Tom is a wild turkey. Life is hard for Tom. Tom has to go out every day and peck for his own food. He has to avoid those duck dynasty guys carrying small armories in their jacked up F-150s.
One day, Tom discovers a wonderful surprise. Tom wanders into Bailey’s backyard and finds a huge pile of food.
“How wonderful!” thinks Tom, “No more pecking for grub worms or avoiding hunters!
Bailey is friendly towards Tom the turkey. Tom stays and Bailey brings out more food for Tom everyday. She stands in the kitchen window, watching him munch away at the trough.
After a few months, Bailey installs a new feed machine: one of those Japanese sushi restaurant conveyor belts. It carries heaping plates of food to Tom as he reclines in his turkey-edition LaZboy.
For a thousand days, every successive day confirms to Tom (and the people in Tom’s risk management department) that, in fact, Bailey loves turkeys.
After 1,000 days, Tom projects that there are two possible futures:
- Life gets much, much better
- Life gets much better.
From Tom’s vantage point, this seems a reasonable conclusion to draw. Things have been getting better for years. Will they continue. It’s not until the 3rd Thursday of November that Tom realizes his mistake. By then, it is too late.
The Turkey Problem is an old story about risk. Like turkeys, many individuals don’t understand the true risks of their decision. It is problematic because it is a situation in which everything keeps getting better, until, well, it does not. There are no obvious warning signs for the Tom.
In a complex and interconnected world, it becomes harder to connect cause and effect. Like a virus spreading through a population, risk cascades. As our world grows more complex, turkey problems become more common.
Many people today are turkeys.
The defining thread of my work over the last decade has been learning how to not be a turkey. Learning how to survive and thrive in an uncertain world. I’ve researched, written, and worked on how to apply that to our careers, businesses and investments.
How can we build more robust careers that keep us from being turkeys at the worst possible time?
How can we build more robust businesses?
And, finally, how can we build more robust, or even antifragile, portfolios?
For the past year, I’ve been working with researchers, hedge funds and risk managers on answers to that final question. Beginning today, I’m going to be revealing some of the research we have done on how to build more antifragile portfolios.
The 2008 financial crisis triggered a realization for me of how important it was for investors to have more antifragile portfolios. It was the year many retirees or near-retirees had to rethink their futures. Many people in what they thought were safe or stable jobs or career paths found out that those jobs weren’t so stable. Many people had fallen victim to the Turkey Problem.
My belief at the time was that thoughtful experts captained the economy. The 2008 financial crisis made it seem no one was at the wheel. No one knew what they were doing. How did something as insignificant and esoteric as an underwriting error in the U.S. housing market bring the global economy to its knees? And how did almost nobody see it coming?
I remember the moment when it clicked for me. I was reading Nassim Taleb’s book Fooled by Randomness on an old blue couch I’d bought for $100 off Craigslist. In his books, Taleb argues that humans tend to create environments where extreme events are more likely. They use incorrect models and faulty assumptions that underestimate the probability of extreme events. This leaves them exposed to black swan events.
The result is a whole lot of turkeys that don’t know Thanksgiving is coming. In 2008, I was one of those turkeys. I thought I was on a stable career path. I thought I had a basic understanding of finance and investing. I was not and I did not.
It became clear to me that we had to reimagine the way our models view the world in a fundamental way. We must build more robust, if not antifragile, systems.
There was a small little corner of the world that had come to a similar conclusion and was attempting to study it. The core idea comes presented in many forms including antifragility, black swans, chaos theory, complex systems science and ergodicity. They all take similar approaches and reach similar conclusions. (I will use the term complex for simplicity’s sake).
Understanding the logic of this new complex world view is a fundamental skill for our time. To be successful as a developer, designer, marketer, CEO, or investor, you must understand how complex systems function.
Something Complex This Way Comes
There are at least two types of systems. One is complicated, the other complex.
