“Reasoning correctly from erroneous premises”

The quote above is from John Locke, but I found it second hand from Nassim Taleb’s The Black Swan. Supposedly, it’s Locke’s definition of a madman.

In my opinion, this quote accurately describes the state of the art in academic finance and economics.

Although it may be hard to believe, the Nobel prize has been given out repeatedly to very smart people who are exemplars of the above quote.

As a result, the field of finance, economics and investing is populated with folks who seem to unquestioningly follow such teachings.

That’s why most people are over-diversified and think risk equals volatility. The result is that most investors are under-protected from low probability, high impact, negative events and over-protected from low probability, high impact, positive events.

When a couple of Nobel laureates who exemplify the quote above followed their own advice, they lost almost all of their investors’ money and nearly caused a temporary collapse in the world’s financial system (if you think I’m exaggerating, read When Genius Failed by Roger Lowenstein).

Despite this paradigm shifting result, most market participants go right on assuming that erroneous premises can be followed with rigorously correct reasoning (and lots of higher math and Greek symbols).

Which reminds me of an apt definition of insanity: “doing the same thing over and over again and expecting different results” (Albert Einstein).

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Black Swan

I have another excellent book to recommend: Nassim Taleb’s Black Swan (Taleb also wrote another favorite: Fooled by Randomness)

The book deals with a subject I’m always thinking about, the impact of improbable events. Taleb is an trader who seems to have made a career out of betting that improbable events may happen more frequently than most people predict, so he knows of what he speaks.

Taleb describes two countries, Mediocristan and Extremistan, which have very different characteristics. In Mediocristan, everything follows a bell shaped curve and is relatively easy to predict. He gives the example of the income of dentists, which tend to fall around an average and not vary too far from it. In Extremistan, however, things don’t follow a bell shaped curve and are almost impossible to predict. He gives the example of authors whose incomes are either extremely high (for very few) or extremely low (for the vast majority).

The reason he highlights this difference is a lot of people, especially academics in economics and finance, tend to assume that we live in Mediocristan even though we live in a world that resembles both Mediocristan and Extremistan. The height of people and the income of dentists are bell shaped, financial markets and the income of authors are not. The problem is that highly improbable events can easily overwhelm the highly probable events that most people focus on.

His point is important to acknowledge, because if you are measuring the height of people, bell shaped curves are great. But, if you are operating in financial markets, using bell shaped curves can be very dangerous (just ask the Nobel prize winners who worked with Long Term Capital Management).

I’m finding the book a pleasure to read because the subject matter is fascinating and relevant, and because I really enjoy his style of writing, which is laced with stories, examples and no punches pulled. Sometimes, he seems to be a bit arrogant in his way of describing things, but I’m usually more amused than offended by this.

I highly recommend the book to anyone operating in Extremistan for a living.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

What separates good investors from great investors

Michael Mauboussin, from Legg Mason, recently released a great article about the difference between good and great investors.

The first issue he highlights is that great investors avoid being destroyed by high impact, rare events. For example, many value investors avoided investing in dot-com stocks during the late 90’s and looked liked fools until the market tanked between 2000-2002. Great investors aren’t great because they can predict such events, but because they have learned to avoid them.

The second issue he highlights is that great investors have the right temperament. By this, he means they don’t get sucked into the psychological traps that most people get sucked into.

For example, most people feel the pain of losses (loss aversion) so much more than the pleasure from gains that they make bad choices. What if I offered you a game where you had a 95% (19 out of 20) chance of losing $5 and a 5% (1 out of 20) chance of making $100, would you play? Would you play if you could play it an unlimited number of times? Most people wouldn’t play this game because they would feel the pain of losing more than the benefit of gaining, even though they would make money with no effort as long as they kept playing the game. Great investors understand this math and would play.

Great investors also understand the difference between probability and impact. In the example above, you have a high probability of losing, but when you win it has a very high positive impact. Most people over-emphasize the probability and under-emphasize the impact. Great investors understand the difference and play accordingly.

Great investors also grasp the randomness of any game they play. Short term results in the stock market are so random that someone with little skill can get wonderful returns over short periods of time (like a day, month, year or even 3 years). Only over the long term can you see who has skill. Great investors get this and judge their investing options over the appropriate time horizon.

Mauboussin concludes his article by pointing out that high impact, rare events, loss aversion, probability and impact, and randomness requires great investors to focus on 3 things: process versus results, a constant search for favorable odds while recognizing risks, and an understanding of the role of time.

Investors who follow this advice and can act on it have the potential of being great instead of merely good or even bad investors.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Low likelihood, high impact events

With an exciting title like that, you must be just glued to the screen right now! Probably not, but stay with me and you may see why I think this is important stuff.

One of the hardest concepts to grasp is how low likelihood, high impact events can really effect our lives. What do I mean by that? Think of winning the lottery. Now, I have your attention. That’s a low likelihood, high impact event. So is inheriting a million dollars from a distant aunt you’ve never met. But, so is getting struck by lightning or attacked by a shark. In other words, such events can be both good and bad, and their impacts are so great as to be really important to us.

The field of investing is filled with such events. According to finance theory, the likelihood of the 1987 stock market crash was statistically impossible, and yet it happened. That is an illustration of a low likelihood event, and an example of how low likelihood events occur much more frequently than theory predicts (fat tails for you statistical types out there).

The problem is that while most people eagerly seek out low likelihood, good impact events (playing the lottery), they also dismiss low likelihood, bad impact events. They think, “that’s so unlikely to happen, I’m just going to assume it never happens to me.” Not the right way to think about things, buster.

Consider speeding up to make a yellow light. Suppose you make it through the light the first 999 times, but crash into someone and kill them on the 1,000th time. If you knew those were the chances you were taking, would you speed up to try to make the light? I sure wouldn’t.

One of the difficulties, here, is that it’s hard to know the probabilities. Will you t-bone someone else’s car 1 out of a thousand times, 1 out of a million times, or 1 out of a billion times? If you thought about it, you may decide never to take that chance because you don’t ever want to court such a disaster. The problem is that most people just decide not to think about it, and have no idea what risks they’re taking.

The same problem occurs with investing. Because most people don’t know the odds–and prefer never to think about it–they take chances that eventually lead to very negative outcomes. If you go to Vegas and gamble often enough, you will lose.

Think about a bank. The way a bank works is it borrows $900 from other people, puts it’s own $100 into the pot, and then makes loans of around $1,000. If 10% of those loans go south, then the bankers get wiped out. Would you want to be a banker and assume that 10% of your loans would never, ever go into default? What if I told you that credit cycles happen every 70 years and that bankers get wiped out when that happens? Makes you want to know the odds, doesn’t it?

And that’s the point with investing, too. It’s very important to know the odds of something bad happening, and what the impact will be if that bad event occurs. If you don’t know the odds, or if you can’t handle a bad event no matter what, you probably don’t want to play.

Everyone has to assume some risks, but there are many risks people take even when they don’t need to. Learning to avoid bad risks and take good risks is the art and science of investing. Surprisingly to most, it turns out avoiding bad risks is what most investment success is about.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.