January 02, 2019

Chasing Fat Tails*

By: Jaffer Ali

Entrepreneurs chase fat tails with the determination of a mongoose stalking a cobra. Before we get too far along, let's define what I mean by fat tails. "Fat Tails" are extreme events where returns are exponential and yes, losses are also exponential. The right tail is where profits lie and the left tail is where losses are. The fatter the tails, either on the left or right, suggests how much impact they have on your organization. Of course, fat tails range in degree and follow its own distribution curve.

Most of the time businesses live within the boundaries of a normal distribution curve, but the real action lies in the outer edges where events have disproportionate impact on your life or business. When your business practice has a profit profile that is convex (exponential returns) or concave (exponential losses), this is a dicey business model. This is a fragile business model. Fat left tails are where losses can mean ruin. Fat right tails are where profits compound. A business model that has both tails embedded is a recipe for trouble.

The outcome with respect to returns or losses is not the key descriptor of fragility. Back in the late 90s, our company experienced both exponential returns AND exponential losses while we marketed videos via television infomercials. The convex returns were glorious as we raked in huge profits from marketing Riverdance and Lord of the Dance on television. We did not think that we were fragile. In fact, arrogance did not allow us to contemplate failure. We had not experienced the left tail risk early on.

While experiencing the fun of chasing the right fat tail, we ignored the potential of left tail risk. We were blinded by the trappings of success. Humility was not part of our marketing mindset. And fragility has a way of teaching humility that no book or MBA class on risk management can relay.

Continuing the personal lesson, after experiencing convex fat tail returns, our company proceeded to experience the devastating curse of the fat left tail. We had 20+ infomercials that collectively lost millions of dollars. We had not anticipated our media costs tripling within 18 months. In the late 90s, the dotcoms discovered how they could reach millions of viewers using television... and they poured hundreds of millions of dollars into television commercials. This raised the lower ad rates we had been paying. The economics of our business changed significantly in 18 months.

Nassim Taleb says fat tails are part of "Extremistan"... or land of the extremes. Fat tails have a huge impact on your business, whether you can measure them or not. There is an existential component to chasing fat tails. Taking risks is an existential part of being for entrepreneurs.

Entrepreneurs do not learn risk management by reading. As risk maestro Nassim Taleb has pointed out, people learn about risk by actually taking risks. The number one lesson I have learned over the years is not about understanding fat tails on the right. It is relatively easy to understand convex profits. And over the years, I have personally been rather successful in concocting convex payoffs.

I think most entrepreneurs understand fat right tails. My personal great learning experience was about understanding ruin. Ruin is the fattest of left tails. Left tail risk is often hidden, that is until it rears its head. Some people like to call these "black swans". I do not like calling them this because left tail risk exists everywhere. And if we are not constantly thinking of new risks that can lead to ruin, entrepreneurs are not doing their job.

In our company's infomercial phase of our business, after we finally recognized the changing economics that put us and our business model on the road to ruin, we shifted all of our business online and away from escalating media costs. We applied the principle of purchasing online media in remnant, distressed areas to sell products. I wish we had made the change quicker, but we survived to fight another day.

Of course it is much more fun to dream and plan for exponential payoffs, but an entrepreneur's number one job is to avoid left tail risk which can lead to ruin. Clipping left tail risk while chasing convex right tail returns is the road to a thriving business model.

*I am indebted to Nassim Taleb for first introducing me to the formalized description of fat tails. Also, many thanks go to Tom Messina and Greg Linster for offering cogent critique on the original draft.

Original Article: Chasing Fat Tails*

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