Antifragile Financial Capital: Part II — Tactics and Tools for Building Portfolios
In the last article, we covered the concept of antifragile financial capital for families. This time, we will get more granular on the topic. Put it another way, last time we covered strategy, and this time we will look at tactics. What can an antifragile portfolio consist off? How can you position yourself to take advantage of opportunities and black swans while mitigating the effects of black swans? What tools are out there? I won’t know them all, but I can share the few that I do know.
Again, I want to stress that this is not financial advice. I share what I learnt and what I think on the topic: the tools I have seen and some I have explored and used. And how I try to apply the principles of antifragile investing.
Portfolio & Money Management
How can we construct a portfolio in a way, that we can call it antifragile? How can one essentially gain from crises and not “just” protect from them? Which bets to make and which not to make.
Applying the Barbell Strategy
I have become more and more a friend of the Barbell Strategy and the concept of trying to assess each investment from a maximum loss vs maximum gain perspective. To reiterate, the barbell strategy suggests that you put most of your money in investments that we can consider safe; the goal is clearly to preserve money. The rest you put into risky investments (Moonshots). Let’s look at some examples of this. We want to avoid any opportunities between safe and risky. The medium opportunities tend to have a skewed risk-to-return payoff.
Gold & Bitcoin: This has become an interesting approach. Gold is known as one of humanity’s oldest safe havens, and this won’t change. It is physical, you can move I,t and it will always be valuable. Yes, governments have banned possession in the past, but with a smart structure, you can protect yourself from losing it. On the other hand, we have Bitcoin, also known as digital gold. It has performed outrageously and might continue to do so. You could of course, create a wider portfolio of cryptocurrencies.
Real Estate & Venture Capital: Again, an interesting combination where you invest most of your capital into rental real estate (residential, office, logistics) and the other 10-20% into venture capital. Here you can go with a mixture of funds and direct investments. While Real estate, depending on location and country, will return between 3-10% p.a., venture capital returns bout 20-30% p.a., with direct deals being the bets where we can look at 20-30x of your investment. This would also work in an agriculture vs venture capital approach. I know families who have done this successfully.
These two constructions are two possible ways of doing the barbell strategy that I have tried out. Before I put together a host of pairings, let’s rather look at investments and put them in the safe and risky buckets.
Safe Bets: Bonds, T-Bills, Gold, Real Estate, Farmland, Timberland, Gems, Value Stocks, Asset-backed private credit, Life Settlements,
Moonshots: Venture Capital, Crypto Currencies, Tech stocks, distressed debt, litigation finance, Art & collectables, Options, Patents, Medicine development, sport teams
The more you are able to spread your portfolio over these areas the better diversified you are. However, be careful not to fall into the trap of death of performance by over-diversifying. Make sure your team has knowledge in each area that you invest in, or you work with partners and advisors who do. And be careful to look at correlation, which brings me to the next point.
Diversification & Correlation
A lot of families have highly concentrated portfolios. These usually, have grown to be this way due to how the financial wealth was acquired: through entrepreneurship. And as much as the adage of investing in what we know is important, it is also a trap we can fall into. If you are a Real Estate Investor and that is all you do, you will perform great. However, you are hit hard by market swings. I am also picking Real Estate on purpose as it is an industry with heavy utilisation of debt, which makes it particularly fragile to market downturns. Your gains melt away very quickly when you finance with debt, particularly if it is late in the cycle. I also speak from experience, having had a great ride in the RE market but also burning my fingers badly. Luckily, I have been investing not only in this Asset Class.
Diversification is often understood in that if you just spread your money over as many asset classes and geographies as possible, you are doing fine. This is what we call Dumb Diversification, and if you lack a team of professionals, this is the best approach. Just as Warren Buffett suggests, the average American citizen should invest in an S&P 500 ETF, and that is it. However, if you want to do Smart Diversification, you want to have an eye on the correlation of assets. And particularly on asset classes that are typically uncorrelated. From the list of investments up top, there are both safe and moonshot bets that fit that description.
