The Logic of Risk Taking: Lessons for investors, traders and Fund Managers

Interpreting the work of Nassim Nicholas Taleb (Book: “Skin in the Game”)

In a world obsessed with returns, rankings and outperformance, one truth remains systematically ignored: survival precedes success. This principle is deceptively simple yet profoundly consequential. While traditional wealth managers and private bankers often base investment advice on long-term historical averages, suggesting that equities will deliver 7% annually over decades, they rarely account for the reality that one severe loss at the wrong time can derail an investor’s entire financial journey. Real-world investors operate under far harsher conditions: once capital is lost beyond recovery, compounding stops. The game ends.

In this article we attempt to offer practical guidance for professional investors , portfolio managers, traders, allocators and fiduciaries, who bear responsibility not just for performance, but for continuity.

The fatal flaw in conventional investing wisdom

Most investment advice rests on an unspoken assumption: that long-term market returns are yours to claim simply by staying invested. We are told: “Equities return 7% annually over the long run,” or “Stay the course through volatility.” But these statements conflate two entirely different realities:

• Ensemble probability: What happens across 100 investors at a single point in time.
• Time probability: What happens to one investor over 100 periods.

Imagine 100 people go to a casino and gamble a fixed sum once. Some win, some lose. You can calculate the average outcome. One person going bust does not affect the others.

Now imagine one person, you, goes to that same casino every day for 100 days. If you go bust on day 28, there is no day 29. Your journey ends.

Yet conventional financial theory treats these two scenarios as equivalent. It assumes that because the market returned 7% per year on average over a century, any individual investor should expect something close to that. But if your path includes a terminal drawdown — due to leverage, concentration, illiquidity or bad timing — you will never reach the long-term average.

You are not a statistic. You are a trajectory and trajectories matter more than averages.

Ergodicity and its implications for Investment Strategy

This disconnect — between the average outcome across investors and the real experience of any one investor over time — reveals a deeper structural flaw in how most portfolios are designed.It has a name: non-ergodicity.

In an ideal world, long-term market returns would be yours simply by staying invested. That would mean the system is ergodic: the return you get over time matches the average return seen across many investors at a point in time. In reality, ruin breaks this link — one bad sequence can end your journey before you ever reach the average.

If you suffer a severe portfolio drawdown early or are forced to exit due to leverage, panic, or life events then your journey ends. You don’t get to compound through the recovery. You’re out of the game. And once you’re out, averages no longer matter.

That’s non-ergodicity: the promise of long-term returns with no guarantee you’ll survive long enough to collect them.

Financial ruin is an absorbing state. Once reached, it cannot be undone. There is no coming back from zero. Therefore, strategies that risk total loss, even with high expected returns, fail the ergodicity test.This has profound implications:

• A 100% gain followed by a 100% loss is not break-even. It is game over.
• $1 million grows to $2 million, then drops to zero. Arithmetic average? 0%.
• Geometric return? –100%. Final wealth? Zero.

No amount of upside compensates for permanent capital impairment. Thus, the first duty of any investor is not to maximise returns, but to ensure they remain in the game indefinitely.

Key Principles for the practising Risk Taker

Below are the core lessons through the lens of active portfolio management and long-term wealth preservation.

Survival is the only Strategy that Compounds

Everything else is noise. Without survival, compounding ceases. No return, however impressive, matters if you were not present to earn it. The greatest historical returns belong to those who avoided extinction during crises — not those who took the highest risks.

The best investors aren’t necessarily the smartest; they are the ones who never died.

Never risk more than you can afford to lose

Blow-ups do not average out. They end careers, firms and client relationships. Avoid strategies where a single event — geopolitical shock, liquidity crunch, model failure — could eliminate equity.

Leverage amplifies both gains and fragility. Use it sparingly, if at all.

