Alas, I have been indisposed for the last two weeks, normal service will resume this coming week.
This is a continuation of my series on extreme events and uncertainty.
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13. For the samurai, life was uncertain, constantly threatened by battle; the spectre of seppuku (ritual suicide by disembowelment) to appease an angry master; earthquakes; the fires in Tokyo -then named Edo- that were so numerous that it was said, “Fires and quarrels are the flowers of Edo”; famines and disease. Even as Japan was pacified by the Tokugawa Shogunate, the realities of life were wild, and brutish. The death-intense outlook of the samurai and Japanese aesthetic of mono no aware, or “sensitivity to ephemera” were shaped by the trauma of an uncertain and toilsome existence.
14. Humanity, as James Franklin’s book, The Science of Conjecture shows, has reckoned with uncertainty since the beginning of time and before Blaise Pascal and Pierre de Fermat conquered probability for the kingdom of mathematics in 1654. We good students of the origins of money, shuddering at the myth of the origins of money in barter exchange, have always remarked at how the oldest written texts we have discovered are debt instruments. Investors have been grappling with uncertainty since money was first created thousands of years ago –Homma Munehisa; Crassus; the first great compounders, the ancient Egyptian engineer class whose rise gave birth to money in Egypt; Mansa Musa; the Medici; the Dutch East India Company; Jakob Fugger…
15. Covid-19 exposes a change in our relationship with uncertainty. If you take a long view of history -the kind of view sympathetic to Zhou Enlai’s fabled reply to Henry Kissinger’s question on his views on the French Revolution, “It’s too soon to tell”-, the uncertainty of modern civilization has been steadily suppressed since the Enlightenment as man has conquered nature and as a half millennia old globalization has taken root and also, partly thanks to sheer good fortune: the investor today speaks only allegorically of “blood on the street”, or and the “masters of the universe” and Wall Street “gladiators” face few of the existential risks that an investor in ancient Mesopotamia, or Renaissance Italy or Tokugawa Japan, or Mansa Musa’s Mali, faced and corporations like the Dutch East India Company were simply too big to be bailed out by the state if they got themselves into trouble. When the capital allocators of the Dutch East India Company sent out ships, they knew some would never make it or return. The consequence of our lack of familiarity with uncertainty is that we have gone into denial about the inherent uncertainty of the future -emotionally, we are unprepared for it and this has added to the impact of unexpected and high impact events, leading to a failure to appreciate how frequent such events are and how we can prepare for them, as Marks, Taleb and Ian Breemer and Preston Kean have argued, and as Machiavelli, in urging his ideal prince to develop his virtù, believed.
16. To be human is to feel the prospect of loss more profoundly than the opportunity for gain. In his Annals (XXX, 21), Livy says, “Segnius homines bona quam mala sentire” (“Men are slower to recognize blessings than misfortunes”). Prospect theory, the ripe fruit of that great partnership, Amos Tversky and Daniel Kahneman, whose work was summarized by Kahneman in Thinking, Fast and Slow, a book worth a thousand other books, allied with the understanding that “imagination is a neurological reality”, to quote Tor Wager, explains the human tendency to avoid facing the possibility of catastrophe -death, massive drawdowns, destruction, existential failure, collapse-. The paradox of life is that those who seek to avoid contemplating catastrophe, make themselves vulnerable to catastrophe, but those who contemplate catastrophe, gain strength by it. So weary are we to contemplate catastrophe that, when Jeff Bezos predicted that, “one day Amazon will fail. Amazon will go bankrupt”, his acknowledgement of the reality that all businesses end in failure, shook many, with the Guardian describing it as a “frank admission of mortality”. For a cut-throat business world that prides itself on facing up to the protean nature of reality, that Bezos’ remarks made news showed a degree of childlike innocence that was quite astonishing.
17. The samurai, for whom catastrophe was a painful death, trained themselves to treat death with contempt, even a reckless indifference, proclaiming that, “The Way of the Samurai is found in death.”. For what purpose would a warrior contemplate his death so vividly, so dramatically and with such ritual? The logic was exquisitely simple: if each day the samurai suffered in his mind the most gruesome death he could imagine, the fear of death would not hold him back in combat, and he could fight with clarity and the calm and determined ferocity necessary to preserve his life and win. Inoculating himself against fear of death by charging toward it every day, he lived as if he was “already dead”, gaining freedom, able to maintain a state of relaxed alertness in the face of adversity. In Hagakure, Yamamoto Tsunetomo declared that, “We all want to live. And in large part we make our logic according to what we like. …If by setting one’s heart right every morning and evening, one is able to live as though his body were already dead, he gains freedom in the Way. His whole life will be without blame, and he will succeed in his calling.”