Complicated systems are those that require analysis and investigation, but there is a knowable relationship between cause and effect. Operating in a complicated domain isn’t easy. It requires investigation and the application of expert knowledge. But, complicated domains have best practices.
Fixing your car is “merely” complicated. If your Toyota Corolla1 breaks down, a qualified mechanic can give you the right answer for how to repair it. As anyone who has attempted to find a good mechanic knows, this is not trivial. An unqualified mechanic can give you many wrong answers and over charge you.
Complex domains are those where the relationships between cause and effect are clear only in retrospect. It is any system with many different components that interact with each other. Complex systems are characterized by the phrase “the whole is greater than the sum of its parts.”2 There are no best practices because the rules are constantly changing.
If a car is complicated, then an environmental ecosystem is complex. If your radiator is leaking, it doesn’t mean your tires go flat. But, if one species goes extinct, it affects everything else in the ecosystem.
A complex environment is one where there is no “right” answer.
Complicated domains have risk, known unknowns that can go wrong. There is a wrong way to fix your car, and if you aren’t an expert, you will mess it up.
Complexity is the domain of uncertainty, unknown unknowns.
Complex systems create turkey problems. They breed unforeseen risks which show up as periods of extreme volatility, be it Thanksgiving for the turkey or the Lehman Brothers bankruptcy in financial markets.
Complex systems are a pervasive feature of the world we live in. In the modern world, it is the water that we swim in and the air that we breathe. When we say that the world is becoming more networked or connected, we are implicitly saying that it is becoming more complex.
A few examples of complex systems include:
- Organizations (AKA your company and job) — Your company is also a system in which the many different employees, managers, and departments interact.
- Organisms (AKA your health) — Your body is made up of many different components, from cells to organs to hormones that interact with each other.
- Markets (AKA how you make money) — Markets are one of the most studied examples of complex systems, where many different players interact with each other.
Understanding how complex systems function can allow you to make better decisions. It can improve your decisions about work, your health, and your portfolio.
A component of a complex system where the future is unknowable has one of three properties:
- Fragile – harmed by complexity and volatility. That is, turkeys.
- Robust – resilient or unaffected by complexity and volatility
- Antifragile – helped or benefitting from complexity and volatility
The thread that has come to define all my work is understanding how to survive and thrive in a complex and uncertain world. Helping myself or others to become more robust or antifragile (and less of a turkey).
I Was Told There’d Be Antifragility
When I started writing about how to become more robust or antifragile, I found that tens of thousands of other people benefited from it as well. I came to see that helping others make better decisions in the face of uncertainty was one of the most important things I could do with my life and work.
My book The End of Jobs showed how to apply complex-systems thinking to your career. The internet made the world of work more complex. Those who ignored it risked ending up as turkey, while those who embraced it could leverage it to their benefit. The End of Jobs provided a playbook for that.
My essay on Antifragile Planning looked at how we could apply complex systems thinking to productivity. Instead of rigidly defined plans, knowledge workers today need flexibility. I turned this article into a popular course that has been taken by over a thousand entrepreneurs, investors, and knowledge workers.
I studied how business owners could apply this type of thinking to grow their business. This resulted in essays like Focus on the Fat Tails and Jesus Marketing which applied antifragile thinking to marketing. Instead of huge ad spends, marketers needed to understand fat tails and how they emerge out of complex systems. I used this antifragile approach to grow an eCommerce startup in California by 527% in 18 months.
My essays on Scaling and The Business Production Function looked at how entrepreneurs and executives could apply complex systems thinking. What did it look like to build a company to both grow a business while keeping it robust, if not antifragile?
I dove into the work of John Boyd, a military strategist who pioneered the OODA Loop, a framework for winning in complex situations.
In 2016, I started researching how to apply this antifragile mindset to investing. Many books on the subject such as Nassim Taleb’s are great at the philosophy but light on details.
The complex system of financial markets and our portfolios is the area where we stand to benefit most from a little more antifragility.
