Holistic Financial Wellness, Barbells, and the Wisdom of Nassim Taleb
The mid 1980’s were a heady time for investment professionals. The truly scary inflation and interest rates of the late 70’s and early 80’s had abated somewhat (10 year Treasuries peaked in September 1981 at the currently inconceivable level of 15.76%) and were now within hailing distance of historical norms. The stock market and the economy were roaring (the Crash of 1987 was still a couple of years in the future), and it seemed that with the accelerating advances in both computer technology and investment theory, the world was on the brink of a new era where the mysteries of risk and return would finally be unraveled and we could all look forward to a bright and secure financial future.
I had just received my ASA (“Associate in the Society of Actuaries”) and was now beginning the long slog toward Fellowship. Having learned all the actuarial mathematics I needed to know to be considered an actuary, I was now faced with the task of passing 5 more lengthy exams dealing with the theory and rules governing all the businesses related to actuarial practice. Much of those exams dealt with the law, taxation and regulation of Insurance, Social Security, and employee benefits in general, but one of the most important exams addressed the investment of the billions (now trillions) of dollars set aside to pay for the liabilities that we as actuaries are charged with managing. And so it was with some eager curiosity that I sat down in the spring of 1986 to begin studying “Modern Portfolio Theory” (as developed by Markowitz), the first of several dense books and papers that comprised the almost 1200 pages of the exam syllabus.
Sadly, my enthusiasm lasted less than a page as in the second paragraph of the opening chapter I was faced with the stunningly blithe statement that “People are risk averse” and based on that “fact”, the remainder of the book would lay out for the reader a beautiful and powerful theory of the “efficient frontier” that purported to demonstrate how for different levels of “risk tolerance” a mix of investments could be developed to maximize expected returns thus allowing one to be maximally “efficient” in one’s investment strategy. This apparently was the “state of the art” and therefore it was incumbent on me as an actuary to be well aware of how the investment professionals charged with managing the asset side of the equation were doing their job.
At the time I had only been in the business world for a little less than 7 years, but even in that short time, I had learned enough practical risk management to know that the statement above was worse than wrong — it was meaningless. And to think that the entire edifice of investment theory (as well as the financial security of millions of policyholders and pension plan participants) was built on such a shaky foundation was a truly frightening thought. As I stared again and again at the words I seriously considered abandoning my goal of becoming a fully credentialed actuary and resigning myself to a career as a technical practitioner (the only path then available to a “career ASA”).
To understand how misguided the statement about people’s view of risk was, it is important to first realize that “people” are not uniformly “risk averse”. Khaneman and Tversky would demonstrate this definitively in a few years, but even then there were “anomalous” behaviors that were obvious to anyone who looked that made those of us in the business doubt the conventional wisdom regarding risk aversion. But, even more importantly, people don’t even know what “risk” is. Hell, I didn’t even know what it was, and risk was the core concept of my whole profession.
As I said, in order to become an ASA I had had to learn all the relevant actuarial mathematics. And while that entailed a fairly deep dive into Probability and Statistics, it also required passing a full actuarial exam devoted to “Risk Theory” itself. Risk Theory as taught to actuaries at the time was a brutally difficult subject. Not only was the math barely penetrable, but the questions addressed were very deep and the kind that if you thought too much about them, you would quickly find yourself mired in unanswerable philosophical questions about “knowability” that could cause you to doubt the efficacy of even studying the subject. Here, though, there was no choice, and I put aside my existential angst, dug in to learn the math and eventually passed the exam. But now with a book on Modern Portfolio Theory open in front of me, I was facing the even more daunting task of suspending my disbelief to learn a theory whose fundamental assumption was clearly flawed. Nevertheless, I am pragmatic, and so I held my nose, read the material and passed that exam as well, eventually going on to get my Fellowship. Fortunately, in the 30 years since, I have never once had to actually use “modern portfolio theory” nor have I ever had to assume it was true for any of the work I had to do as an actuary.
In fact, until recently, except for the occasional “asset liability modeling” project where I had to bite my tongue while my investment advising colleagues “explained” the theory, I never even bothered to think too much about efficient frontiers. Lately however, as more and more actuaries are thinking about how assets should be invested, and as I have begun thinking and writing about Holistic Financial Wellness, I have come to the conclusion that it is now important to put my 2 cents into the discussion about exactly what “financial risk” means and how we as individuals should act in light of the virtual opacity of the future that we face when we make decisions about our financial lives.
Those few of you who have read my book “What’s Your Future Worth?” and the many fewer who read the original “An Actuary’s Apology” upon which it was based will know that Nassim Nicholas Taleb is one of my heroes and, like him, I believe that the future is far less predictable than we think. As I mentioned in both of my books, reading Taleb’s “Fooled by Randomness” changed my view of the world, our ability to predict the future, and, more importantly, the way I communicate with people about what to do about it. In many ways Fooled by Randomness made explicit and gave form to much of the vague unease I have long felt about the way uncertainty and the future is talked about by the media, by the “experts” and even, in many cases, by practicing actuaries who really should know better. I became a missionary of sorts, buying multiple copies of Taleb’s book and recommending it to any who would listen and many who wouldn’t.