Another samurai, Daidoji Yuzan, wrote, “One who is a samurai must before all things keep constantly in mind the fact that he has to die. If he is always mindful of this, he will be able to live in accordance with the paths of loyalty and filial duty, will avoid myriads of evils and adversities, keep himself free of disease and calamity and moreover enjoy a long life. He will also be a fine personality with many admirable qualities. For existence is impermanent as the dew of evening, and the hoarfrost of morning, and particularly uncertain is the life of the warrior”
18. Mencius’ solution to the problem of living under uncertainty deviated from what is often preached: rather than calling for more precise risk models and a colder, less emotional, more robotic approach to decision making, or preaching the virtues of listening to one’s seemingly unerring instinct, Mencius believed that good judgment was the child of emotional balance allied with clear thinking.
Gary Klein, the father of naturalistic decision-making, recommends what he calls a “premortem”, a form of scenario planning in which one ushers the angel of future history toward a project one is engaged in, imagines that it has ended in “spectacular failure”, and, leveraging prospective hindsight amidst the debris, uncovers the plausible reasons for failure, increasing the odds of future success. One approaches the project as if it has failed, what might go wrong is, therefore, as Klein tells us, not the question, rather, one asks, “what did go wrong?”. Intriguingly, prospective hindsight has been found to improve one’s ability to proactively identify reasons for future outcomes by up to 30%. Karl Weick suggests that such thinking works because it is easier for the mind to imagine the detailed causes of a single outcome than it is for it to imagine multiple outcomes. As Andy Grove once said in his invigorating book of the same name, “Only the paranoid survive”. By allowing oneself to think about the worst of the worst things possible, one prepares both emotionally and practically for negative events. The samurai focused on imagining the knowns, he did not imagine a time when Commodore Perry would arrive, like a black swan, and force Japan to open up the world, but not only did this practice serve the samurai well for centuries, but, within a decade of Perry’s arrival, the Meiji emperor had set in motion the industrialization of Japan. Emotionally, Japan was ready for the worst. Imagining and feeling terrible consequences had prepared them to adapt to a black swan and be loose to randomness, like a reed in a storm that survives while the strong oak tree is ripped from its roots. Our failure to keep uncertainty and catastrophe before us, our determination to banish to the nether-regions of our lives the great risks that we face, some of them existential, had made our world more vulnerable than at any time since man first organized himself into tribes.
19. The Stoics had a practice similar to the premortem, the premeditatio malorum, or premeditation of evils. Each morning the Stoic would imagine the worst day possible, arming himself against impediments, preparing himself to act with relaxed alertness, what the Japanese call, “zanshin”. Seneca, in one of his wonderful letters, remarked,
“Nothing is durable, whether for an individual or for a society ; the destinies of men and cities alike sweep onwards. Terror strikes amid the most tranquil surroundings, and without any disturbance in the background to give rise to them calamities spring from the least expected quarter. States which stood firm through civil war as well as wars external collapse without a hand being raised against them. How few nations have made of their prosperity a lasting thing ! This is why we need to envisage every possibility _and to strengthen the spirit to deal with the things which may conceivably come about. Rehearse them in your mind : exile, torture, war, ship wreck. Misfortune may snatch you away from your country, or your country away from you., may banish you into some wilderness these very surroundings in which the masses suffocate may become a wilderness. All the terms of our human lot should be before our eyes; we should be anticipating not merely all that commonly happens but all that is conceivably capable of happening, if we do not want to be overwhelmed and struck numb by rare events as if they were unprecedented ones ; fortune needs envisaging in a thoroughly comprehensive way”.
20. We lose little by acknowledging uncertainty and the possibilities of ruin. In a study titled, “The Effects of Communicating Uncertainty on Public Trust in Facts and Numbers”, the van der Bles et al noted that “uncertainty is inherent to our knowledge about the state of the world yet often not communicated alongside scientific facts and numbers. In the “post-truth” era where facts are increasingly contested, a common assumption is that communicating uncertainty will reduce public trust.” They found that openly communicating uncertainty about facts and numbers increased the sense of uncertainty but did not meaningfully diminish trust in the facts and numbers or the communicators.
