Does It Make Sense To Implement The Taleb Portfolio?

by: Roger Nusbaum

Over the years we've touched on a concept put forth by Nassim Taleb that I find interesting, even if difficult to implement. In an interview with Consuelo Mack several years ago he talked about putting 90% of your portfolio in t-bills from around the world and then taking a lot of risk with the remaining 10%. I have referred to this a going berserk with the other 10% which was just an attempt to be funny.

My first exposure to this concept actually came several years before when a coworker was very amused by the fact that 98% cash and 2% short Nikkei futures delivered the same result as owning the S&P 500 with 100% of the portfolio. Being able to achieve market equaling returns with a tiny sliver of the portfolio while taking very little overall risk is intriguing and that is what Taleb's idea was about.

Now apparently this has been studied in a little more detail and turns out it might be a valid approach. Robert Powell published an article about a paper written for Financial Analysts Journal by Jason Scott and John Watson. They call the strategy the Floor Leverage Rule and by their work investors would put 85% in what should be stable investments (the equivalent of t-bills from around the world) and put the go berserk 15% in triple levered ETFs that track broad indexes.

Powell gave both sides of the argument for levered funds. The bottom line on them is that they do what they are supposed to do except for the times when they don't which is to say that how they perform depends on variables of up days and down days and percentage moves on those days and of course that is all unknowable.

One thing about this strategy that I haven't mentioned before is that the intense risk and volatility taken with the 10 or 15% reminds me of the old Carnegie quote about putting all your eggs in one basket and then watching that basket very closely.

The Floor Leverage Rule or whatever you want to call it would require more work in terms of rebalancing if all that is being used is a 3x SPX fund or active management of positions for someone using options of some sort or buying speculative stocks with the go berserk portion.

More work isn't necessarily bad unless you didn't realize there would be more work or you don't want to do more work.

In the last few posts the Montier concept of permanently impairing capital has come up a couple of times. Some version of floor leverage obviously reduces the potential consequence of panic selling out of a "normal" asset allocation after a large decline. A long position of 10 or 15% in levered ETFs faces a max loss of only 10-15% (actually less) versus more than 30% at the 2009 low (starting at 60% in equities and selling out after the 56% SPX decline).

For the right temperament this can be a valid strategy but there is a faddish element to it as well. Switching to this strategy or any other strategy that is different from the one you are using only to then give up after two years to try something else is not conducive to long-term investment success.

The tendency is to switch to something that has just done well. No strategy can do relatively well all of the time and a valid strategy has a good chance of not doing well for a while after is has just done well.