But I was cocky. I thought that having read the book, I really understood uncertainty and began preaching about the “right” way of looking at risk. I still stand by what I have written, but now having fully digested Taleb’s most recent and best book, “Antifragile” as well as some of the mathematical back
up in “Silent Risk” ( http://www.fooledbyrandomness.com/SilentRisk.pdf ), I realize that my message has been somewhat incomplete and that risk is more complex, poorly understood, and discouragingly dangerous than I have communicated to my readers. Not only that, but the more I think about it, the more I realize that the ideas expressed in Antifragile are directly relevant to the concept of Holistic Financial Wellness which is the one area where, at least for the moment, I have an audience that will pay some attention to my ramblings. In fact, to my knowledge, no one has yet tried to apply Taleb’s concepts to Financial Wellness, and so, beginning in the remainder of this piece we will explore some of the financial planning implications of Taleb’s powerful and important insights.
Future essays may discuss different aspects of the application of Antifragility to Holistic Financial Wellness, but for now let us consider one simple lesson — how the use of a “barbell strategy” can improve your financial health.
Barbells and Antifragility
Before introducing the barbell strategy and how it can be used, we first need to talk about two other critical concepts discussed by Taleb. The first is “path dependence”. This is a concept that everyone understands but most people rarely consider. Fundamentally it means that when imagining different aspects of your possible futures (e.g. the value of your house in 10 years) it is important to consider the path which leads to that future. So for example, suppose you decide to invest $150,000 in a house worth $500,000. You take out a new 30-year $350,000 mortgage requiring a loan and property tax payment of $3,000 per month (about equal, net of taxes, to what you might have to pay in rent). Your net equity is therefore $150,000. If everything goes as planned and the house appreciates at a steady 4% per year, you could end up after 10 years with a house worth about $740,000 and a loan balance of a little bit less than $300,000 increasing your net equity to $440,000, a very nice return on your initial $150,000. But there are two problems with that. First, what if instead of rising steadily at 4% per year, the road is more “choppy” and the housing market drops 25% in the first year and then goes up and down with returns averaging 7.2% per year for the next 9 years (still an average of 4% per year)? In that case rather than being worth $740,000 your house will only be worth less than $700,000 (perhaps much less depending on how volatile those returns are during the 9 years). But even assuming a steady 7.2% return during the 9 years, the 10 year annualized return on your investment has gone from 11.4% to 10.3% . Actuaries call this phenomenon “sequence of returns risk”. In this case it has only made a superlative investment a little less spectacular, but in other cases it can make the difference between a winning and a losing strategy. I have written extensively about how to address sequence of returns risk in various ways, most notably in the work I have done with Barry Sacks around the effective use of Reverse Mortgages ( see for example http://www.peterneuwirth.com/wp-content/uploads/2017/01/RM-Paper-Final-Pre-Pub-Draft-NOT-REDLINED-v13.pdf ).
But there is a much more important aspect of path dependence that needs to be highlighted. Specifically, note that in the example above, we have assumed a first year 25% drop in the housing market. What if that drop was a result of a serious downturn in the economy? And what if some of the fallout from that downturn was that you lost your job and couldn’t afford to make the mortgage payments? Now you will have to sell your house (currently worth $375,000 after the drop) and will be left with a mere $25,000 after paying off the $350,000 you still owe. The return on your $150,000 investment has been a catastrophic negative 83.3% and your chances of accumulating your expected $400,000+ payoff after 10 years have receded into insignificance.
The above example illustrates what Taleb calls “fragility”. This concept will eventually lead us to the barbells, but first we need to understand what that means mathematically. Specifically, an investment (or any system for that matter) is fragile if its response to “stressors” (e.g. the effect of volatility in the economy on your net home equity in the example above) is non-linear, and in particular, concave down. You can see this in your house investment by noting, first that even if the relationship between the economy and housing prices was linear, the downturn in the economy that caused a 25% drop in housing prices would have caused more than twice as much damage to your investment as a downturn only half as bad causing only a 12.5% drop in housing prices (upon the sale you would have been left with $87,500 or more than 3 times as much as if prices had dropped 25%). But it is even worse than that. If the economic downturn had been milder you might not have lost your job, thus allowing you to “stay in the game”, and continue to make your mortgage payments until housing prices recovered. In Antifragile Taleb considers many examples of things (including investments, ecologies, corporate, political and financial systems etc.) that are fragile, as well as other systems which are “antifragile” where stressors produce a convex up response and disproportionate returns are experienced (or a system strengthens ) as the environment get more variable.
