Real options and tail risk/opportunity

The modern technology markets have grown to love the terms “Black Swan” and “Unicorn.”  The former was first coined by statistician Nassim Nicholas Taleb in his book The Impact of the Highly Improbable, but is today more often associated with the investment style of Vinod Khosla.  The second, was popularized in a TechCrunch article, “Welcome to the Unicorn Club,” by Kleiner Perkins’ Aileen Lee identifying 39 technology companies founded since 2003 that had achieved public or private market valuations of greater than $1B.  Success is a Black Swan that grows up to be a Unicorn. 


But much of Taleb’s more interesting work actually focused on the existence of tail risk (both good and bad) and how one can employ options theory to economically benefit from the existence of that risk. 


A market in stasis can generally be accurately described with a bell shaped curve where the most probable outcomes gather strongly at the mean and extremely good and bad outcomes are accompanied by much, much lower levels of probability.   Markets under stress can, however, assume just the opposite shape, where there is little safe haven at the mean and a clustering of outcomes at the extremes – implying a greater probability of loss and a greater chance for success both for those who stand still and for those who seek to seize upon the opportunity.  Dealing with these markets often means adopting a barbell rather than a bell shaped perspective – safety comes not from following the herd but from the diversity of playing and hedging the extremes.


In this type of a rapidly changing world, options theory suggests that you:


  • expose yourself to many small risks and opportunities so that you can learn from both;

  • understand that only a tiny number of those positions will produce large results – but recognize that as a result of complexity, interdependence, globalization, and efficiency the world is increasingly becoming a winner-take-all environment (a 95/5 rather than an 80/20 kind of place);

  • constantly tinker but do so aggressively, not passively, otherwise you squander the optionality – what we have referred to elsewhere as “not revolution but continuous and rapid evolution”;

  • look for open-ended, not closed-ended options;

  • invest in people with proven optionality (ability to change dynamically);

  • be both “creatively destructive” and “destructively creative;”

  • focus not by saying yes to the thing you’ve got to focus on, but by saying no to the hundred other good ideas that there are (Steve Jobs: “Innovation is saying no to 1,000 things”);

  • celebrate heroism – a respect for those who take downside risks for others – not risk avoidance (those who enrich themselves by taking free options paid for by others); and

  • become, in Taleb’s words: “antifragile” – embrace the spirit of that which doesn’t kill me strengthens me, embrace change, risk and volatility and remember that “results are meaningless without effort, joy without sadness, and convictions without uncertainty.”


The reality is that most modern corporate executives, particularly those subject to the whims of the public markets, go through all the motions of exposing themselves to optionality but when they bet, 99% of the capital goes to risk preservation and only 1% goes to true optionality.   Those chasing Black swans and building Unicorns, on the other hand, have often adopted behaviors that the markets might characterize as 1% rationality and 99% risk – until they succeed.