One outgrowth of this was a deepening interest and research on cryptocurrency and Bitcoin. In my research, I saw that Bitcoin exhibited interesting antifragile properties. The financial system that created the 2008 economic meltdown appeared centralized and fragile. Bitcoin’s design was far more decentralized and robust. What could the impact of that be?
Yet, from an investor’s perspective, Bitcoin remains a speculative and unproven asset. Investing more than a small allocation in something as new and as-yet-unproven as Bitcoin is not a thoughtful asset allocation strategy.
Antifragile Investing in Traditional Markets
In 2016, I began reaching out and talking with hedge fund managers specializing in high volatility and black swan scenarios. These types of funds are often categorized as tail risk, meaning they do well in bad years for traditional markets such as the S&P Index.
I burrowed down the rabbit hole from there, reading a range of books and research papers. I started to dabble in trading options, a common tail risk strategy, to understand how they worked.
Through that process I met Jason Buck, an investor with over 20 years of trading experience. 2008 had been a light bulb moment for him as it had been for me. He had spent the next decade working with family offices and high net worth individuals to build more antifragile portfolios. He had found some answers.
We spent hours on the phone talking about his research every week for months.
There were some pretty good answers to the questions I had been asking. There were people who had worked to figure out viable approaches to tail risk hedging against black swan events. They were attempting to find a way that investors could add an effective form of diversification to their portfolios.
While diversification is often thrown around as a buzzword, it’s hard to overstate how important it is. Hedge fund manager Ray Dalio summed it when he said “diversifying well is the most important thing you need to do in order to invest well.”
Diversification generates higher returns with fewer declines over the long run. more returns per unit of risk. For one, this allows investors to achieve higher returns. For another, it leads to less stress for investors. It helps to prevent emotional over reactions such as panic and “selling at the bottom.”
A diversified portfolio means having some assets that go up while others go down and vice versa. The challenge is how to actually do that well.
The year 2008 showed how interwoven the global economy is today. A seemingly isolated risk like U.S. residential mortgage bonds can have devastating effects across many asset classes. If Mr. Market drives down everything in a portfolio at the same time, it isn’t really diversified.
In 2008, a “diversified” portfolio of U.S. stocks, international stocks, real estate, commodities, and high yield bonds turned out to be not so diversified.
To be truly diversified, investors need something that reacts positively to tail risk events like 2008 and actually benefits from volatility. True diversification requires some element of antifragility, something that benefits from volatility, in a portfolio.
While many investors believe they have diversified portfolios, the reality for nearly all investors is that almost everything in their portfolio is fragile and harmed by volatility.
When combined with short volatility assets such as stocks, bonds, real estate, venture capital/angel, or private equity, an effective antifragile or long volatility asset tries to provide a truly effective form of diversification with the goal of truly allowing investors to both reduce their drawdowns and achieve higher returns.
But, I also learned that there are some challenges with existing solutions. One is that many don’t necessarily work as well as many investors believe. One common solution for adding a tail risk long volatility asset to a portfolio is using government bonds, particularly U.S. Treasury bonds. Over the last 30 years, when stocks have fallen, government bonds have increased, providing diversification.
A very popular version of this is the “60% stocks / 40% bonds” portfolio that is widely used by many investors today.
The inconvenient truth for many of these portfolios is that U.S. Treasury bonds have only very recently been an effective form of diversification and may not be in the future. Though stocks and bonds have been an effective diversification strategy over the last 30 years, they have been moderately or highly correlated in 89% of months going back to 1883.
It’s likely that some of that more recent correlation is driven by declining interest rates. When the stock market has fallen over the last thirty years, the Federal Reserve has cut interest rates which increases bond prices as stocks are falling. According to interest rate historian Jim Grant, rates have never been lower in the 3,000 years of recorded interest rate history. So while no one knows what the correlation will be going forward, there is, at least, some reason to be skeptical that the recent historical anomaly will continue into the future.
