Geoff Considine

Black Swans, Portfolio Theory and Market Timing

John:

I agree on a number of points. First, QPP and related tools are not for people who want to trade monthly and weekly. Mean reversion operates on longer time scales. Second, you mention a Taleb-endorsed strategy in which you buy calls with part of the portfolio and bonds with the rest. Consider what this means. You are paying premium to buy a time decaying asset: the call. On very volatile issues, this is likely to result in drawing down your premium as options expire out of the money. Sure, you will hit big sometimes but there is much greater potential for gambler's ruin. You are also betting that the market consistently undervalues these options because of the fat tails. But is the under-valuation enough to make this kind of strategy cost effective? You would need a model to assess that but Taleb thinks the models are insufficient...

One of the things that I think a lot about is the fact that when you invest, you are buying a piece of a business. You can then diversify by buying multiple businesses. But the ultimate gains are from buying businesses cheap and diversifying well. I own the future earnings of these companies and I have to take risk to get these.

To think that buying out of the money calls on part of the portfolio gives you the upside while avoiding the downside is naiive. I do not believe that markets are all that efficient, but to assume that you could consistenly do this and generate decent returns is to make a VERY strong assumption about market inefficiency. To then follow Dr. Taleb and say you can't quantify it seems even worse.

As far as exit strategies go, I do address that in a number of articles but this is a function of your risk tolerance and some other factors. Personally, I tend to only sell my speculative positions which I identify as separate from my long-term holdings. My articles focus on long-term holdings. If this point is unclear, I have an idea for an article....