Sunday, July 29, 2007

The black swan strategy

I recently read a few articles on this subject and found it extremely interesting..

Nassim Nicholas Taleb has built his career based on the theory of unexpected rare events. Taleb calls himself a "skeptical empiricist", and believes that people generally overestimate the value of rational explanations of past data, and underestimate the prevalence of unexplainable randomness in that data. Simply put, he says that "No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion."

His company Empirica follows a particular investment strategy - It trades options, i.e it deals not in stocks and bonds but with bets on stocks and bonds. It takes very small bets from people on an unlikely event. For example, if a stock has lets say never dropped below 10% in a particular month, it takes a bet from you for a very small amount (lets say 1 cent) that the stock will indeed drop by 10% or more in this month. You don't mind this bet, because this event has never happened in the past. However, the company buys millions of such options from various people. If as expected the event doesn't happen then the company loses. But remember, its loses are pre-determined and small. However, if indeed the event does happen, the company rakes in millions of dollars.

Empirica makes its money when there is an exceptional day in the market. Something new or different happens and the unexpected unfolds. Under such circumstances, which were probably all but impossible to predict, Empirica will be able to exercise its options and reap a healthy profit. Huge gains will make up for the numerous days of small loses.

Venture Capitalists use this at all times. They invest in tons of “white swans,” lose a little bit all the time on those investments, and be poised for the singular “black swan” whose returns swamp all of those losses.