Nassim Nicholas Taleb
reminds me of the venerable Charlie Munger in many respects: they are both
experienced (and successful) in finance, multidisciplinary, iconoclastic,
unwilling to mince words and voracious readers. After hearing his name crop up
many times with regards to investing, I knew that I had to get around to seeing
what all the fuss is about, and I'm glad I eventually did.
In Fooled By Randomness:
The Hidden Role of Chance in Life and in the Markets and The Black Swan:
The Impact of the Highly Improbable, Taleb argues that the world we live in
is subject to considerably more randomness and extreme events (Black Swans)
than we usually realise. I think they're both great reads, not just for
investors but anyone who needs to make decisions under uncertainty (i.e.
everyone).
One of my favourite
examples from The Black Swan is his idea of the turkey problem. Imagine
a turkey that is fed every day for 1000 days. From its point of view, with each
passing day and each meal, it gains increasing confidence that humans are
acting in its best interests. That is until day 1001 which turns out to be the
Wednesday before Thanksgiving... This event is a Black Swan for the turkey, but
not for the butcher who knew it would eventually happen. Extend this problem to
any patterns that humans interpret - even with 1000 years of evidence to
suggest something will continue, it is impossible to predict a Black Swan type
event that has never occurred before and we could find ourselves helpless as a
turkey in the face of the unforeseen event.
What does this mean for us
then? It means that we need to be very wary of relying on past data to predict
the future and individuals should try to make themselves robust to Black Swans.
In financial terms, that might mean reducing debt or eliminating leverage from
your life altogether, taking out more insurance protection, or it might mean
that you need to diversify your investments more. It makes me wonder whether it
is reasonable to assume that share markets will continue to outperform all
other asset classes over the long term. Despite over a century of information
indicating share markets return around 10% per annum, the next century could
severely disappoint - Taleb reminds us that Black Swans aren't just completely
unexpected events, events that are widely expected but do not materialise are
also Black Swans. It is impossible to determine with precision the likelihood
of this Black Swan.
Perhaps we need to look
deeper and try to determine the cause/s of the pattern we see in order to
establish whether it is truly sustainable and to find out what could disrupt
its continuation. For instance, one could argue that because share markets are
more volatile in the short term, they deserve to be priced at a discount to
less volatile asset classes (in finance speak, shares require an equity risk
premium). A 5% p.a. return from the share market that could vary wildly year to
year is not as desirable as a smooth 5% p.a. return from your bank account, so
shares should be priced to give a higher return. Therefore, one would need to
figure out what if and what could disrupt this driver of returns. Is it possible that
shares become less volatile in the future? Is it possible that corporate
earnings (another driver of the excess returns from share markets) could grow
at a much slower rate in the future or be hit negatively by a Black Swan? Is it
possible that interest rates will be permanently lower (and therefore all
investors receive a lower return)? The answer is yes, they are all possible,
but I would guess improbable. Therefore, with an awareness that 10% returns are
not set in stone, I come to the conclusion that investing in the share market
over the long term is still the best course of action - others may disagree and
they would be perfectly justified in doing so as the answers are too unclear.
Speaking of the best course
of action, I recently wrote about my loss on Antares Energy: "I think that
the initial reason for purchasing was still valid, as it appeared more likely
than not that the deal would go ahead, in which case the net cash per share
would have been almost double my buy price. Unfortunately, chance has an
annoying habit of making rational decisions look silly from time to time, but
that's just a part of investing you have to deal with." I was trying to
communicate the rather counterintuitive idea that even though I made a loss, it
was the right decision to invest in Antares.
Fortunately, I'm not the only who thinks this way and Taleb is more
eloquent in explaining it than I am: "I will
repeat this point until I get hoarse: A mistake is not something to be
determined after the fact, but in the light of the information until that
point." If that still doesn't make sense, consider a situation where if
you roll a six-sided die and land a three, you have to pay me $5 but if you
roll anything else, I'll pay you $5. Clearly, the odds are skewed in your
favour - the rational thing to do would be to grab the die and roll it as many
times as you can before I realise my idiocy. But what happens if I only gave
you one roll and you happened to roll a three? Sure, you lost money but your
decision to roll the die was not a mistake. In light of the information that
you were provided, you made the rational choice but the outcome was obscured by randomness. The exact opposite occurs in a
casino.
Taleb expands on this concept a little more, stating
that, "One cannot judge a performance in any given field (war, politics,
medicine, investments) by the results, but by the costs of the alternative
(i.e., if history played out in a different way). Such substitute courses of
events are called alternative histories. Clearly, the quality of a decision
cannot be solely judged based on its outcome, but such a point seems to be
voiced only by people who fail (those who succeed attribute their success to
the quality of their decision)." He applies this alternative history idea
to the choice of a career. For example, if you decide to become a dentist, your
future financial position is far easier to predict than one in which you become
a writer (where only a very small minority claim the majority of money to be
made in the writing industry). Therefore, even if you made it big time as a
writer and became a billionaire like J.K Rowling, you made the irrational
decision financially. If you lived your life as a writer another thousand
times, in the majority of those lives you would be pretty poor. Although it is
very unlikely you'll ever become a billionaire in your thousand dentist lives,
it is also unlikely you'll be struggling financially. Performance should be
evaluated using this logic - despite a favourable or unfavourable outcome
having occurred, what were the alternatives that could have happened?
Unfortunately, it seems humans are wired to take outcomes at face value and
ignore these alternative histories.
A corollary of this alternative history idea is that
the financial success of many billionaires or the fame of many celebrities is
simply due to luck. There will always be a few lucky fools that were simply in
the right place at the right time, but they are usually admired all the same as
those who succeeded due to inordinate skill or effort. Equally, it is an
unfortunate truth that there are many extraordinary individuals deserving of
success that the world will never know of because they were unlucky in some way
or another. I suppose the lesson to learn here is not to simply judge people on
where they ended up, but rather to look at the alternative histories that would
have occurred if they lived their lives many times over. Or in Taleb's more
profound words, "Heroes are heroes because they are heroic in behavior, not because they
won or lost."
Although I
have doubts about some of Taleb's other ideas such as his 'barbell strategy'
and found him to criticise a little too much for my liking, I wholeheartedly
recommend you read Fooled by Randomness and The Black Swan. In
this blog post I've only scraped the surface of what he writes about
in those two books, as it is difficult to compress his ideas - a compliment to
Taleb. I haven't got around to reading his most recent book, Antifragile,
but I'm expecting it to be similarly thought-provoking.
Finally, I thought I'd pass on a great piece written by Tony Hansen, who runs Eternal Growth Partners. More interesting thoughts abound here.
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