Life does not work in a linear way. One unit of work does not necessarily result in one unit of output. The old and discredited labor theory of value would have you believe that spending 10 hours building a computer was worth less than spending 100 hours building a pile of dirt. Sorry, but that just isn’t how the world works.
The same goes for just about everything. For example, falling three feet on 10 different occasions won’t hurt you nearly as badly as falling 30 feet once. When it comes to more global events, 9/11 had a much bigger impact on the world and the economy than if 3,000 people had died separately of unrelated causes on the same day.
This concept of “nonlinearity” is a key insight in Nicholas Nassim Taleb’s book Antifragile. Another is that we delude ourselves into thinking we can accurately predict the future. Many Wall Street analysts and government bureaucrats have what Taleb calls the “Soviet-Harvard delusion” that all of life’s outcomes fall on a neat bell curve where 68 percent of all possible outcomes fall within one standard deviation of the mean.
This comforting bell curve of future predictions is interrupted by what Taleb calls black swans, which take us by surprise all the time. The 2008 financial crash and 9/11 are examples of such black swans. Indeed, in 1998, a company called Long Term Capital Management based its entire investment model on impossible-to-understand math that took into account “every” possible market variable from the previous few years to determine how to beat the market. The founders even won the Nobel Prize in economics for all of their elaborate mathiness.
Unfortunately, their numbers didn’t account for black swans, and thereby didn’t predict the Asian Financial Crisis of 1997. The company went belly up and was so over-leveraged that it almost brought down the world economy. Unfortunately, such hubris regarding our predictive power of the future didn’t die with Long Term Capital Management.
Taleb believes that trying to predict such rare events is mostly a fool’s errand. Instead, one should try to become “antifragile.” Antifragility doesn’t describe something that can survive disorder or even a downturn. For that, he uses the term “robust.” Instead, antifragility is something that gains from disorder.
So whereas most companies struggle in a recession, a company that thrives in a downturn would be antifragile. And often, this thriving involves the “nonlinearity” I mentioned at the beginning. Those who “thrive from disorder” can often grow exponentially while others are declaring bankruptcy.
When it comes to investing, Taleb recommends trying to find investments with small costs, but potentially, even if unlikely, big payoffs (i.e. nonlinearity). One example he gives is when he reviewed Fannie Mae’s balance sheet in the early- to mid-2000s. He saw that when Fannie Mae’s portfolio was stress tested, it failed miserably when defaults went up ever so slightly.
He had no idea what would be the cause of this disturbance. That would require predictive power we don’t have. But he did see that Fannie Mae was particularly fragile and worth shorting.
Taleb recommends the barbell strategy for stock investors. Namely, this involves buying mostly very safe assets, but a few high-risk assets with the possibility of a really large payoff. So for example, even if you didn’t understand Bitcoin five or six years ago, it might have been wise to buy a few hundred dollars worth while putting most of your money in treasury bonds and the like. If only…
Now for us real estate investors, things are different of course. Although, it should be noted that Taleb is not a fan of debt. Debt makes you fragile because if things go wrong (say you lose your income) you still have a liability to pay back. So as far as personal finances go, he is strictly in agreement with Dave Ramsey.
I agree with this as far as personal debts go, but real estate investment all but requires using leverage. The key, is to use it wisely. For one, you shouldn’t leverage all the equity out of your properties because that makes you very susceptible to a down turn. Any sort of dip in real estate prices would leave you underwater.
It also means you shouldn’t settle for low or no positive cash flow from a property unless you have other cash-flow properties to hold you through—and a very good reason to believe that property will appreciate.
Indeed, what Taleb highlights is why it’s so important to buy at a discount. Buying real estate under market value makes you antifragile because you have built-in equity to protect you in case of a downturn.
Further, while I’ve said before that “you aren’t a real estate investor unless you’re cash poor,” that’s really only something you should accept in the early going. Building cash reserves allows you to pounce on opportunities when they arise, and can get you through a rainy day. Indeed, Jim Collins found that companies that kept large cash reserves were substantially more successful than those that didn’t, as reported in his book Great by Choice. Cash reserves help make you antifragile.
Finally, I would suggest cultivating and building trust with a group of private lenders that can lend to you. This isn’t so much to survive a black swan (i.e. be robust) but to thrive (i.e. be antifragile) in a downturn.
Reading Antifragile reminded me of how Warren Buffett made most of his fortune during recessions. For example, Berkshire Hathaway made something like $10 billion during the last financial crisis. The reason is simple; assets are selling cheap, so those who can buy them up will make a killing.
Indeed, on a much smaller scale, this is similar to what we did. In 2011, we came out to Kansas City and started buying almost exclusively REO’s in a very depressed market. It honestly pains me to remember how cheap those properties were back then. The disorder of the financial crisis allowed us to grow in a nonlinear way.
Now there is no way to know when the next financial crisis, recession, or noteworthy drop in real estate prices will be. But sooner or later, it will come. The important thing is to be ready for it. If you have the infrastructure in place, have learned the business, and have cash reserves as well as private lenders in waiting, the next crisis is not something to fear, but rather something that could be an incredible opportunity.
So get to work making yourself as antifragile as possible.
Do you agree with Taleb’s points of view? Let me know in the comments below!