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the black swan
Old 09-10-2007, 10:58 AM   #1
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the black swan

A Black Swan Review

An interesting read and worth one’s time if understanding risk is worthy of consideration. But I believe Taleb under-perceives risk components in some ways and over-perceives in other ways.

But . . . he seems to focus primarily on the macro, his outside of the box risk and in that process misses or fails to process an enormous amount of micro risk inherent in all financial and business phenomena. He focuses on the flashy, the dramatic, the extreme--all to the exclusion of the mundane, the incremental, and the huge middle area that occupy most folks.

In the late middle part of the book, Taleb mentions as a Black Swan event for a casino a lion attacking Sigfreid (sp?) of Sigfreid & Roy fame. Taleb said that the casino lost about $100 million when that happened and the show ended for good. Who could have predicted such a thing would happen and when and where it did? The odds and asymmetry spin out of whack very quickly. Taleb sees this as a sort of perfect Black Swan event—unforseeable and, probably, the money making odds stacked in favor of anyone who could. But Sigfreid probably saw and knew what could happen. But perhaps after twenty-five years of doing wild animal acts, he had grown complacent to the risk of wild animals, of his wild animals, perhaps feeling he had these creatures completely under control. Perhaps he was just a bit too worried about a few missing sequins on his outfit that night and not focused enough on the level of irritability of his lions. Who knows? But Sigfreid may. It may not have been an unforeseeable event to him; it just may have been a letting down of one’s guard that particular evening or a forgetfulness. To Sigfreid, it should have been an important, although perhaps small event that should have been prepared for adequately; for Taleb, who focuses on macro events (important to him?) detail work is inconsequential. He thinks he thinks big, and he may not see inside the box.

But back to the $100 million single event loss. My thought is that casinos, all businesses, do an incredible amount of risk management on a daily and incremental basis. Even making sure that there is an adequate ratio of managers to employees at a firm is a method of risk management. Part of a supervisor’s job is to make sure risk is reduced in the local working environment: the supervisor may tell the crane operator to go home that day because he smells liquor on his breath. He trains the fry cook not to dip his hand in the oil or splatter the stuff around so that the floors are slippery. In a thousand small, incremental ways, a manager’s job is to make sure his staff is doing things with a redueced amount of risk.

An obvious failure and perhaps a grey swan in the making right now is the mortgage crisis. As observers from outside the box, we may only see the event as a dramatic, unpredictable event. But, I suspect, that it arrived for our viewing as such due to a huge number of incremental mistakes supervised and perhaps encouraged by upper and mid level management. “In order to make our numbers for this quarter (and get our bonuses), we need each office manager to accept and process 10% more loans.” Pretty soon those small initial mistakes turn into a powerful force in the financial markets, rolling thru the market place. And they were foreseeable, as always, if one only stuck his head into the environment where these mortgage excesses were happening.

The same could probably be said about LTCM . If someone had just objectively taken a close look at their formulas and quant stuff, one might have seen problems. But the LTCM folks were the supposed experts, so why should anyone else bother?

On the positive side of business management, Warren Buffett is someone that I see as very, very good at risk management. He looks for and sees all those incremental events that reduce risk and enhance profits and value. I suspect he has gotten better with age too. He has a nose for those non random patterns within businesses and for those people who know that attention to detail is very important. I suspect he knows that if one pays attention to the details in the proper fashion, one can significantly reduce risks and prevent many big negative events from ever manifesting. Of course, for the most part, we as outsiders only see that Berkshire-Hathaway’s stock just keeps going up and the money just keeps pouring in. But those that are interested probably know that Mr. Buffett manages risk very well, but also that it is just one facet of the entire gem package.

Taleb creates an imaginary creature using a real world black swan event as a metaphor. He then builds a wall of rationalizations around this prior creation. He says these Black Swans are random events, but then in the next breath he tells you that he can discern a pattern, a hinted at non-randomness in those random events. And if you follow him . . . .