The alternative that Jason has been researching and implementing was to try to hedge using products that are more directly negatively correlated to traditional markets. For example, if you own an S&P index fund, you can buy options on the S&P that function as a type of insurance against market crashes. The challenge with similar option buying strategies is that they tend to lose money in good years. In effect, options are like buying insurance, so every year a market crash doesn’t happen, you lose all the premium you pay-in.
While this is perhaps the prudent thing to do (we “lose money” every year by having home insurance or health insurance), it is difficult to stick with a strategy that loses money six years out of seven. This is particularly true today. If you started using most of these strategies in 2011, you would have been losing your premium every year.
In some cases, the “premiums” can be so high that even when the crash does come, you will have lost too much for it to be worth it. An easy-to-implement strategy tail risk strategy is to use an ETF like the ProShares VIX Short-Term Futures. The challenge is that it has declined 99% from its peak in 2011. This particular insurance policy is so expensive that it isn’t worth it.
What Jason realized is that investors needed to find products that benefit from tail risk events and market crises without paying so much insurance premium in good years that you miss out.
Investors need a dynamic tail risk strategy that instead of buying insurance on the whole market all the time, buys insurance on the risky parts at the riskiest times. It would be expensive to insure all the forests in the world, all the time, against all forest fires. But, if you insured just against certain areas, and just when they were dry and had high winds, you would get nearly all of the protection you needed, but at a small fraction of the cost.
In January 2019, Jason convinced me to go to Miami for an alternative investments hedge fund summit where we met with many of the hedge fund managers I had been researching. We talked to existing managers who were employing the kinds of dynamic tail risk strategies that worked. However, there were some challenges.
One was that minimum investments tended to be high, upwards of a million dollars. This made it difficult for most investors to get access to these types of strategies.
Second, it became clear that each individual dynamic tail risk strategy had areas that they weren’t focused on. Some specialized in monitoring and insuring against areas with high winds. Others focused on insuring particularly dry areas.
They each had scenarios where their particular tail risk strategies might not catch a down move in markets or might lose premiums at an unacceptibly high rate. They were all buying insurance on slightly different parts of the forest at slightly different times. However, it seemed possible to combine these strategies into a basket in an attempt to capture the whole-is-greater-than-the-sum-of-its-parts effect where one manager’s weak points were covered by another.
By combining a handful dynamic tail risk strategies, we came to believe that you could get something like better coverage for a lower premium.
This also made sense to me because as I immersed myself in learning how to competently trade options, I had come to see that it wasn’t exactly something you could do part-time, it was a very specialized skill. While anyone could learn to do open heart surgery, you wouldn’t trust someone to do it well without many years of training. The same appeared to be true of options and volatility strategies, so it became clear to me that it made sense to use professionals.
I came to see that this approach could make a big impact for me for three key reasons:
- I could manage my exposure to short volatility assets such as stocks, bonds, real estate, VC/angel, or private equity, potentially reducing the sting and length of their down periods while increasing my overall returns over the course of a full market cycle. I like to sleep well at night, and knowing I am effectively hedged is part of that.
- I could mitigate market risk in my business and career. Since I do most of my work in or around the startup industry, which tends to be highly cyclical, I wanted to know that I had something that would hedge that risk out. I believe the key thing is to prepare for a situation where the markets drop and my income gets hit at the same time. In one lifetime, it will likely happen.
- It could function as an entrepreneurial put option. Because the payout for investors in this type of strategy is expected to come in years where markets are down, I wanted to have liquidity when others didn’t, and there are clear buying opportunities (e.g., a house that costs $1 million now may fall to $650k in a broad sell off, but that opportunity is only available for those with the cash). An effective tail risk asset would be throwing off excess returns just at the time excess capital is most valuable.
