Renegade Trader Makes $1.7 Billion in Bear Market

Last month as the Dow dropped 20% and portfolios got battered, one investor was prepared. Nassim Nicholas Taleb, who founded the risk management firm Universa Investments, watched his portfolio soar 65% and 115%.

If Taleb’s name sounds familiar that’s because his book The Black Swan: The Impact of the Highly Improbable, spent 17 weeks on the New York Times Bestseller list.

Universa was launched in December 2007 with $300 million in assets. It is now estimated to be worth close to $2 billion. Technically Taleb is an “external advisor” to Universa, which is managed and owned by former professional trader Mark Spitznagel.

How did Universa Investments gain 115% in the vortex of the worst bear market in two decades?

Did they look into a crystal ball and see the credit crisis playing out as it has. Did they employ a room full of PHD chart wizards? The answer is “no”.

Universa’s trading theories are based on Taleb’s ideas about profiting from rare events – or “Black Swans.” When those rare events occur, they are in for a big pay day.

In this case, Universa purchased far out-of-the-money “put” options on stocks and broad market indices. A put option gives the owner the right, but not the obligation, to sell an underlying asset at a set price within a specified time period. It’s a bet that a stock or market is going down.

For the past year, Universa has been betting that the market would take a radical turn for the worse. I made the same call (“Why The Dow is Going to 8,000”) back in July, but I didn’t have $300 million to back up my prediction.

Universa makes a lot of small bets and watches most of them go bad. But when one hits, it’s big.

The foundation of Taleb’s strategy is revealed in his first book, “Fooled By Randomness.” It’s required reading material here at Q1 Publishing. Here is the core of Taleb’s philosophy:

“We are genetically still very close to our ancestors who roamed the savannah. The formation of our beliefs is fraught with superstitions. Just as one day some primitive tribesman scratched his nose, saw rain falling, and developed an elaborate method of scratching his nose to bring on the much-needed rain, we link economic prosperity to some rate cut by the Federal Reserve Board.”

Taleb’s assertion that people will frantically search for – and find – causal connections where none exist, leads to the second leg of his investing theory: investors are so programmed to seek order that they neglect to account for rare or “random” events. In fact scientists – who are trained to think analytically – will often discard data that falls outside a statistical norm. When confronted with an anomaly, throw up their hands and say, “This is crazy, so let’s not count it.” Instead of, “Apparently crazy things happen, let’s factor it in.”

“The typical case is as follows. You invest in a hedge fund that enjoys stable returns and no volatility, until one day, you receive a letter stating, ‘An unforeseen and unexpected event, deemed a rare occurrence…’ But rare events exist precisely because they are unexpected. They are generally caused by panics, themselves the results of liquidations.”

Taleb’s hedge fund exploits investors’ reluctance to factor in random events, which he traces to deeply rooted narcissism. Wealthy people, for instance, invariably assume they gained their wealth through skill, knowledge and hard work. That may be true in some instances. But the fact remains, if you invite 1,000 monkeys to play roulette, 10 of them are going to end up fabulously rich.

Universa keeps 90% of its assets in cash or cash equivalents and simply tries to break even as it places small bets on rare events.

Five weeks ago when the S&P 500 was trading around 1200, Universa bought S&P 500 Index put options with a strike price of 850, due to expire late October. They were betting an “unlikely” drop would occur.

They paid around 90 cents for those options. By Oct. 10, the S&P had dropped 300 points in a month. The options Universa purchased for 90 cents were now trading for $60 each. Universa cashed out of its position around $50, good for a gain of 5455%.

Universa also paid $1.29 for a put option on the insurance company AIG. They’d be in the money if AIG dipped fell below $25 a share by September. AIG imploded in a tangle of bad debt and Universa sold the AIG put options for $21 apiece.

Most of the time Taleb stands on the sidelines. He’s one of the few money managers with the patience or the inclination to make allowances for rare events. He first made a killing when the stock market crashed in 1987. Typically Taleb has a couple of big wins a decade.

Taleb’s views on risk are starting to attract a lot of attention. He received a $4 million advance for his next book. He also teaches mathematical finance at New York University and charges appearance fees of $60,000 for his lectures. But he makes much more money betting on rare events.

Former Federal Reserve Chairman Alan Greenspan probably wishes he’d read Taleb’s book. He recently admitted to congress that there was a “flaw” in his financial strategy that contributed to a “once-in-a-century credit tsunami.”

“I was shocked,” said Greenspan, referring to the recent market meltdown, “because I’d been going for 40 years with evidence that it was working exceptionally well.”

In other words, Greenspan failed to factor in the likelihood and impact of a rare event. In this case, it was a meltdown in real estate that brought down not just real estate values and REIT share prices, but the entire global economy.

Taleb’s strategy isn’t for everyone. It takes patience to wait around for a rare event. But when that event happens it can be very profitable.

The “get rich quick” bull market is over. It’s a different ball game now. There is a historically proven conservative investing strategy that will help you to rebuild your portfolio. Taleb’s big October win reminds us that successful investors seldom follow the herd.

By Guy Bennett

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