Empiricists and rationalists know that things aren’t static, that life--and knowledge--is in constant flux with the general trend always upward and towards more. Saying “All swans are white.” is only a temporary pit stop for the scientist. He knows a three legged swan may someday be born, a yellow swan my arrive, etc. And at that time, a small adjustments will be made to the definition--if warranted. Things are always entering the box from outside of it. No need to be melodramatic about such events.

--greg
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Old 09-10-2007, 11:36 AM   #2
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I read this book last month. Interesting take, Greg.

I thought the book was disjointed and the author was cynical and egocentric. He dismisses his dissenters out of hand. He seems troubled personally.

I agreed with, and learned a lot from, the reminder that well-designed plans and contingencies can take you just so far, while more often than we like to admit seemingly random and unforeseeable events tend to kidnap things along the way. But that's not news, and it's the only coherent message in the book.

From a retirement perspective, it's like saying you should keep cash on hand because you can't predict the market. Blah, blah...
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Old 09-10-2007, 11:51 AM   #3
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Originally Posted by greg View Post
A Black Swan Review

An interesting read and worth one’s time if understanding risk is worthy of consideration. But I believe Taleb under-perceives risk components in some ways and over-perceives in other ways.

(snip)

In the late middle part of the book, Taleb mentions as a Black Swan event for a casino a lion attacking Sigfreid (sp?) of Sigfreid & Roy fame. Taleb said that the casino lost about $100 million when that happened and the show ended for good.

(snip)
I've got the book, but haven't read it yet. Thanks for this summary.

And as a nitpick, the tiger attacked Roy, not Siegfried. Roy is recovering, apparently, though he (IIRC) also had a mild stroke around the same time.
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Old 09-10-2007, 12:57 PM   #4
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I've got the book, but haven't read it yet. Thanks for this summary.

And as a nitpick, the tiger attacked Roy, not Siegfried. Roy is recovering, apparently, though he (IIRC) also had a mild stroke around the same time.
Yeah, I didn't go back to check exactly what happened to who.

Rich: I guess, maybe, implied within what I said is that the author doesn't pay any attention to the "little people." That by itself indicates an arrogance of sorts. I'm usually more forgiving of this sort of stuff because when I'm thinking about things, all things not related to what I'm thinking about, they shrink in importance for the duration--even politeness. Sometimes this appears as spaciness, sometimes as insensitivity. But when writing a book one should be going back for repeated rereads to look for flaws of that sort before publication. Unless one doesn't see them. His editor should have.

I think Taleb truly doesn't see all of the mass of events that reduce risk going on inside a particular company as important events. Such worries are for peons and if one person can't do something then another one will just fall into his place sort of automatically. Maybe large institutions are seen that way sometimes, that folks are just replaceable cuberats. But on the floor, good managers see the world completely different. Each individual becomes a key component in the machine and needs attention to keep things running smoothly. Same phenomenon, differing perspectives.

I see a strong connection between individual workers and top management--and risk (or non-risk) as obviously evident at each point between all the way up the line--if one looks. And most every black swan can be attributable to some ignorance or lack of understanding of where that risk is on that continuum. Tableb's book is a partial environment.

I also think this book is mostly for extremists. Those who might be petrified of some terrible event on the horizon and are looking for protection. You won't find a use for this book unless while reading it you derive a forseeable Black Swan that makes you money. This really isn't likely just by Taleb's definition alone--Black Swans are unforseeable. You can split hairs about it and say "well I'm just seeing something everybody else is seeing (a grey swan?), but I, personally, have the ability to see the consequences of that grey swan better than other folks and truly see the risks in that looming grey swan, so I'll make money off of it by taking advantage of its asymmetrical risk." But that is no different than saying "I know and understand pharma and biotech and can pick those hot drug stocks better than others." Sometimes you can and sometimes you can't. But it will require a huge amount of study and work to learn such skills and beat the averages or beat a small-cap pharma etf's gains.

These are not methodologies for retired folks who have more important stuff to do at this stage of life.
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Old 09-10-2007, 01:13 PM   #5
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Rich: I guess, maybe, implied within what I said is that the author doesn't pay any attention to the "little people."
There are still 18 people ahead of me waiting for the book at the library, but from what I read and heard from him, I don't get that impression.