One very important aspect of antifragility is that, unlike fragility, it entails “optionality” and asymmetry. The optionality (on investments for example) comes from having many “irons in the fire” some of which can be pulled from the fire at any time while the asymmetry comes from having a limited and finite downside with an upside that is either unlimited or unknown, but potentially far in excess of the amount of the downside. With having many small “bets” in play, no single one can be expected to pay off, but if from the many, one or a few do pay off, the returns should be so disproportionately positive as to out-weigh the small individual losses that all the other investments might experience before the payoff arrives. In fact, were it not for the fact that there is some possibility that none of the many little long shot investments will pay off, leaving you with big or maybe total losses, then investing all your assets in an “antifragile” manner might make sense as a personal investing strategy. However such a strategy runs counter to the basic idea of Holistic Financial Wellness where so many components are interrelated and failures can cascade (see for example http://www.peterneuwirth.com/?p=320 ). As a result, when one’s total financial picture (including your future and the fragilities that arise from these interdependencies) is taken into account it is clear that another strategy is indicated, not just for investing but for the overall management your financial life.
Simply stated, a “barbell strategy” is one that is simultaneously extremely conservative and extremely aggressive. It protects against those aspects of your financial situation that are “fragile”, and takes advantage of the convex returns for those aspects of your financial situation that can be isolated and made “antifragile”. The math is complicated, but fundamentally this kind of strategy can work whenever the situation you are applying it to is a complex non-linear system and can be separated into components. As I have written elsewhere, the core insights about Holistic Financial Wellness arise because of the complex interactions between the various interdependent components of our financial worlds. In addition to being complex, the consequences of our financial decisions, as shown above, are very often decidedly non-linear. It is also true, as we see below, that some sections of your financial life can be “cordoned off” and treated separately.
An Example of a Barbell Strategy in Holistic Financial Wellness
In addition to being a brilliant thinker when it comes to uncertainty and risk, Taleb is also a philosopher with both a well-articulated view on ethics and a fairly unique perspective on the relationship between Theory and Practice. In particular he believes strongly that practice informs theory and not the other way around. Related to this is his view that one should reject those offering advice or taking action that will affect others if they don’t have any “skin in the game”. I fully agree with him on this point, and therefore the barbell strategy I want to talk about is one that I have taken in my own life.
Last year, after almost 40 years of working in the retirement plan industry, I retired from my employer. I then had to sit down to “eat my own cooking” and figure out how to manage life (financial and otherwise) without the benefit of an organization to provide me with work to do every day and money to live on. I thought I was prepared for it, but as with most things, reality is somewhat different from “theory”. On paper, I had done all the right things; saved an adequate amount each year, invested in a “balanced portfolio” (though I am sure my asset allocation was not on the “efficient frontier”), and managed my debt and annual expenses in such a way that theoretically all my future liabilities could be met by income from my savings and the pensions I had earned along the way. But the more I looked at things from a holistic point of view, the more I saw how fragile my financial life actually was. There were all kinds of systemic risks and potential fragilities I hadn’t analyzed in a detailed way, from the possibility that I might live far beyond my life expectancy, to the possibility that there might be an economic “discontinuity” that could cause the market(s) to crash and/or double digit inflation and interest rates to return. There were local disasters (e.g. earthquakes) and global catastrophes (e.g. war or a financial system collapse) which would have both first and second order financial effects to consider. Any one of these disasters was a low likelihood event, but as Taleb points out, not only does it take only one to “terminate” your plans, but eventually one of these “black swan” events is inevitable, and time itself is a source of volatility (a concept we will address further in a future essay). The long time period over which I expected to be retired made a seriously concave result something to consider and protect against.
In the end I decided to go against conventional wisdom and even the advice put forth by the most sophisticated retirement planners and embarked on my own barbell strategy. I sunk almost 75% of my retirement assets into the purchase of guaranteed lifetime annuities, TIPS (Inflation protected Treasury Bonds) and gold. When I turn 62, I will also take out a Reverse Mortgage credit line on our house to provide additional cushion against catastrophe. This ultra conservative end of the “barbell” will provide enough to live on if even the worst happens. The rest I have broken up into small pieces and am investing in highly speculative ventures (e.g. leveraged rental income units in gentrifying neighborhoods with non-recourse financing, some small cap equities, and a few other investments in unconventional long shots like old books and collectibles) to form the other end of the barbell.
Unfortunately I didn’t have enough hard assets to create a truly balanced barbell, but then as I thought more holistically about my financial life, I realized that the other “investable asset” I have is my time and earnings capacity (retirement planners almost never tell you that this is the third most valuable asset most retirees own after their home and their retirement savings). With that time I am adding to the second side of the barbell by involving myself in several “fixed downside/unbounded upside” ventures that I both enjoy and could have possible but unknown financial upsides for me. I may talk about some of those other antifragile ventures in a later piece as many of them also provide non-financial upside (e.g. writing and speaking about Holistic Financial Wellness) and it will give me an opportunity to discuss some of the other more complex concepts that Taleb addresses in his work.
As I write these words, I continue to be unwavering in my faith in both the unknowability of the future and our ability as humans to survive and even thrive in that uncertainty. I truly believe that all we need to do is to accept that uncertainty is an immutable reality and move as quickly as we can from the fragile to the antifragile. As Taleb says; “The tragedy is that much of what you think is random is in your control, and what’s worse, the opposite”. The trick is knowing the difference between the two.