Friday, 20 June 2014

Random Thoughts About Randomness and Black Swans

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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