Gaining from disorder

In the book The Black Swan, the author Nassim Taleb introduces the concept of a black swan. It's an unexpected event which has a high impact. A good example of that is the Satyam scandal, which caught India by surprise. No one (except the insiders) could have foreseen it or prepared for it, much less gained from it. The 2008 financial crisis was also a black swan. Investors in sub-prime mortgages lost heavily and equity investors went through a harrowing period. But there were also people who foresaw it and gained immensely from it; for instance, hedge-fund managers John Paulson and Kyle Bass.

How did they do it? They had built 'antifragile' portfolios. In his book, Antifragile, Taleb talks about the antifragile theory. 'Antifragile' things are those that gain from disorder. When applied to investments, it is about building portfolios that do very well and even become better during black-swan events. Such portfolios may not outperform others during bullish times, but they are ideal in the times of crisis. Here is an analogy: your coffee cup is fragile. If it falls down, it breaks. Your stainless steel cup is robust. If it falls down, pretty much nothing happens to it. If there were a cup which became sturdier every time it fell, it would be antifragile. A good portfolio should be like that non-existent cup.

A fragile portfolio is one which is overexposed to one type of risk, be it inflation risk, currency risk or commodity-price risk. For instance, a bond-only portfolio is overexposed to inflation risk. In the 1920s, Germany experienced a hyperinflationary episode, which completely wiped out the wealth of German families, including that of government officials and civil servants. In the 1970s, the UK experienced two consecutive years of 43 per cent and 26 per cent inflation, wiping out bond investors' and pensioners' wealth. Russian bank accounts had their value cut to half in 2014 as a result of a massive devaluation of the ruble. Currently, Venezuela is undergoing a currency crisis as a result of the steep drop in oil prices over the last two years.

For most investors, a truly antifragile portfolio is beyond their reach, since it involves complicated derivatives strategies and deep knowledge of financial markets. But all investors can move their portfolios along the spectrum from fragile to antifragile.

Own a bond-heavy portfolio? You are exposed to inflation risk and currency risk. Own an equity-heavy portfolio? You are exposed to market risk. Own a balanced portfolio of Indian equities and bonds? You are exposed to country risk. A bond portfolio with some allocation to gold will be less fragile, since gold tends to do well when inflation rises and the rupee loses value. An equity portfolio can have some debt component. An internationally diversified portfolio will minimise country risk.

The further one moves along the spectrum towards antifragile, the lesser the risk of losing heavily due to black-swan events. While black-swan events cannot be predicted, the wise investor would think through the risks in his or her portfolio and figure out ways to minimise their impact.