His message to the little people is that MPT is a farce, and little people shouldn't be risking their retirements in the stock market.

He's all for risk taking, just not the kind of risks that could wipe you out if you get hit by an unexpected surprise. Take a chance. Write a book. See what happens. You never know -- something wonderful and unanticipated could come from it. But put your nest egg in treasury bonds just in case the future is different than the past (which it will assuredly be in many ways).

I'm not saying he's right, I just like the unconventional viewpoint, and it fits with how I've lived my life....
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Old 09-10-2007, 01:18 PM   #6
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His message to the little people is that MPT is a farce, and little people shouldn't be risking their retirements in the stock market.
I'm not saying he's right, I just like the unconventional viewpoint, and it fits with how I've lived my life....
I appreciate his pointing out that most financial analysis is built on the assumption of a bell-curve distribution, yet almost none of that is actually the case. I can't think of another financial writer who makes that point, with the possible exception of Bernstein.

Our high-school sophomore doesn't understand why she should take a statistics course before college, because she says she's going to be studying engineering! I told her it'd make her a better blackjack player and investor, so she's happy again.
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Old 09-10-2007, 02:05 PM   #7
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I appreciate his pointing out that most financial analysis is built on the assumption of a bell-curve distribution, yet almost none of that is actually the case.
Yes, that was insightful. He points out that the bell shaped curve is valid only for randomness with very clear boundaries, that is the roulette wheel.

The randomness among the numbers is real, but given enough spins the behavior is highly predictable and thus not really random. True "life randomness" rarely follows those rules. The curve thrashes and crashes and moves in strange ways; our futile attempts to ascribe some sort of explanation or pattern to past events is human nature, but invalid.

I believe strongly that there is an innate human tendency to connect the dots. Maybe its' an evolutionary advantage - Uh, oh...I see a snake in this tree; hmm, I just climbed the big tree over there, jumped over that stream, and walked a ways in this direction. Probably best if I didn't do that again.

I see people creating untested and invalid theories retrospectively all the time. "I'm sure I got this appendicitis from broccoli."
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Old 09-10-2007, 03:04 PM   #8
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I see people creating untested and invalid theories retrospectively all the time. "I'm sure I got this appendicitis from broccoli."
I remember seeing that in the compelling critically-acclaimed documentary recommended by CFB-- "Broccoli: The Silent Killer".

Isn't appendicitis caused by the dangerous helicobroccoli pylorii bacteria?
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Old 09-10-2007, 03:32 PM   #9
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. . . I don't get that impression.

His message to the little people is that MPT is a farce, and little people shouldn't be risking their retirements in the stock market.

He's all for risk taking, just not the kind of risks that could wipe you out if you get hit by an unexpected surprise. Take a chance. Write a book. See what happens. You never know -- something wonderful and unanticipated could come from it. But put your nest egg in treasury bonds just in case the future is different than the past (which it will assuredly be in many ways).

I'm not saying he's right, I just like the unconventional viewpoint, and it fits with how I've lived my life....
I should have been more explicit about what "little people" I was referring to: all those folks that work for a living and just don't sit around pondering all day. These are the ones who really do keep all the everyday risks at bay. The supervisor of a work crew at McDonald's, the police, snow clearing crews, etc. They make sure risk doesn't get out of hand and impossible to deal with in our personal, real lives. They keep companies from Enron-izing.

I do think Taleb is trying to help small investors. My perception of him (unmentioned in my review) is that he really has a severe bias against things going well for any duration in these modern, highly technological times. His perception is that there are lots of looming and unforseen negative possibilities, with profound complications possible, skirting around out there in "just beyond our sight land." He says more so than in the past in his book.

One of my arguments against this notion is that folks always feel that way and have thruout history. It is just that the objects of worry were different then: maybe folks worried that they had syphilis, might be facing a drought or nearby plague, worried that the Huns were just over the hill, and dealing with dysentery that a child might have, they faced just as many if not more Black Swans or possible tragic events than we do today. I truly think his speculative perceptions regarding increasing frequency of black swans are off base. Life doesn't get any larger or smaller than "You're now dead."

