Swans, turkeys and tigers – the false security of the bell curve

I’m reading The Black Swan by Nassim Taleb. Before Australia was discovered by Europeans, the idea that a swan could be anything other than white did not exist. The book’s premise is that we are deluded in using historical models to predict future events, be they world changing political moments, or risk and return in financial markets. He talks about the ludic fallacy – “believing that the structured randomness found in games resembles the unstructured randomness found in life”. When we look at risk, we draw bell curve distributions, or test our portfolios against maximum expected losses – for example by modelling the impact of a 1987 style crash on our equity holdings. Yet it is the “black swans” that make the big differences to long term portfolio performance – the disappearance of the Chinese and Russian stock markets at the start of the last century for example. Taleb gives the example of measuring a thousand days in the life of a turkey, and measuring its happiness and comfort over that period: for the first 999 days, the bird’s utility gradually increases as it becomes happy in its surroundings (only if free range, obviously) and gets fatter. Chart this and you have an uptrend with fairly low volatility (a nice Sharpe Ratio). On the 1000th day it is killed and eaten. We should stop thinking of financial markets as having predictable, casino style returns. Even casinos don’t have predictable casino style returns. Casino owners have models which analyse the odds of all the games they offer, with overlays that predict some big swings if a big hitter walks through the door and wins heavily on “black”. They also carefully model fraud risk, either from employees or cheating customers, and thus spend a fortune on video cameras and security guards. Here then are the actual 4 biggest losses or near losses suffered by one Las Vegas casino, as told in the book:

1. They lost $100 million when their star entertainer (either Siegfried or Roy) got mauled by a tiger on stage
2. A builder tried to blow up the casino with dynamite after being injured during its construction
3. An administrative employee failed to post several years worth of tax forms to the IRS, resulting in a massive fine
4. The casino owner’s daughter was kidnapped, and casino takings were used (illegally) to pay the ransom

A “black swan” has three characteristics – it is unpredictable, its impact is huge, and after it has happened we try to explain it in order for us to make it feel as if it was not so unpredictable (9/11 for example). Moving back to bonds, as we must do from time to time, the book rubbishes the historical “fact” that the First World War was both inevitable and universally anticipated. He cites Niall Ferguson‘s study of British and European bond prices in the months leading up to the start of the conflict; even though a coming Great War would surely destroy both public finances and the wider economy, the bond prices saw no movement. The fact that volatility in global markets is at record lows right now tells us nothing about future events. We must expect the unexpected, and position portfolios to benefit from black swans – how we do that is the hard bit.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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