Arithmetic Returns are lies; Geometric Returns are true

If you make +50% one year and lose 50% the next, you end up with 75% of your starting capital. $100 → $150 → $75
That final number, $75, is what sits in your account. That is the geometric (compound) return. It is the only figure that reflects real wealth creation over time.

Big Drawdowns destroy years of Compounding in months

A 50% drawdown requires a 100% gain just to recover. A 75% loss demands a 300% rebound. These are not merely inconvenient but they are career-threatening.

Protect against large losses not because volatility is bad, but because recovery becomes mathematically improbable.

Diversify broadly to align Ensemble and Time Averages

Left to chance, concentrated bets expose you to idiosyncratic ruin. Owning too few assets means your personal experience may diverge drastically from the market’s long-term return.
Think of it like this: if 100 children each draw one candy from a jar, collectively they get the full mix. But one child drawing once might get only a sour one. By holding many securities, across geographies, sectors, styles and strategies, you increase the likelihood that your personal time path mirrors the broader market’s ensemble return.

Diversification isn’t about reducing volatility; it’s about making your fate look like the average, rather than being hostage to outliers.

Avoid Leverage that breaks Ergodicity

Leverage distorts risk asymmetry. It gives you 100% of the downside for less than 100% of the upside. Worse, it introduces the possibility of forced liquidation at the worst moment: precisely when prices are lowest.

Even moderate leverage increases the probability of ruin under stress. And once ruined, you cannot participate in the recovery.

Size Positions conservatively

No single position should threaten the viability of the portfolio. Ask: “Could this bet put us out of business?” If yes, reduce it.

Position sizing is not a function of conviction alone. It must account for uncertainty, correlation shifts and tail dependencies. A seemingly sound idea can become catastrophic if oversized.

Focus on consistent small edges, not rare big wins

Chasing outlier outcomes, moonshots, macro calls, black swan predictions, invites ruin. Instead, seek numerous repeatable advantages with limited downside and open-ended upside.These resemble option-like payoffs: small premium paid regularly, large payout occasionally.

Over time, such convexity generates superior risk-adjusted returns without fragility.

Test for Black Swans

History shows that extreme events occur far more frequently than Gaussian models suggest. Do not design portfolios around “normal” conditions. Ask: “Can we survive the worst plausible scenario?”

Not every crisis needs to be predicted. But every one must be survivable.

Monitor path dependence

Early losses hurt disproportionately. Losing 50% of a £10,000 account leaves £5,000, a long road back. Losing 50% of a £1 million account still leaves half a million. The psychological and mathematical burden differs vastly.

Sequence of returns matters immensely, especially during accumulation phases. Protect capital aggressively when assets under management are small.

Embrace Mean-Reversion strategies over the long term

Markets behave like yo-yos tethered by rubber bands. When valuations swing to extremes, whether euphoric or despondent, forces pull them back toward fair value.Patient investors who buy when fear is rampant and sell when greed dominates exploit this ergodic tendency. They do not need to predict the future; they only need to wait for normalcy to reassert itself.

Over decades, such discipline produces reliable outcomes without reliance on forecasting accuracy.

Conclusion: The rational investor is the survivor

Modern finance teaches us to optimise Sharpe ratios, track benchmarks and chase alpha. But it forgets the foundational rule: you must survive to collect returns.

Ergodicity reveals the flaw in treating investment as a series of independent trials. It is, instead, a continuous path: irreversible, cumulative and fragile to ruin.

The most enduring investors are not those who achieved the highest peak returns, but those who avoided irreversible losses. They prioritised geometric growth over arithmetic illusions, diversification over heroics, patience over prediction.

Final message:

Aim for robustness through redundancy and margin of safety, not forecasting. We cannot predict black swans but we can (and must) build systems that withstand them.

Bet small enough to survive, large enough to grow. Do these things consistently, and compounding will do the rest.

Survive. Spread your bets. Keep reinvesting. Avoid catastrophe early. Wait for sanity to return.

Because in the end, the longest-lasting investor doesn’t have to beat the market every year.They just have to never die.