your portfolio to garner convex payoffs. The gravity of this kind of thinking goes so far beyond trading and war. It extends to the workings of massive and complex systems (like Mother Nature and the economy) and how stability can be maintained or fragility be avoided.

Now back to war.

For Hannibal, the payoff was victory, vengeance and glory. He crossed the Alps, surprised Rome, killed a lot of soldiers, and temporarily disrupted the might of Rome (don’t worry, Rome hedged her bets). But Hannibal’s gamble had paid off greatly.

I want to stop here and immediately clarify I am not suggesting simply taking massive risks that are unexpected to pay-off. The idea is balanced by a duality: it’s not just about taking huge ballsy risks that no one’s ready for (I could develop carpel tunnel from typing the obituaries of all-or-nothings). You must also rigorously protect from ruin. Ruin is, mathematically, an absorbing barrier that your model is prone to. Basically, make sure you don’t take risks you can’t learn from (thank you Bill Ackman for a good modern example). Let me explain:

When shit hit the fan, Rome canned its usual politics and elected a special kind of dictator. When Hannibal hit Northern Rome, they elected Fabius. Fabian tactics are colloquially known for conservative and attrition warfare (George Washington was a fan of fighting this way). Fabius fought by making sure he never risked too much. Analogously, when the markets are erratic (like when a huge war happens) trade like Fabius ruled: take the most incremental risks that rigorously protect from ruin when the odds are severely not in your favor. People hate doing this (especially the Roman masses, who seem to be war-mongering curmudgeons save their philosophers).

You psychologically resist living with doubt of the future, especially when you have something at stake (a business, a trade, your reputation, a hot date etc.) You won’t want to bet on something no one thinks will work, you will want to do what you think has always worked, you will want to go to war (metaphorically, war always worked for Rome). This is stupid. Rapidly changing, complex systems like economies and cultures colliding are not predictable, especially not by our Neanderthal brain and irrationalities. So: be like Fabius, not a certainty-coddling sucker like some of his generals or the hedge fund manager Victor Niederhoffer (author Malcolm Gladwell wrote a great bit on him).

This LTCM plot shows us what ruin looks like. It cannot show the ensuing embarrassment and frustration.

The Roman People hated Fabius for not fighting, for not seizing the glory of a good return. But they owe him their lives and liberties. Fabius allowed Rome to survive and set the random machine of history to produce how things are today. Being unconventional, or taking risks in which you have the least to lose and the most to gain from a really unlikely but big event, is how you achieve longevity. The ultimate enemy of your portfolio is time. This is the only metric of success for anything: our species, empires, businesses (elucidated by Nassim Taleb’s the Lindy Effect).

The climatic event and real feature of this story is known as the Battle of Cannae, one of the most epic battles in history. This particular event involved prominent generals betraying Fabius’ advice and marching to war. Hannibal won and nearly annihilated Rome’s army. 3,000 of 80,000 survived. In a very sadistic way (and I do regret even making this comparison): this is like losing 96% of your portfolio.

By the end of the war (tail event/crisis/market crash), Rome had lost 20% of its male population. And you think you’re taking risks on a 100k trade, or investing in real estate. The empire & Fabius were betting on the lives of people, on whether their society would prevail. Don’t make yourself seem important. This too makes trading easier. If you’re curious in really understanding risk-taking, learn from the research by the U.S. Military and DARPA. They get what it means to achieve a risky objective when you have your actual skin in the game.

Taking risks on events of perceived improbability can lead to remarkable payoff. As an example, see the tail risk hedge fund Universa (previously Empirica Kurtosis) — Hannibal would approve of their risk-taking. To be candid however, he ultimately met his end at the hands of the famed Roman General Scipio Africanus, who history remembers for defeating Carthage and ending the Second Punic War. Nonetheless, Hannibal is remembered by time as one of the greatest leaders and impactors of civilization.

To wrap this epic tale up: Fabius, the Roman Emperor who everyone hated that didn’t take big risks with supposedly certain outcomes when important things were at stake — he and Rome survived (Rome fell centuries later, but not for lack of Fabius’ tail-hedging). Many, many famous Romans died at Cannae. Their rings were brought to Carthage by Hannibal and only their names returned to Rome. Don’t take risks like them. Be like Fabius. Make your portfolio survive.

Note 1- In afterthought, i found its important that history (the interaction of rapidly changing and vastly interconnected systems) is to be delineated. Outcomes are probabilistic in war just as the market. The logic of risk taking is what’s important. I don’t want to construct an explanatory narrative: there was much occurring in the world beyond Hannibal and Rome (it is not the whole picture) and things could have worked out that Latin isn’t the basis of Western languages…