Black Swans, The Ludic Fallacy and Wealth Management

Accepting Uncertainty As A Fact Of The Investor’s Life

One of the very first clients that my then boss entrusted to me, in the early 1970s, was Mrs. Z. The daughter of a famous European author, she already was a lady “of a certain age” but certainly no fool, very curious of everything and, somehow, always surrounded by young creative talents in various disciplines.

For the first anniversary of my taking over the management of Mrs. Z’s investments, I had prepared a comprehensive report with performance analyses, economic graphs and market tables. As I started my presentation, she put her hand on my arm and said: “Dear Mr. Sicart, it is very nice of you to try to explain all this, but I don’t understand anything. In any case, you must not worry, because the money I entrusted to you, I consider lost!”

Years later, upon Mrs. Z’s death, a grateful letter from her son confirmed to me that I had deserved her equivocally-expressed trust. But, in retrospect, it is amazing how much her statement empowered me as a money manager.

Paradoxically, successful portfolio management requires a certain detachment on the part of the money manager, even the one most devoted to his clients. Time-tested investment disciplines are based on theory, experience of “what works”, and common sense in assessing risk. They require one to approach investment decisions with an almost clinical detachment and with as little psychological and emotional baggage as possible. This is particularly true when one follows a contrarian/value discipline like ours, which often leads us to stray from existing consensuses and the prevailing media coverage to which clients are exposed.

But, with empowerment comes greater responsibility. For example: How much risk is a manager to accept in the pursuit of investment performance? Do we really know the risks we are taking?

What triggered this reflection was the reading of excerpts from a soon-to-be-published new book by Nassim Nicholas Taleb: The Black Swan: The Impact of the Hidden Improbable (April 2007 – Random House).

Nassim Taleb has been both an active derivatives trader and a professor in the “sciences of uncertainty” at the University of Massachusetts at Amherst. His condescending writing style leaves little doubt that he despises most academic statisticians, professional traders, journalists above all and, probably, a majority of his readers. But to me, he has one overwhelming attraction: he criticizes conventional statistical methods with common sense and historical wisdom rather than with more statistics. It’s hard to read him without being coerced into thinking.

In an earlier book, Fooled By Randomness: The Hidden Role Of Chance In Life and The Markets (2001, Random House), Taleb made the point that we often tend to see predictive qualities in patterns that, in fact, are totally “random” (i.e. the result of pure chance).

Sometimes, of course, we simply draw stupid inferences from seemingly correct historical observations. One blatant example would be:

“I have carefully studied the life of President George W. Bush and made more than 16,000 daily observations. Not once did President Bush die. From this, I can safely infer that President Bush is immortal”.

But even when common sense prevents us from stupid inferences, statistics can still mislead us. In an example that hits close to home, Taleb has us start with 10,000 money managers, who simply toss a coin each year (no skill involved here). Since the odds of tossing a coin are 50-50, half of the managers will “outperform” each year. We, as the client, keep the winners and fire the losers. At the end of the first year, we will have kept 5,000 managers. After year two, we will still have 2,500. After five years, 313 winning money managers will be left. In fact, even after ten years, a tenure longer than that of most investment professionals today, there will still be 9 money managers left with an un-interrupted, ten-year record of annual gains … All out of pure luck!

In what is called “survivorship bias”, we forget that we started with a sample of 10,000 money managers of whom 9,991 have been eliminated. We think we will improve our chances of achieving superior performance in the future by picking a manager among the 9 “winners” with uninterrupted records of gains. This is obviously erroneous, since the surviving managers will still toss coins with 50-50 odds of winning. So much for picking portfolio managers solely on the basis of past performance!

But there is more. Beyond the fallacy of many “observed” patterns or correlations that look credible but are in fact purely random, there also are risks that exist “out there” but that we simply cannot foresee or evaluate. For example, a generalization such as “all swans are white” merely means that, up to now, only white swans have been observed. But it is enough for one black swan to appear for this conclusion to become entirely false. The odds of encountering a white swan are then irrevocably altered. Unfortunately, until a black swan has been observed, no amount of information collected about white swans can help us assess the odds of there being black swans.

Taleb prefers to focus on the kind of Black Swan (rare) events that have a large impact, probably because they are more relevant to trading. Like black swans before their discovery in Australia, these are events that are beyond the realm of “normal” expectations; but, once they have happened (as with the terrorist attacks of September 11, 2001 or the advent of World War I in 1914), they can fundamentally alter both our lives and our assessment of the future.

Transposed to the investment realm, the possibility of such events poses a conundrum that resembles a 99-to-1 bet: by assuming that rare events won’t happen, you almost always win; but if you lose, you can lose everything.