But he certainly offers a reasonable, alternative investing formula for those with a similar set of worries as him. But also, simultaneously, if you follow his formula of investing the majority (90%) of your money in some sort of gov''t guaranteed paper product and the remainder in index puts which are re-upped as they expire or cashed if money is made, you might do well. But you might not because you are waiting for some great unknown that may or may not be on its way. While waiting, you could be drawing down your put portion and balancing them against you interest payments for a net little if any gain.

We all know that the market goes up and the market goes down and that on average over the years it goes up more than it goes down. We make our money knowing this, and riding thru negative events and doing a bit of formulaic timing by rebalancing during the extreme highs and lows. Such folks trust the history of the S&P or DOW and believe they have a formula that is history tested.

Taleb sees something different is on his horizon.

On average, history says the markets go up, so that means on average you will lose money on the strategy suggested by Taleb, unless you agree with him (and it turns out to be true) that we face some serious unknown unknowns. I don't think they exist. I do think we can deal with the known unknowns coming up the pike.

I also think Taleb's idea is an interesting speculation and worth considering if one sees a similar world, one close to his view.
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Old 09-10-2007, 03:52 PM   #10
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I appreciate his pointing out that most financial analysis is built on the assumption of a bell-curve distribution, yet almost none of that is actually the case. I can't think of another financial writer who makes that point, with the possible exception of Bernstein.
Mandelbrot wrote a book on this very topic, which to me is a better book than Taleb's.
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Old 09-10-2007, 03:52 PM   #11
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I appreciate his pointing out that most financial analysis is built on the assumption of a bell-curve distribution, yet almost none of that is actually the case. I can't think of another financial writer who makes that point, with the possible exception of Bernstein.

Our high-school sophomore doesn't understand why she should take a statistics course before college, because she says she's going to be studying engineering! I told her it'd make her a better blackjack player and investor, so she's happy again.
Good for your daughter!

Actually Bernstein convinced me to bet against him - even though he proved his non bell point my one in six odds beat the Powerball quick pick odds when I gas up the vehicle.

And the Norwegian widow always says melt cheddar not butter on your broccoli and be patient - collect some dividends while you're waiting.

heh heh heh -
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Old 09-10-2007, 04:12 PM   #12
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Greg, I don't agree with the idea that this approach is for the fearful. We all have fears. It's an evolutionary advantage. The questions we need to ask are:

1) What's the risk of failure?
2) What happens to us in the case of failure?
3) Can we mitigate that risk of failure?
4) What's the cost of mitigation?

A lot of people just look at (1), and figure they can ignore the rest. We'll build our house near a cliff to get a nice view and rationalize away the risk of a mudslide by saying "there hasn't been one in 100 years." Unfortunately, if that rare event does occur, we're hosed.

People think that same way about their investments. "It's been all good for 100 years!" OK, let's say the risk of something terrible like the Great Depression or Japan 1990 is very low. Once in 200 years, say.

If our lifespan is 70 years, the chance of us seeing a once-in-200-year event is 35%. Pretty high, eh? And the consequences would be pretty bad, eh?

Now, there's no need to worry about such an event, but would it be smart to consider a risk mitigation plan just in case? Or should we just go balls out and hope for the best?

If the consequences were small, I'd say go balls out. But since the consequences would basically be "yikes, I'm hosed," it's something I'd like to guard against.
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Old 09-11-2007, 08:02 AM   #13
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Greg, I don't agree with the idea that this approach is for the fearful. We all have fears. It's an evolutionary advantage. The questions we need to ask are:

1) What's the risk of failure?
2) What happens to us in the case of failure?
3) Can we mitigate that risk of failure?
4) What's the cost of mitigation?
I disagree a bit.

