Black Swans, Nuclear Disasters and Your Portfolio

by Mike

 

No, I’m not talking about Natalie Portman and her baby bump.

I’m talking about a very interesting idea of how humans think about (or, more to the point, don’t think about) huge, life-altering but infrequent occurrences that are typically outside everyone’s expectations.

The phrase originates from the Roman poet Juvenal who lived in the late 1st and early 2nd century BCE, who wrote:  “rara avis in terris nigroque simillima cygno,” which loosely translated means “a rare bird is in the lands, and very like a black swan.”  Because no English person had ever seen a black swan, the saying gained currency in 16th century London as a statement about impossibility, until black swans were discovered in 1696 in Western Australia.

The concept was re popularized in 2007 by the author  Nassim Nicholas Taleb in his book, The Black Swan.  Taleb argues that huge, life-changing phenomena like World War I, personal computers ,the  Internet, and 9/11 are black swan events.  This concept of the black swan as popularized by Taleb means the shortcoming of belief systems that fail to contemplate extremely rare but significant occurrences that lie outside common experience but with the power to dramatically change received wisdom, dogma, and how we engage with the world and survive.

To qualify as a black swan event something must be high impact and lie outside the reasonable expectation or historical predictability of the thoughtful scrutiny of economics, history, sociology, technology and science.  Furthermore, the black swan theory argues that there is a peculiarity in human psychology that renders it blind to the massive importance of black swan events both individually and collectively.  We rationalize them with the benefit of hindsight, and to soothe our minds make them both more mundane and predictable than they really are.  To believe that enormous, history-changing events are not predictable is terrifying to the human psyche.

The black swan theory sits beside another powerful observation of the limitations of human cognition that we are mostly incapable of accurately assessing risk.  We tend to have too much fear of certain kinds of risk, while downplaying other risks that statistically have a much better chance of taking our lives.  Think car accident vs. shark attack.  Think I’m wrong?  Take this little quiz that was published in the magazine Psychology Today:

How good is your grasp of risk?

  1. What’s more common in the United States, (a) suicide or (b) homicide?
  2. What’s the more frequent cause of death in the United States, (a) pool drowning or (b) falling out of bed?
  3. What are the top five causes of accidental death in America, following motor-vehicle accidents, and which is the biggest one?
  4. Of the top two causes of non-accidental death in America, (a) cancer and (b) heart disease, which kills more women?
  5. What are the next three causes of non-accidental death in the United States?
  6. Which has killed more Americans, bird flu or mad cow disease?
  7. How many Americans die from AIDS every year, (a) 12,995, (b) 129,950, or (c) 1,299,500?
  8. How many Americans die from diabetes every year? (a) 72,820, (b) 728,200, or (c) 7,282,000?
  9. Which kills more Americans, (a) appendicitis or (b) salmonella?
  10. Which kills more Americans, (a) pregnancy and childbirth or (b) malnutrition?

ANSWERS (all refer to number of Americans per year, on average):

  1. a
  2. a
  3. In order: drug overdose, fire, choking, falling down stairs, bicycle accidents
  4. b
  5. In order: stroke, respiratory disease, diabetes
  6. No American has died from either one
  7. a
  8. a
  9. a
  10. b

So why am I going on and on about Black Swans?  Because all of this matters enormously.  Do you have an emergency kit (for my Southern California comprades – an earthquake kit)?  If you lost your job tomorrow could you survive?  Or to be more precise,do you have enough liquid assets to last as many months as your current annual salary divided by $10,000?    That’s how long it takes on average (NOT in a bad economy) to find a new job.

In addition, it’s now estimated that you will need between $360,000 and $500,000 in savings when you retire to pay for your medical treatment.  This is on top of Medicare benefits and your savings to fund your normal living expenses.  Staggering, isn’t it?

I don’t know if the brutal effects of the Japanese 9.0 earthquake, triggering the heart-wrenching tsunami that reached 6 miles inland, leading to the slowly unfolding nightmare of a nuclear disaster with multiple reactors in meltdown is a black swan or a series of more mundane ignoring of actual predictable events. Either way it’s sobering, mind-numbing and shocking as hell.

In our financial lives we have to be stone cold sober in our assessment of risk if we are to be successful.  Part of that process is understanding how our deep-rooted psychological biases work against our objectivity. This does not mean we can or should flee all risk.  That would lock us into either paralysis or wealth-destroying conservatism.  But it does mean that we need to assess the downside scenario in everything we do, and then understand that there are the “unknown unknowns,” the black swans, the things that we have not built into our model because they are so rare that we’d have no way to build them in.

But the Black Swans rule history.  They are the great agents of both horrific destruction and miraculous creation, which are really two sides of the same coin (to paraphrase Joseph Schumpeter, who first argued the case for creative destruction).

What does this all mean for you?  You need to make sure that in all aspects of your life, including your investment portfolio, you are well prepared for all of the events that are likely to occur – and even the events you haven’t even contemplated.  At my company I always challenge the leader of every project plan to develop a “world goes to hell” contingency.  This is the plan that we hope to never use, but is what we’d need to do if everything possible goes wrong.

But we have to also understand that Black Swans can be positive or negative. Or, more to the point, they can have upside as well as downside.  Economic black swans just are.  Whether they are bad or good depends on how you are positioned in the market.  To protect yourself on either side you should make sure that your portfolio has both conservative wealth-protecting investments as well as high-risk high-reward investments ins new technologies and paradigm-breaking start-ups.

Change is your friend, if you’re listening, ready, and ready to move quickly.

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