Steding's Unverified Theory of Strategic Inversion

In August 2008, I made a presentation to a money management firm in Dallas to attempt an explanation at what I then saw as an impending upheaval in the financial markets that would bring to question the very models of investment strategy that had existed since (at least) the Great Depression.  One month later, Lehman Brothers collapsed, and by the end of October 2008 trillions of dollars in wealth had evaporated from the balance sheets of the world.  (If you want an entertaining telling of that calamity see HBO’s Too Big to Fail, based on Andrew Ross Sorkin’s book of the same title.)  What I saw, and what is now evident not only in financial systems, but in political systems around the world (particularly in the Middle East), is the danger of employing old thinking and models of risk management in a world where complexity compounds thereby exacerbating disequilibria created by fraud and oppression.

            My argument was posed as Steding’s Unverified Theory of Strategic Inversion (SUTSI). SUTSI argues that as complexity compounds, enabled by technology and as manifested in globalism, the distribution of data points – of actual results – represented by the bell curve flattens. Rather than complexity validating regression toward the mean – the center axis of the bell – it produces a greater number of outliers – those events nearer the rim of the bell such that the principle of regression is moot. In the investment world, I argued further, old portfolio allocations and holding periods might be ineffective, and Federal tax policy may need to be flipped.  For example, investment strategies that target the 0 to 20% returns (‘long’ positions – the area immediately to the right of the center axis of the bell) or the 0 to -20% returns (‘short’ positions – the area immediately to the left of the center axis of the bell) actually accept greater risk due to a relatively smaller number of results within that range.  The better strategy is to play the edges, which now include a greater number of data points, taking both long and short positions, not so much as a hedge, but in pursuit of absolute gains.  Nassim Nicholas Taleb has most forcefully made this argument in his book, The Black Swan: the Impact of the Highly Improbable.

In this investment strategy scenario I suggested that perhaps a strategic inversion was warranted:

·      Rather than a portfolio allocation of 50% equities, 30% bonds and 20% cash, maybe one should have 50% cash, 30% bonds, and 20% in equities.

·      Rather than holding investments for the long term – the traditional investor strategy – one should look at short term investments, more of a guerrilla investment strategy.

·      Rather than being highly diversified one should have fewer positions, mitigating risk by having only 20% of wealth ‘exposed’ in equities (and much less leverage but more due diligence).

·      Rather than having a tax policy that penalizes short-term gains at high tax rates (35%) maybe we should swap them with long-term rates (15%) as a better way to support the creation of wealth?

These suggestions fell on polite but mostly deaf ears in August 2008.  Today, you can find many investment strategists arguing for variations of these suggestions.  Since 2008 we have witnessed a bumper crop of Taleb’s so-called black swans, not only in financial markets, but also in political systems.  (Although politicians are even slower slow to catch up than financial managers.)

            In the May/June issue of Foreign Affairs, Taleb, together with Mark Blyth, Professor of International Political Economy at Brown University, apply these same notions of complexity and risk in “The Black Swan of Cairo: How Suppressing Volatility Makes the World Less Predictable and More Dangerous.”  Taleb and Blyth argue “both the recent financial crisis and the current political crisis in the Middle East are grounded in the rise of complexity, interdependence, and unpredictability” where linear models and a preference for stability – what I have called ‘staring at the mean’ – may actually be the most, not least, risky (p. 34).  What may be called for in foreign policy may mirror the strategic inversion we have witnessed in investment strategy.  The “illusion of control and action bias” that are traditional hallmarks of US foreign policy, may in fact produce greater instability and reduced security (p. 39).  The US may be much better off playing less often, and at the margins, where the black swans live.

            Three years after penning my theory and making my presentation about the prospect of strategic inversions to the investment world, it seems at least one thing is clear: compounding complexity requires new modalities of inquiry that reject the linear traps inherent in conventional thinking. While I am not ready to strip "unverified theory" from the title, changing it to Steding's Rule of Strategic Inversion (SRSI), I'm getting closer every day.