A Dozen Things I’ve Learned from Nassim Taleb about Optionality/Investing

1. “Optionality is the property of asymmetric upside (preferably unlimited) with correspondingly limited downside (preferably tiny).”  Venture capital, when practiced properly by a top tier firm, is a classic example of a business that benefits from optionality. All you can lose financially in venture capital is what you invest and your upside can be more than 1000X of what you invested.  Another example of optionality is cash held by a disciplined patient value investor with the temperament to not buy until Mr. Market is fearful.  As just one example, Warren Buffett did exactly this during the recent financial panic and earned $10 Billion by putting his cash to work.  Seth Klarman, Howard Marks and other value investors use dry powder in the form of cash to harvest optionality since Mr. Market is bi-polar.

2. “‘Long volatility’ in trader parlance, has positive optionality.” As an example, the optionality of cash allows the holder to buy assets from people who were “short volatility” when a crisis hits. The wise value investor sits and waits patiently for Mr. Market to deliver a fearful market and when the intrinsic value of a company’s shares presents a “margin of safety” buys in quantity.

3. “If you ‘have optionality,’ you don’t have much need for what is commonly called intelligence, knowledge, insight, skills, and these complicated things that take place in our brain cells. For you don’t have to be right that often. All you need is the wisdom to not do unintelligent things to hurt yourself (some acts of omission) and recognize favorable outcomes when they occur. (The key is that your assessment doesn’t need to be made beforehand, only after the outcome.)”  Being able to make decisions which do not require correctly forecasting the future is a wonderful thing.  Not one of the great value investors identified in the series of posts in this blog relies on macro forecasts of the future.  Instead, value investors use the optionality of cash to buy after the outcome exists (i.e., a significant drop in intrinsic value). Regarding venture capital, Warren Buffett believes:  “If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually- independent commitments.  Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted  for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but  unrelated opportunities.  Most venture capitalists employ this strategy.”

4.  “Optionality can be found everywhere if you know how to look.” Living in a city, going to parties, taking classes, acquiring entrepreneurial skills, having cash in your bank account, avoiding debt are all examples of activities which increase optionality.  As another example, a venture capitalist who invests in a team which (1) is strong technically, (2) has sound business judgment and (3) addresses a huge market opportunity has acquired optionality since the company can often find success with an offering the founders did not conceive from the beginning, but rather found as they went along.

5. “Financial options may be expensive because people know they are options and someone is selling them and charging a price—but most interesting options are free, or at the worst, cheap.”  Some of the most important options are not obviously financial in nature and for that reason are not labeled as “options.” In those cases it is more likely that you will be able to purchase or acquire a mispriced option since other people often don’t understand what is involved (e.g., investment bankers have cheap options since losses are socialized when huge).

6. “Make sure the optionality is not priced by the market.” It is possible to overpay for optionality. For example, what venture capitalist Bill Gurley called “frothy trades in the bubbly late stage private market” in 2011 is a great example of overpaying for optionality.

7. “[Avoid] companies that have negative optionality.” Companies (1) focused on a niche market,  (2) have employees with limited technical skills, (3) which raised too much money at an inflated early valuation or(4)  are highly leveraged are examples of companies with negative optionality.

8. “A rigid business plan gets one locked into a preset invariant policy, like a highway without exits —hence devoid of optionality.”  I am at my self-imposed 999 word limit so what follows including this quotation must largely stand on its own without commentary. 

9. “Optionality… explains why top-down centralized decisions tend to fail.”

10. “Optionality works by negative information, reducing the space of what we do by knowledge of what does not work. For that we need to pay for negative results.”

11. “That which benefits from randomness (increased potential for upside in the presence of fluctuations) is convex.  That which is harmed by randomness, concave.  Convexity propositions should be embraced – concave ones, avoided like the plague….  ‘optionality’ is what is behind the convexity of research outcomes. An option allows its user to get more upside than downside as he can select among the results what fits him and forget about the rest (he has the option, not the obligation)…. Payoffs from research are from Extremistan; they follow a power-law type of statistical distribution, with big, near-unlimited upside but, because of optionality, limited downside.” 

12. “Like Britain in the Industrial Revolution, America’s asset is, simply, risk taking and the use of optionality, this remarkable ability to engage in rational forms of  trial and error, with no comparative shame in failing again, starting again, and repeating failure.”  Entrepreneurs harvest optionality when they tinker and experiment as they run their businesses and as a positive externality benefit their city/region/nation/the world in the aggregate by generating productivity and genuine  growth in the economy even if legions of entrepreneurs may fail.   Taleb: “Most of you will fail, disrespected, impoverished, but we are grateful for the risks you are taking and the sacrifices you are making for the sake of the economic growth of the planet and pulling others out of poverty. You are the source of our antifragility. Our nation thanks you.”

18 thoughts on “A Dozen Things I’ve Learned from Nassim Taleb about Optionality/Investing

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  15. I am new to this stuff. Can you help me understand why “Optionality… explains why top-down centralized decisions tend to fail” please?

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