Hedging The Black Swan" Nassim Taleb

In early2007 I read the Black Swan, by Nassim Taleb. It was a fascinating book that really helps define the way you look at risk. It is a sort of counterpoint to Peter Bernstein's Against the Gods. His prior book, Fooled by Randmoness is just as illuminating. Taleb argues that unlikely scenarios are undervalued. In other words, those scenarios that have not occured before are almost completely discounted in the present. This gives a smart trader an opportunity to make small bets on a huge range of unlikely outcomes very cheaply. If even a few of these bets come true the payoff can be enormous. Picture the hedge fund that bought out of the money put options on the S&P when the DIA ( an etf representing the DOW) was near $130 in the beginning of the year. Puts November DIA 100 put would have cost just dimes. When the DIA ETF hit $85 in early November those puts would have been worth maybe 100x what you paid for them. Betting on hundreds of unlikely events is bound to pay off in the long-run, but you may suffer losses for years before hitting the jackpot. For a hedge fund manager this strategy may be a difficult, particularly preventing redemptions after three or four losing years. That big payday may come with very few assets.

Finally, after many difficult years, Nassim's hedge fund, Universa has finally been getting its time in the sun this year.