Anti-Fragility in Financial Markets

Abnormal Returns linked to an excellent interview with Noassim Taleb, the author of “The Black Swan” and “Anti-fragility”, his most recent book. Taleb is obsessed with the idea of “robustness” and “fragility” in all contexts but particularly with regard to the financial system. He likes to make analogies by comparing the human body with the financial system – Taleb says things to the effect of “when you go to the gym and lift 100 pounds your body prepares to lift 105 pounds the next time, whereas, in finance analysts use the worst case scenarios of the past as the worst case scenario for the future (the market can only fall 22% in one day because that is the most it has fallen in the past etc.)”. In other words, the financial system does not become more robust or anti-fragile over time, rather, it actually becomes more fragile and susceptible to shocks over time. This is due to a number of factors, the main ones being:

  • Too much focus on scale, the drawbacks of “too big to fail” institutions far outweigh the benefits. Taleb greatly prefers a system made up of many smaller entities rather than a few giant ones.
  • Too much intervention in financial markets by government entities such as the Fed and Treasury leads to a weakening of the market’s fabric and increases the “fatness” of the tails that can result from shocks.

“when you spend a lot of time without variations you have a lot of exposure built that would be harmed by it (variation)…so if you spend six months without a new low and you make a new low you have a lot more blowups” Taleb

Anti-fragility is the idea that stressing things makes them stronger – Taleb uses the imagery of a hydra losing one head and growing back two as an example of anti-fragility. When systems or organisms aren’t stressed they weaken and the impact of shocks upon them becomes much greater; this concept should be eminently clear to experienced financial market participants. Listening to the Taleb interview brought two recent financial market episodes to my mind and prompted me to ponder which market may be the next to succumb to anti-fragility:

 

$SPY Nov 2010-July 2011

 

$SPY early August plunge – the magnitude and rapidity of which took the vast majority of market participants by complete surprise.

 

Gold ($GC_F $GLD) had a parabolic rise into late August 2011 causing even the staunchest gold bears to capitulate at the top.

 

Gold lost robustness and became fragile during its parabolic surge in August 2011 – most market participants began to expect a pullback of $100-$200, however, as usual the break exceeded most expectations as gold fell to $1535 from its all-time high of $1924.

Which market is next up for a test of its fragility?

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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