Peripteral Investment Strategy

I have been greatly inspired by Nassim Nicholas Taleb’s book The Black Swan, that discuss the nature and impact of highly improbable events, probability, uncertainty and unknowledge. The author presents some very interesting views on these subjects. Being a software developer, where uncertainty and making predictions (unfortunately) are fundamental parts of the job, I was able to strongly relate with his ideas. I can also testify that most of what is discussed in the book is very applicable to software development too.

Black Swan events are undirected and unpredictable. They are born out of an ignorance of unknown unknowns. These events completely disrupt the current trend, to establish a radically new order. Taleb regards almost all major scientific discoveries, historical events, artistic and technological accomplishments as “Black Swans”.

Taleb repeatedly warns at listening to “experts” in knowledge fields were prediction is almost impossible, like economics and politics. As a non-professional investor and trader, I have become equally skeptical about following predictions of industry prophets and pop media. One of the fundamental principles of my approach to investing is to perform my own original research “at source”, and to avoid, as much as possible, advise and predictions from commercial media and “experts”. For example, I prefer to read yearly company financials reports directly, instead of reading articles about these companies. Here are some things to keep in mind when you read narratives from the mainstream financial media:

1. How to gain an edge. If you follow the same news as everyone else, how will you ever get a market beating portfolio? If you follow the crowd, at best you will get similar results as everyone else. Also, by the time you read something in a magazine, you can be sure the market has already acted to that information long before you had a chance to read about it, and the advantage lost with it — and you just paid for that stale analysis.
2. Sensationalist bias. The financial media prefers to sell stories that will get the most attention, instead of those with the most important information. Also, even if you do read something that contains important information, a narrative will be weaved into it, so that it becomes difficult to separate fact from fiction.
3. Information overload. Because commercial media is a business like any other, they get paid to generate news stories to keep their audience coming back for more. This causes a constant stream of information, some of it useful and most of it useless.
4. Applicability. Make sure you understand what your investment strategy is, and what information applies to it. If you follow a value investment strategy based on fundamentals, then reading stories that that goes to great lengths to explain why it’s a good time to buy or sell a stock based on technical analysis patterns of the last three weeks, will be entirely inappropriate to the way you invest.

Barbell Strategy

As a trader Nassim follows a “barbell” investment strategy:

“If you know that you are vulnerable to prediction errors, and if you accept that most “risk measures” are flawed, because of the Black Swan, then your strategy is to be as hyperconservative and hyperaggressive as you can be instead of being mildly aggressive or conservative. Instead of putting you money in “medium risk” investments (how do you know it is medium risk? by listening to tenure-seeking “experts”?), you need to put a portion, say 85 to 90 percent, in extremely safe instruments, like Treasury bills — as safe a class of instruments as you can manage to find on this planet. The remaining 10 to 15 percent you put in extremely speculative bets, as leveraged as possible (like options), preferably venture capital-style portfolios.”

Currently I roughly follow a long term industrial contrarianish, valueish, investing strategy. My portfolio consists of stocks in fundamental technology industries and resources, with strong cash flows, lowish P/Es and that pay at least a small dividend. For example I’m currently investigating the following stocks GlaxoSmithKline (GSK), American Express (AXP) and Mobile TeleSystems (MBT). This stretegy has been working out quite well.

During my research I have often stumbled on more aggressive stocks like Solazyme (SZYM) and Sevion Therapeutics (SVON). These seemed to present a potential for enormous upside, should their unqiue investment cases turn out to be true. I just wasn’t sure how to approach specialized stocks like these, and how to effectively include them in my portfolio, as they didn’t meet any of my usual criteria for a value stock. I couldn’t understand why anyone would want to invest in stocks like these, with other options on the table that provide a long proven track record of solid performance, a global footprint, and regular dividends (however small), albeit perhaps going through a rough patch currently.

But now I understand, it’s all about maximizing exposure to positive Black Swan events, and at the same time protecting against any possible downside from negatives ones. Remember there are positive and negative Black Swans. These rare events have the ability to disproportionately dominate the entire statistical range, and making sure you have access to their positive effect could mean all the difference.

But Taleb has given me an idea. Why not create a “peripteral” investment strategy? Peripteral refers to the architecture of many ancient Greek temples, like the famous Parthenon temple on the Athenian Acropolis, that were surrounded by columns carrying entablature. Using this strategy I allocate a large percentage of my portfolio to government bonds and treasuries using Exchange Traded Funds (ETF) like iShares S&P/Citigroup International Treasury Bond (IGOV) and ABF Singapore Bond ETF (A35), another large percentage to my usual value stocks, and the remaining 15 percent to very aggressive stocks like Sevion and derivatives like Contracts For Difference (CFD), futures and options.

So instead of a “barbell”, you get a single column with conservative government bonds on the one side, value stocks in the middle and speculative stocks on the other side.