Uncorelated Assets: Gems, Farmland, Timberland, Litigation Financing, Art & Collectables, Medicine development, Patents, Sport teams, Catastrophe Bonds,
Optionality & Debt & Liquidity
Optionality and debt go hand in hand. Debt can be a tool to facilitate optionality, but at the same time, if overused, it can hinder optionality. To take advantage of opportunities or in other words, to build optionality into our portfolio, we need liquidity. Liquidity can be achieved in three ways:
Cash reserves
Cash-similar liquid assets like T-Bills
Strategic credit lines
I am a big fan of strategic credit lines. You usually pay a provision fee (around 1% p.a.) and that allows you to use the credit at any time. I have used this strategy with legacy assets like historic buildings as collateral. You can also use it with T-Bills as collateral. This liquidity gave me the chance to seize some deals that returned 40% in 6 months. Without the credit lines, that would not have been possible. Some people prefer to load up on debt and have cash reserves. This is a fine tactic as long last the market is buzzing. However, especially in downturns, you want to be ready to pounce.
Optionality. How can we add this? There is option trading, which I am not very familiar with, so better to talk to a financial expert on this. There are options in Real Estate. Give you an example that I have seen play out: you approach a farmer whose land could potentially become rezoned to residential. Typically, farmland goes for much less than residential, in most places that is a factor 10 upwards. You offer the farmer an option where you pay 50% of the current land value as a fee, but if the rezoning happens, you can buy at 3x the current value. Most farmers hate to sell, but they tend to be open to options. For a small upfront investment, you have the option. If your family has a long investment horizon, these options are a no-brainer.
Portfolio Rebalancing
Traditional portfolio rebalancing is the process of realigning a portfolio’s asset mix back to its target allocation after market movements cause drift. It typically involves selling overperforming assets and buying underperforming ones to maintain a consistent risk profile. Rebalancing is usually done on a set schedule (e.g., quarterly or annually) or when allocations deviate beyond set thresholds. The strategy assumes mean reversion and helps enforce discipline, but may ignore emerging risks or structural changes.
What happens here often is that we continually sell our well-performing assets, while we end up adding more in non-performing assets. Given a long enough investment horizon, you can change the game here. Rather than looking purely at mean-reversion, it is better to look at mega trends and macroeconomic indicators. As an example, if you had seen the shift happening in international finances (cryptocurrencies), it made sense to continually increase allocated capital in this area, rather than rebalance it. Similar to if a geography is continually becoming uninvestable, it makes sense to drop investments there to go elsewhere. Russia or Venezuela have not become any better in the last 10 years. How likely will this change in the next 10 years. You could also look at rebalancing from a cash flow perspective. To make sure you have adequate cash flow.
In short, rebalancing should reflect the goals you have set for your financial capital. So, a more goal-based investing approach.
Structure & Risk Management
How you structure your investments is key to being prepared for black swan events. You need to protect it from internal and external factors. For this, there are several tools available. Not all of them make sense for everyone in every situation. Not all your capital should be structured using only one tool. From a risk management perspective, there are a few tools, such as SPVs (special purpose vehicles), trusts or life insurance wrappers, that can serve as structures to help in risk management.
SPVs, Life Insurance & Trusts
Life insurance is a common tool to plan for inheritance taxes, as life insurance is tax-exempt. By underwriting a large enough policy, so that at death the death payment is roughly the size of the inheritance tax, you can plan for this scenario ahead. Also, life insurance is insolvency-protected.
Trusts are often used to ensure that family members do not get direct access to capital. In some cases this is an appropriate tool. Sadly, this is, however, over-used and many advisors use fear as a motivator to get the mandates. Unless your family members are grossly incompetent or mentally sick, I advise caution on this one. Again, structuring some capital into a trust may make sense; nevertheless, just think long and hard before you put it all in there.