Given the expectations of a majority of clients, most money managers are in the delicate position of being forced to make such a bet. By chasing relative performance (e.g. attempting to beat stock market indexes or simply other managers), they implicitly are making the bet that the future will resemble the past and that investment disciplines that have produced superior performances in the past will continue to do so in the future. If a rare event occurs, however, they (and many other managers) are liable to “blow up”, which means to experience losses that dwarf all their cumulative, previous gains and essentially wipe them and their clients out.

Unfortunately, it seems to me that the likelihood of rare events, in the form of financial crises and their domino effects, has increased steadily in recent years, apace with financial innovation and the development of mathematically-sophisticated models of portfolio management. The increased risk arises, in large part, from what Taleb, in his forthcoming book, calls “the Ludic Fallacy”.

Once invited to visit a casino, Taleb had an epiphany: he realized that the casino’s risk management, aside from setting the gambling policies, was geared toward reducing the losses resulting from cheaters. Otherwise, the “house” was sufficiently diversified across the different tables to not have to worry about taking a hit from an extremely lucky gambler. Therefore, both for security and to identify cheaters, they had installed an extremely sophisticated surveillance system, worthy of a James Bond movie.

However, upon prodding, it turned out that the six largest risks actually incurred or narrowly avoided by the casino fell completely outside of their sophisticated model. Among those, for example, were: the loss of an irreplaceable performer, maimed by a tiger; a disgruntled contractor’s attempt to dynamite the casino’s foundations; and the failure, for years, of an employee to file reports of outsized winnings with the IRS, which exposed the casino to the potential loss of its license.

On the back of an envelope, the professor figured that the dollar cost of these “Black Swan” events could have been 1000 times larger than the risks taken into account by the casino’s gambling and security models.

Not surprisingly, Taleb finds it dangerous that, in universities, we are taught about uncertainty and probability from gambling examples, whereas he views gambling as merely a sterilized and domesticated uncertainty.

In gambling we are in situations that have been and can be repeated many times, and where the probabilities as well as the monetary gains and losses are the same for everybody and well known. The casino never surprises you by announcing that it will pay either 100 times more or only 1/10th of your take. By contrast, real life is messy and often surprises us. We don’t know the odds: we have to discover them and the sources of uncertainty are not defined.

In other words, the kind of uncertainty we face in real life has little connection with the uncertainty we encounter in exams and games. Furthermore, card games, lotteries, and dice games normally don't kill you; but in real life, the consequences of a Black Swan event on one’s investments, for example, can be devastating.

Taleb calls Ludic Fallacy the misuse of games to model real-life situations. The hundreds of PhDs employed by hedge funds and other institutions to calculate risks and build mathematically-sophisticated trading models are the main culprits of this Ludic Fallacy.

Based on thousands of historical observations and correlations, their models not only suffer from survivorship bias (since they are based only on what has worked in the past): they also fail to incorporate possible Black Swans and other possible but unquantifiable surprises. They are fit for a sterilized environment such as exists in casinos but will prove dangerous if not lethal in real life.

So, what is a money manager to do?

The good news is that Taleb’s direst predictions apply primarily to the world of hedge funds, many of which use a lot of financial leverage (debt). Leveraged instruments can easily “blow up” if their model or strategy, for one reason or another, stops working.

Let us say, for example, that a hedge fund starts with $1 billion in shareholder equity and borrows $3 billion, which is not altogether unusual nowadays. The fund’s total portfolio is now $4 billion, but its “net worth” remains only $1 billion. The market value of the fund’s investments then drops 25% from $4 billion to $3 billion. Since that is what it owes the banks, the fund’s net worth has been wiped out.

Fortunately, investors who do not use this type of leverage may get hurt in a Black Swan event, but they are unlikely to “blow up”. In fact, assuming they keep a certain amount of dry powder, in the form of liquid reserves, this type of event may actually present unique investment opportunities.

Beyond this, the best way to protect ourselves from the unforeseen is to use the intuitive wisdom that we derive from the living or the study of history. In Fooled by Randomness, Taleb makes a crucial distinction between information and “noise”. History, though subject to differences in interpretation, provides valuable information, in the form of enduring ideas, whereas the daily news, as reported by the media, is mostly useless noise.

While no indicator will foretell us when Black Swan events are about to occur, we can at least remain alert to the “idea” of Black Swans and, possibly, recognize times when financial markets are more or less vulnerable to this type of event.

“For an idea, age is beauty”, says Taleb. An idea that has survived a long time, across many cycles has demonstrated its relative fitness. Noise, at least some noise, has been filtered out. “All of my colleagues whom I have known to denigrate history blew up spectacularly…”

I do not have any definite answer to the questions raised by this paper, but I cannot resist citing one last Nassim Taleb observation, which I find personally most gratifying:

“A preference for distilled thinking implies favoring old investors… Older people have been exposed longer to the rare event and can be, convincingly, more resistant to it”.

Amen!

François Sicart (In San Miguel de Allende)
February 25, 2007

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