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Finance Investment Strategy Portfolio Management

The Law of All or Nothing

Introduction

In probability theory, the Kolmogorov’s zero–one law, named in honour of Andrey Nikolaevich Kolmogorov (yeah, I couldn’t pronounce that either), specifies that a certain type of event, called a tail event, will either almost surely happen or almost surely not happen; that is, the probability of such an event occurring is zero or one.

The significance of this law is more pronounced in our lives than we are aware of. In words of Morgan Housel, author of “Psychology of Money” –

“Anything that is huge, profitable, famous or influential is a result of a tail event- an outlying one-in thousands or millions event. And most of our attention goes to things that are huge, profitable, famous or influential. When most of what we pay attention to is the result of a tail, it’s easy to underestimate how rare and powerful they are.”

Now to drive this point home, let me walk you through two stories, one attune to rainbows and ponies and the other embodying a not-very-happy-ending.

Story Numero Uno

Universa Tail Risk, a Miami based hedge-fund scooped a whooping 3612% return in March 2020 when basically the whole world was experiencing one of the worst market drawdowns of this generation. How you wonder? Well, this firm founded by Mr. Mark Spitznagel in 2007 focuses on providing “insurance” on such once in a blue moon type of events. The premise is painfully simple, they don’t mind losing small amounts regularly for reaping stupendous amounts in one-off high tail-risk events such as the Great Financial Crisis of 2008 and the COVID-19 induced market panic in 2020.

Tail-Risk Hedging

The main focus of the Investment Management firm is “Tail-Risk Hedging”. Now, what exactly does that mean?

Tail -Risk in the context of investing refers to the possibility of incurring large amounts of losses due to rare events (also called, tail-events). So, in order to protect investments from incurring such large, catastrophic losses, one can create offsetting strategies which mitigate this tail-risk. One simple example would be, suppose a hypothetical person called Joe has invested heavily into the NIFTY50, but feels that the index might perform abysmally the coming year because of large-scale bad-loan problems in the nation. In this case, Joe can protect his position from such events by purchasing a long position in a negatively correlated asset or by the use of derivatives (Eg: purchasing put options).

This is basically what Universa does, but obviously on larger scales with strategies involving greater complexities and research. Their main focus is on such “Tail-Risk Mitigating” strategies.

Now that we covered the positive side of the tail-event coin, where Mr Mark Spitznegal went to bed as a financially happy man end of Q1 2020 (while probably feeling horrible for the plight of humanity?). Things could just as well go the other way. I mean, take Long-Term Capital Management for instance.

Story Numero Dos

As you can see, these tail-events, albeit rare have materially pronounced impacts on us living beings, be it financially (evidenced from the stories above), geographically (division of Earth’s singular supercontinent Pangea gradually from 2 to the 7 continents we know today caused by shifts in the tectonic plates), cosmologically (A massive asteroid which struck the planet 66 million years ago and brought a calamitous end to the reign of dinosaurs) and the list goes on. We silly humans don’t have the intellectual processing capability to be prescient of such events. Does this mean we’re doomed? Of course not.

Amor Fati

To quote an influential 19th century German philosopher Friedrich Nietzsche, “Amor Fati” which is to fall in love with one’s fate. You see, we have control over a limited number of variables, the rest, well it’s left to randomness incubated by the other 7 billion people and infinite variables this world contains. Our very make-up as an individual infact was beyond our control: genetics (our ancestory), psychology (our experiences and reactions), emotions (our perceptions cultivated by what we have been exposed to on a random basis ever since we were born). So basically, what you are as an individual today, was in a way a form of randomness too, yeah?

In a world like that, all we can do is say “Amor Fati!” and acknowledge the beauty of randomness, chaos and everything in between. We can’t possibly be prescient of every event that is going to take place, we can’t possibly rely on “past information” to forecast with utmost accuracy of what the future holds, what we can do however, is be humbled by the magnitude and degree of events that can go wrong and yet take mindful decisions which might be in our “control” to not get wiped out by the same.

To quote Morgan Housel again (haha, can’t help it, I am currently reading his book!)

Not “growth”or “brains” or “insight”. The ability to stick around for a long time, without wiping out or being forced to give up, is what makes the biggest difference. This should be the cornerstone of your strategy, whether it’s in investing, your career or a business you own.

With that we come to an end of this article, before I bid adieu for the week, in the words of Daniel Kahneman – “The correct lesson to learn from surprises, is that the world is full of surprises”.

Further Reading

Take Care,

With Love,

Coffee Time Finance


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