SPVs again are a good tool to contain risk into a single entity. If you expect some risks that you cannot account for it may make sense to contain risks in a special entity. This is typically used for real estate developments. SPVS are also a great structure to work with other families on a deal together.
Banking
We hardly ever think about it, but what to do if the bank you work at goes down under? Or if something happens in the country where your bank is situated, like confiscation of private gold holdings? Diversification also applies to your structure and not just the type of investments. Using several banks and spreading your portfolios over several different countries is prudent. With more diversification in structure comes more administrative expenses. So don’t overdo it.
Risk & Antifragility Analysis
What can you do to regularly assess your financial capital?
There are a few things. First of all you will need to introduce some KPIs that you can track. There is all these standard KPIs like the sharpe ratio and whatnot. However, if you want to assess for antifragility, you will need to create something new. You can try to track the main aspects of antifragility: Optionality, redundancy, cashflow, liquidity, volatility and downside vs upside potential (asymmetry).
Another great tool to use in risk analysis is scenario planning. This is a standard exercise for disaster response and the military. However, it is still used too little in wealth management. Also, because traditional risk management ignores black swan events due to their small probability. However, there will be a swan event every so many years, we just do not know which one. The responses for each black swan have overlap, which makes preparation a wee bit easier.
Quarterly After-Action reviews, or in other words, learning reviews, are a habit that you should incorporate. Again, after-action reviews are a standard procedure in the military. One aspect of antifragility is constant improvement; your systems and your strategy are never good enough. They need to constantly evolve. I have seen many families go down under because they have stuck to a proven model for too long.
Decision Making & Skin in the Game
To antifragile your decision-making, a crucial ingredient is skin in the game. Decision-makers need to participate both on the upside and the downside. We do not want people to engage in defensive decision-making. Also known as covering their ass decision making. Gerd Gigernezer write about this a lot.
Decision Buckets & Decentralisation
Outline clean decision or investment buckets for your team. Assign an amount of money for each bucket, which may be invested quickly upon a person’s gut instinct. Also, define the maximum size per bet. This will give your team a clear directive on how much they may “gamble” on speed. This is a little bit like Google’s 30% rule, which created some of their best products.
With this comes an agile decision-making structure. Design a clear framework within which each of the team members or family members may move. With clear directives, when a decision needs to be escalated upwards. It might be counterintuitive, but you don’t wnt the small stuff and the wildly urgent stuff to be going up the hierarchy. The small stuff is just not important, and the wildly urgent, well, is too urgent; there is no time. Even huge decisions. It is like the standard emergency button at the production line, where a line worker can halt the whole production if he sees something that can wreck everything. The production halting for not a good enough reason is a big waste, however, the production line breaking down because of an altercation is a disaster.
Productive Conflict and Dissent
Train your family members and the team to create an environment of productive conflict. You want people to speak up if they think you are about to do something stupid. You really need to encourage people to speak their mind and to contradict you. Especially in investing. Dissent is an amazing tool, if practised correctly. The challenge and the conflict thereafter need to be productive. Discussion and conflict in investment decisions make sure that the thought process behind the investment is sound. If everyone agrees on an investment, it serves to look twice. One method to ensure that all views are discussed is to designate a dissenter for every meeting. A person who needs to argue the opposite of what you want to do. This way, all avenues are explored.
Pre-Mortems & Generational Perspectives
We spoke about Scenario planning. Pre-mortems are basically the same, just on a pre-investment basis. You go through scenarios that can impact an investment, both positive and negative and see if you can position yourself for each. Sometimes, when we did not think of what could go wrong or well, we are contractually handcuffed. By thinking about it before, you can try to adjust the contract to give you the flexibility needed.
Pre-mortems need a lot of perspectives, which brings me to the point, that you want to include all generations (in an age-appropriate manner) in investment decisions. While older generations bring a ton of experience to the table, the younger generation brings a better understanding of what is changing in the world and on what is new. If these discussions can be had productively, the outcome will be better than if you exclude the younger or older generations.