Members (or “names”) of Lloyds of London, the famous insurance market, know more than most about the “black swans” of Monday’s column.

Names earned extra returns on their capital each year by putting it on the line to underwrite the world’s insurance losses. They were told they were potentially liable for losses, “down to their last pair of cufflinks”.

But the absence of losses bred complacency. In 1982 one London gent explained how becoming a name at Lloyds would make him around £15,000 a year and he’d only lose out “if London burnt down or something - and that ain’t going to happen”.

London hasn’t burn down but asbestos compensation has led to huge insurance losses around the world. Large numbers of Lloyds names lost their metaphorical last pair of cufflinks to a black swan.

Another black swan reared its head when the Russian Government defaulted on its national debt in 1998, sending shock waves through the financial markets and causing the collapse of hedge fund Long Term Capital Management.

The Nobel-prize winning PhDs running LTCM proclaimed that their fund’s failure was the result of a “ten sigma event”, meaning that it had odds of one in several billion billion.

As Nassim Taleb explains in Fooled by Randomness, someone saying this “either: (a) knows what he is talking about with near perfection … and it is an event that happens once every several times the history of the universe; or (b) just doesn’t know what he is talking about when he talks about probability … and it is an event that has a probability higher than once every several times the history of the universe. I will let the reader pick from these two mutually exclusive interpretations which one is more plausible.”

Today, there are worries about Dubai’s financial condition and questions are being asked of nations such as Greece and Mexico. Such “sovereign defaults” would likely send shockwaves around the world. Given the powerful sharemarket recovery since the low point reached in March, this is particularly pertinent. Complacency can steal your cufflinks.

What to do?

Taleb suggests that most successful traders and investors over the long term are flexible, being prepared to admit mistakes and change their minds.

They also don’t employ strategies that make them hostages to fortune. In other words, they do more dentistry and play less Russian roulette (to return to Monday’s example).

In investing terms, this means maintaining a balanced portfolio and steering clear of debt, both personally and in the companies in which you invest. At The Intelligent Investor, we also seek a “margin of safety” in each investment we make; aiming to acquire a dollar’s worth of assets for less than 100 cents.

Taleb stresses that he doesn’t think everything is down to luck. He just thinks that luck is more important than we imagine and that it’s very hard to know what’s luck and what’s skill. Such thinking is reflected in his investment strategy.

Taleb is a trader with a twist. Instead of doing what most people do, which is to buy instruments that provide small but steady returns until they get hit by a black swan event, he buys instruments that ensure small but steady losses until a black swan arrives, at which point he cleans up.

His theory is that bearing the drip, drip, drip of losses, waiting for the big win, is more than most people can manage. Most people can’t handle such unpredictability, Taleb reasons, so these extremely high-risk securities are often cheap.

Taleb’s approach combines a high portfolio weighting in ultra low-risk investments with a much lower weighting in a widely diversified portfolio of super-high risk investments and instruments.

This might mean a 90 per cent weighting in short and longer-dated government securities combined with a 10 per cent weighting in hundreds of very risky propositions that might pay off hugely in extreme events.

The areas he considers for the very risky part of his portfolio include technology and biotech companies; he’s seeking positions that others shy away from which have a small probability of a huge payoff.

Combining these highly risky securities with an overwhelming allocation to low risk investments provides a balance where you’ll get mostly steady returns (from the low-risk investments) and occasional huge payoffs from the other part of the portfolio.

It’s an approach only feasible for those with a portfolio large enough to ensure the transaction costs involved in buying hundreds of different positions won’t offset the potential returns.

It’s not the strategy we recommend at The Intelligent Investor, but there are interesting lessons for us all in the insights it is built on.

This article contains general advice only (under AFSL 282288).

Greg Hoffman is research director of The Intelligent Investor, which provides independent advice to sharemarket investors. BusinessDay readers can enjoy a free trial offer at The Intelligent Investor website.

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