I still own some gold miners and a wee bit of physical gold that would fit in my pocket if I had to run away and couldn't get to a bank for cash. It might last a month or so if all goes to hell in a hand basket.(One can always swap out some gold for services and stuff--anywhere and anyplace.) Historically, the old adage was that one should hold 5% gold in one's backyard portfolio. Plus, I've followed some of the bear writings over the past few years. So I feel I have a 'reasonable' handle on how fear affects one's self and groups. And how this fear can translate into, ummm, behaviors (e.g. see the overcompensation disaster of our current administration when fear overwhelms good and stable sensibilities; these emotions can linger for years and even increase if one dwells on them obsessively. "They're* all out to get us."). Fear can get out of balance--easily.

Again, I seem to only be able to answer you in a sort of obtuse fashion. I have no idea why. Answers by the number:

1) As I see it, to answer #1 you need to have a handle on what degree or quantity of negative event or events will happen. A minor recession or series of them, a major one, a great depression, or a Weirmar (sp?) Germany semi-permanent meltdown where we rise from the ashes all twisted and contorted and twenty years later. Each possibility has its own corresponding preparation activity. Risk or probability can be assigned to each stage or event of each negative possibility.

Inside this context, Taleb seems to be a very mild sort of doomsdayer. And it begs the question "Is he mild because he wishes to reach the largest audience possible (the moderate middle?), or does he really believe these black swans won't have a powerful effect on society?" I don't have a clue for sure, at least something I'd bet on. Anyway, his perceptions of outcomes seems not too extreme, although he spends a great deal of time talking about a metaphorical Extremistan in his book where all extreme behaviors and thinking are good.

So, 2), 3). and 4) flow out of one's perception of 1). That is where most of the initial time needs to be spent exploring the validity/probability of one's perceptions. To paraphrase something Taleb said "A small miss early on can have profound and large consequences later on." I guess it's similar to what Vanguard says about mutual fund fees: small savings early on can have profound effects on the portfolio later on. Well begun is half done.

I think fear needs to be understood if it is to be used correctly. It has both good and bad aspects. When it overwhelms folks, bad stuff often happens.

Owning PM miners have pacified my own fears quite a bit. So that--right there--is good enough reason for me to own some. Taleb too adds a method of dealing with the unknown using one's portfolio. And it could very well work on multiple levels.

* you could replace "They're" with Muslims, or Liberals, or Conservatives, etc.
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Old 09-11-2007, 12:49 PM   #14
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I don't think one can anticipate a certain type of failure very well. Humans are bascially pattern matching engines, so we will always try to predict the future. But the world, like any complex system, is truly unpredictable.

So, in a sense, you're right. We can only try to mitigate risks we perceive. We can't protect against all unknown unknowns. Taleb's "put 90% in treasury bonds" fails in the cases of hyperinflation, dollar devaluation, the fall of the American Empire, comet strikes, etc.

That's why I think the cost of the mitigation strategy is so important. The cost of putting 90% of your port in treasuries is potentially 5%/year or so. That cost is too high for most early retirees. Especially since you're only protecting yourself from a prolonged stock market crash.

So, what's a reasonable expectation of risk with a reasonable mitigation cost? Frankly, the only thing I come up with is variants of the corny old "age in bonds" bit.

For potential early retirees, I think it makes sense to go balls out before retirement. You can simply delay your retirement if that strategy fails.

Once you retire, I think a mix of nominal bonds and TIPS is prudent, and probably in a fairly high allocation. It makes sense to vary that allocation with both age and portfolio size as you progress in retirement, but perhaps not in the overly simplistic "bonds = age" heuristic of Bogle.

Basically, your need to take risks changes with time, wealth, and earning power. Taleb's strategy doesn't consider that or the cost of risk mitigation.
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Old 09-11-2007, 01:09 PM   #15
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Twaddle, your post presents in a nutshell was is obviously true- but for reasons I can't fathom hard for many to accept. What counts is not just the risk, which is anyway very hard to estimate, but also the cost of failure and the cost of mitigation. It's like the risk of borrowing money varies a lot with where you are in life. If you are young with not much in assets a loan to start a business is heads I win, tails some one else loses. Not so later on.

As an aside to the age/bonds thing, a young retiree might actually be in the same or even worse soup than an older one, depending on how easy it woujld be for him/her to get back in harness profitably.

