Taleb's Hyperinflation Call: Proceed Carefully

As the inner workings of the global financial system deteriorated in unprecedented fashion following the collapse of Lehman Brothers, the natural inclination amongst investors and the media was to scan the universe of prominent voices, and identify a sage or two who had managed to "predict" the seemingly unpredictable. From this seer-seeking process emerged Nicolas Taleb, the author of Fooled By Randomness and The Black Swan. Taleb proved correct in his postulation that, despite the day's prevailing wisdom, the financial system was actually riskier and more prone to collapse than at any other point in history. He asserted that the advent of "mega-banks", and the proliferation of securitazation practices had produced a degree of financial interconnectivity such that the failure of one important player could trigger a global failure. While this assertion proved correct, we feel that it would be advantageous for investors to familiarize themselves with Taleb's stated investment strategy.

The impetus for the most recent media coverage of Taleb has been the news of his purported "bet" on hyperinflation. While Taleb is obviously in possession of admirable analytical abilities, we would caution against interpreting the "bet" as Taleb's prognosis that hyperinflation is More Likely to Occur than it is not i.e the probability of hyperinflation is greater than or equal to .5. Upon actually reading either of Taleb's books, it becomes clear that his investment approach is markedly different than the consensus approach taken by most money managers. Conceptually, Taleb advocates the use of a small portion of one's capital, distributed across numerous positions. The perceived probability of success for any given position is extremely low, however, a correctly selected position will result in an extremely high return. Taleb indicates that he has sometimes gone years without a correct call-it is the outsized gain that occurs Once which vaults him into profitability. For instance, Taleb was short the market for several years leading up to the Crash of 1987, probably losing money on expired put options the whole time. However, when the Crash finally did happen, the gains were far in excess of the losses that had been suffered in previous years.

A rational assessment concerning the liklihood of hyperinflation would lead one to the conclusion that the scenario fits nicely within Taleb's existing investment framework. While we will not pretend to know the exact probability associated with a looming bout of hyperinflation, we can say that a correct wager in favor of hyperinflation would lead to outsized gains in the event that it transpired. In addition, to not hedge against this possibility, albeit of questionable liklihood, would subject one's entire portfolio to great risk. For a similar, yet more grave analogy, simply peruse the web for an explanation of "Pascal's Wager". Furthermore, we know that Taleb has historically maintained a portfolio consisting of roughly 75% US Treasury Bonds - an asset class that would be sure to perform poorly in any hyperinflationary scenario. Ultimately, we consider it vital that individual investors be able to properly consume the many media accounts of Nicolas Taleb's latest "market prediction".

Sphere: Related Content