And so we set out to see if we could actually build such an investment strategy. We spent a year doing due diligence on dozens of potential strategies, building upon the thousands of hours Jason had spent in the preceding decade as well. We partnered with RCM Alternatives, an award-winning 20-year-old firm managing billions of dollars, piggybacking on their ongoing due diligence of these managers, extensive database of hedge funds, and expertise in analytics and measuring risk and reward profiles.
Out of that process, the Mutiny Investment Strategy was born.
The Mutiny Investment Strategy
Why did we call it Mutiny? Mr. Market is the captain of our financial lives. And while he may be right much of the time, he must be held in check. The mutinous first mate’s role is to step in when the captain threatens the entire ship and her crew. His role is to take control of the ship, ensuring the safety of all aboard and sailing onwards into calm waters.
The Mutiny Investment Strategy has been designed to act as a so-called “black swan” investment. It is a form of “antifragility” or “crisis alpha” that is intended to achieve large asymmetric gains in times of high volatility or tail risk such as the 1987 flash crash, 1998-2001 dot-com rise and crash, or the 2008 financial crisis.
When combined with short volatility assets such as stocks, bonds, real estate, VC/angel, or private equity, Mutiny aims to provide an effective form of diversification, allowing investors to achieve superior portfolio performance while reducing drawdowns over the course of a market cycle.
To help achieve this, the Mutiny Investment Strategy aims to limit the cost of this protection during good times, with the goal of earning enough to outpace inflation in years when the market is up—in effect trying to create insurance that you get paid to own.
Mutiny takes a multistrategy approach. This approach hopes to offer broader and more effective protection against the many types of tail risk or black swan events that can take place, leaving the ensemble better positioned than a single tail risk strategy may be, while also limiting the premium paid and improving performance when times are good. Of course, there is no guarantee that the approach will work out in exactly this way, but there’s a fundamental logic behind each piece of the strategy’s approach.
The best portfolios are diversified; they have some assets that go up when markets go up and some assets that go up when markets go down. This increases their long-term return. There’s lots of assets that go up when markets go up; Mutiny is for when markets go down.
Over the coming months, I’ll be publishing more of our research behind the Mutiny Investment Strategy. We are already finding interest from a wide range of groups including:
- Founders who had some meaningful liquidity event and want to “insure” some of that.
- Individuals with significant market exposure through homes and stock portfolios but don’t want to sell (often for tax purposes)
- Retirees who want to make sure they are balancing growth with capital preservation.
- People looking for an entrepreneurial put option to be able to have liquidity after a market crash.
If you are interested in getting more information and staying up to date with the ongoing research releases, please click here.
For the last decade, I’ve been trying to find ways to build better tools and offer frameworks to help us thrive as individuals and a society in an increasingly complex world. It’s hard to overstate how important that is and how essential a skill it is for the future.
Though most people are not aware, we are almost all brought up as turkeys. We are taught ways of thinking based on a different world.
In order to avoid the turkey’s fate, we will have to reinvent how we think about almost all of the major components of our lives: our work, our health and our investments.
If you’re interested in learning more about it, you may enjoy some of the research and podcasts at Mutiny Fund where I work on helping investors build more ergodic portfolios by attempting to add a form of ‘antifragility’ or ‘crisis alpha’ that is intended to achieve large gains in times of high volatility such as 2001 and 2008.
P.S. Do you have any particular questions about tail risk or black swans in financial markets? Ping me on Twitter or drop me an email at taylor at this domain and I’ll do my best to address them in future research reports.
P.P.S. If you’d like to get more information about the mutiny investment strategy and tail risk investing in general, here’s that place to drop your email again.
Last Updated on June 30, 2020 by Taylor Pearson
- For all the 23 year old Bitcoin millionaires, a Toyota Corolla is similar to a lambo but not quite as fast and the valet parks it in the back of the lot.
- Though it is equally possible that the whole is worse than the sum of its parts. It is more accurate to say the whole is other than the sum of its parts.