If I were much better off, I would definitely adopt some modification of the Taleb strategy for a portion of my portfolio. Maybe .95*(1/3 TIPS+1/3 Bills+1/3 ST Treasuries), depending on yield curve. Then 5% is left for options. It would feel good to have $5,000,000 invested this way. What is left would be in an equity portfolio, managed on a stand alone basis.

A lot of decisions have to be made under contraints. I think it is best to understand that, rather than trying to convince oneself that those constrained decisions somehow represent the best plan in some absolute way.

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Old 09-11-2007, 02:06 PM   #16
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twaddle:

I certainly don't disagree with much of what you said (except as usual the randomness stuff). And we have to remember that many folks here probably aren't in the fat part of the bell curve either. My uncle lives on SS and his remaining CDs. All of his regular expenses are covered by this regular income, but when he wants a new different car or trip to Vegas (which isn't very often at 80+), he cashes out a CD. He feels very comfortable with this approach and always has. And I think this is far more typical than some may imagine. And in a sense, the folks that retire this way are really using 90% to 95% of Taleb's methodology--just not the speculative, timing part.

As was mentioned, most early retirees have a far different perspective than my uncle. In order to live well and have money twenty, thirty, or forty years from now, one has to attempt to capture more than a safe withdrawal rate for the duration. I actually use a Taleb-like portfolio (if I squint and completely close one eye) plan that gives me 20% hormone money, to time and/or pick stocks or whatever to my heart's content. This leaves the 80% to grow, compound, collect dividends or interest in a diversified and somewhat safe way. There have been many arguments on this board about whether or not long-term equity returns will stay significantly above the inflation rate. My best guess after a significant time of disagreement over recent years is that, yes, this is a pretty safe bet. But I'm planning to live another fifty years at this point so that skews my perception a tad.

One worry with following Taleb's plan is that one might get Restless Financial Assets Syndrome (RFAS). If everyone is making money in stocks for a few years and you're sitting there with mostly worthless puts that keep expiring as you keep adding, you might end up pretty irritable. If everybody else's portfolio is growing at 7%/yr and yours is mostly staying even or shrinking as you withdraw or rebalance into puts, you'll at minimum feel lonely. My 20% hormone money give me a substantial stake in following my own nose and my 80% stake keeps me grounded in the common, shared reality. It's a proportion that works for me.
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Old 09-11-2007, 02:30 PM   #17
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Yeah, that thing about crusing for 50 years on my faith in the markets is what keeps me glued to this site. That's as close to a religious faith as an atheist can get, and I need this church to keep the faith.

BTW, I've mentioned Swedroe's 30/70 portfolio before. In theory, that should perform as well as 100% S&P 500 with 1/2 the volatility, but he'll freely admit that the hard part of maintaining that allocation is the wild tracking error.
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Old 09-11-2007, 04:35 PM   #18
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. . . I've mentioned Swedroe's 30/70 portfolio before . . . .
So, what's the name of the book that explains it?

Seriously. Better yet. Is it on the world wide web?
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Old 09-11-2007, 04:46 PM   #19
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He's in the process of publishing a book on "alternative" investment strategies. In the meantime, there's this thread:

Bogleheads :: View topic - Larry Swedroe: concentrating risks/minimizing dispersion
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Old 09-11-2007, 09:00 PM   #20
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I've read Taleb's 'Fooled by Randomness'. I thought it was a very good book to bring a different perspective to risk in your portfolio. I really think about some of the ideas when I look at the risk in my portfolio.

It sounds like the Black Swan book is similar. What I'm not certain I agree with though, is that you can turn these theories around to make money, rather than just not losing money.

Is there anything in Black Swan that talks about *making* money? I have heard him talk about buying these far out-of-the-money puts, his theory is that they are undervalued because of this supposed misunderstanding of risk. But I'm not sure an individual (or even a group) can take advantage of these regularly enough to make money year to year. It doesn't help if you go broke the month before you were going to get the big pay-off.

IMO, Taleb is trading off the risk of a blow-up with the risk of slowly running out of cash. Waiting for a Black Swan event in order to make money may be like waiting for Godot.

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