Minimalist Investing and Black Swans – Pt. II

By Kristoffer

Pt. I can be found here.

There we are, me and my climbing partner, sitting on a glacier in the Swiss alps, between the twin peaks Castor and Pollux. We’re killing time, talking about this and that, doing the principal chore of alpine camping – keeping our gas stoves going and melting snow for drinking water. We’re at almost 4000 meters of altitude and the views over Italy are breathtaking. We’re both in awe of the privilege it is to be alive and experience such beauty.

We’ve decided to bivouac close to the summits we’re about to climb the day after, rather than staying in the comfortable hut a few hundred meters below us. We reason that we’ll get at least an hour’s head start and – which is probably closer to our real motivation – it’s way more bad-ass to sleep under the stars on the glacier, than with all those wimps in the hut. As amazing as the whole thing is, though, I’m getting increasingly anxious as the afternoon drifts into evening. In just one hour a pillar shaped cloud has grown – from quite far beneath – to shoot up several hundred meters above us. I point at the cloud and say “Do you think this will become a problem?”. My climbing partner replies “Nah, the forecast promised nice, stable weather. Don’t worry!”.

If the ensuing horror show taught us one thing, it was that forecasts and probabilities are nice and all, but reality always gets the last laugh.

We weren’t one bit less scared shitless by the raging thunderstorm right above our heads, just because it was highly improbable. We got no less soaking wet from the pouring rain, just because it was unexpected. Neither did we get one bit warmer when the storm cleared, the temperature dropped and our sleeping bags turned to ice cocoons, because the weather had been nice so far during our stay in Switzerland.

Someone’s about to get a very humbling lesson in the perils of putting his well being at the mercy of statistics.

This seems pretty obvious, right? Still, I find that most prevailing investment advice ignores two things: First, the fact that all forecasts and statistical models, no matter how fancy and Nobel prize winning, can be obliterated instantly by an unexpected reality. Second, that reality is what you’ll have to deal with when the shit hits the fan – not the forecast.

There’s ample evidence that the human race is bafflingly useless at predicting future economic development, or, for that matter, anything future related. A lot of of investment advice is therefore irrelevant. This is brilliantly proved in “The Black Swan: The Impact of the Highly Improbable” by Nassim Nicholas Taleb. Taleb’s overarching thesis is that it takes only one blow from reality to overthrow even the most credible of assumptions. It’s illustrated by the fact that Europeans spent several hundreds, if not thousands, of years being utterly convinced that all swans are white. The evidence was overpowering. During millennia of observations, all swans had been nothing but white. This was taken as proof that swans can only be white. It didn’t take long after the first Europeans landed in Australia until there were black swans high and low, though.

If you look at nothing but the logic of the situation, you’ll soon find that the only thing all those observations of white swans had proved, was that swans can be white. Nothing else had actually been proved. The very second a black swan was sighted, the model of reality that said all swans were white was falsified. It didn’t matter one iota how many observations there had been of white swans. This too might seem obvious, but our poor monkey minds are full of limitations. These limitations make us very prone to jump to the kind of premature conclusion it is to believe all swans are white, because only white swans have been sighted. Daniel Kahneman’s book “Thinking, fast and slow” explains the cognitive mechanisms behind this in a beautiful way. Please read it, if you doubt the fact that we understand almost nothing.

קובץ:Black Swan bg.jpg
An improbable, but yet very real, Hungarian black swan photogrpahed by Kiril Krastev. 

After this little rant, we can go back to the subject of investing. Even before reading “The Black Swan”, I had come across a lot of reasoning along the lines of “It’s impossible to predict the future and beat the market, so don’t even try it”. I found most of it very convincing. My only problem was the proposed solution, which left me deeply frustrated. Have a look at the graph below. It’s supposed to prove that something called index investing is the way to go. The line of thought goes: “Sure, the stock market goes up and down in ways we simply can’t predict, but over time you’ll always end up on top if you just follow index”.

100 year historical development of the Dow Jones index. Link to source.

Do you notice the logical somersault here? The way to counter our uselessness at predicting the future is supposed to be based on one single, dead certain, assumption on how the future will pan out – namely that the stock market always goes up*. How can we be sure that something like peak oil, or an unpredicted tipping point in global warming, won’t make these last 100 years of economic growth a historical parenthesis? I find it very possible that our belief in an eternal growth of the stock market, has a lot in common with the poor turkey in the graph below. It was pampered and well fed every single day of its life, providing seemingly fool proof evidence that its well-being would continue to increase over time.

Imagine a turkey being lovingly fed and cared for in preparation of thanksgiving. The turkey has no concept of thanksgiving whatsoever. All it knows is that humans are pretty great – every time one shows up, life gets better. This model of reality only gets reinforced as time moves on. Until day 1001, when the turkey has to face the true intentions of its human benefactors.

I’m not saying that dystopia and a regression to the dark ages it the only way forward. I’m only saying I don’t know what will happen. Hell, artificial intelligence, space travel and solar power might very well save our asses, drive civilization into unprecedented bliss and create unimaginable riches for all. The thing to remember here is that I just don’t know. And neither do you, or anyone else.

Even though I don’t know what will happen, It’s way easier to keep an open mind to what can happen. If we go back to the two idiots in the Swiss alps, we can illustrate this in a pretty simple way. You could argue that these two idiots should have made more of an effort getting hold of a correct weather forecast to inform their decisions. This would be the equivalent of a fancy investing strategy, or trying to find proof of were the world is going. But this is not enough, since forecasts and predictions are at best qualified guesses based on historical events. I would like to propose am entirely different approach: one of fundamental logical reasoning.

If the two dumb-asses would have done some logical reasoning, it could have sounded something like this: “The forecast looks good” -> “Are weather forecasts reliable in alpine environments?” -> “No, they’re not” -> “Can there be an occurrence of very bad weather despite the nice forecast” -> “Yes” -> “Will the consequences of very bad weather be intolerable without proper counter measures?” -> “Very much so!” => “Bring a damn tent or sleep in the hut!”.

Note that there’s no getting technical here. We’re not going into the weeds of cloud formations, barometric pressures or probabilities at all. Still, we end up with a very robust strategy. It would have let us enjoy our experience in case of good weather, and it would have made the consequences of bad weather much easier to live with.

In the next part of this series, I’m going to elaborate on how this kind of simple logical reasoning can be applied to create a minimalist and, if you will, clutter free investment strategy. It’s based on the kind of logical reasoning the two alpine knuckleheads should have engaged in, steers clear of statistics and will allow me and Emmie to sleep well at night.

*I might come across as a bit whingeing here and I would like to point out that there’s a lot of excellent reasoning in the blog I’m linking to here. It’s very possible that I’m dead wrong and that index investors will come out with the last laugh. I just don’t agree with (or understand) all the conclusions and can’t feel comfortable betting everything on the world being a cornucopia.

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