21. In one of his Saber Notes, John Huber shows that large-caps often get mispriced despite wide analyst coverage -even when they possess high returns on invested capital, are gushing with free cash flow and parade a trend of strong core earnings-. Much as markets interpret events according to their impact on the long-term value-creating ability of a business, markets are not infallible and in the short-term, often lose sight of the intrinsic values of assets. In a later note on the investor’s edge, Huber gives the example of Bank of America’s stock as it stood in December 2016, “Bank of America is an example of how significant the gaps between price and value can be even when it comes to large cap stocks. BAC ended 2015 around $17. It traded for around $11 just over a month later in early February 2016. It now trades around $22. In other words, the value that the stock market placed on Bank of America dropped by about $60 billion in just 6 weeks at the beginning of the year. Even more incredibly, the market now values this same company around $110 billion more than it did just 10 months ago.”
Huber surmises that the investor can, therefore, profit by what is well known, where secrets are open, that is, without an informational edge, by adopting a long-term strategic horizon, and taking advantage of the market’s manic-depressive swings. This implies some ability to forecast, to say with Benjamin Graham, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
Berkshire Hathaway’s PetroChina trade speaks to the problem of profiting from widely held information. Here is an excerpt of an exchange between Warren Buffett and a questioner at the 2002 Berkshire Hathaway Annual Meeting, with a comment by Charlie Munger:
Q35: San Francisco. In 2002, you invested in PetroChina and all you did was read the annual report. Most professional investors have more resources at hand. Wouldn’t you want to do more research? What do you look for in an annual like that? How could you make the investment only on a report?
WB: I read it in the spring of 2002, and I never asked anyone else their opinion. I thought it was worth $100 billion after reading the report. I then checked the price, and it was selling for $35 billion. What is the sense of talking to management? It doesn’t make any difference. If the market value was $40 billion, you would need to refine the analysis. We don’t like things you have to carry out to 3 decimal places. If someone weighed somewhere between 300-350 pounds, I wouldn’t need precision—I would know they were fat. If you can’t make a decision on PetroChina off the figures, you go on to the next one. You weren’t going to learn more if you thought their big [oil] field was going to decline out slightly faster, etc.
CM: We have lower due diligence expenses than anyone in America. I know of a place that pays over $200 million to its accountants every year, and I know we are safer because we think like engineers—we want margins of reliability. It is a very dicey process.
The final cost of Berkshire Hathaway’s investment in PetroChina was $488 million by 2003 when the last stocks were bought. In 2007, Berkshire Hathway sold its stake in PetroChina for $4 billion, with Berkshire Hathaway’s capital compounding at 55% annually from 2002 and 2007.
Berkshire Hathway were, of course, investing in line with PetroChina’s widely known intrinsic value -the annual report is publicly available- by taking advantage of market expectations which were excessively pessimistic about the ability of PetroChina to create value. More intriguingly, Buffett and Munger understood the limitations of information in spite of our appetite for information to allay our feelings of angst in the face of uncertainty. What mattered was that PetroChina had the characteristics necessary to navigate through an uncertain future more comfortably than the market expected. Berkshire Hathaway merely had to exercise a long-term strategic horizon and wait for the inflection point when market expectations would shift and a self-reinforcing trend would cause price appreciation.
George Soros, a different kind of investor to Buffett, offers a different avenue to profiting from what is well known, and spoke of this in an interview in Soros on Soros:
“The prevailing wisdom is that markets are always right. I take the opposite position. I assume that markets are always wrong. Even if my assumption is occasionally wrong, I use it as a working hypothesis. It does not follow that one should always go against the prevailing trend. On the contrary, most of the time the trend prevails; only occasionally are the errors corrected. It is only on those occasions that one should go against the trend. This line of reasoning leads me to look for the flaw in every investment thesis. My sense of insecurity is satisfied when I know what the flaw is. It doesn’t make me discard the thesis. Rather, I can play it with greater confidence because I know what is wrong with it while the market does not. I am ahead of the curve. I watch out for telltale signs that a trend may be exhausted. Then I disengage from the herd and look for a different investment thesis. Or, if I think the trend has been carried to excess, I may probe going against it. Most of the time we are punished if we go against the trend. Only at an inflection point are we rewarded.”
That there exist situations in which the market is clearly wrong does not imply that one should always invest against the crowd. Reflexive processes within complex systems involve positive feedback loops that create self-reinforcing trends upwards or downwards, so that market errors are only corrected at inflection points. The investor’s pool of high probability bets depend, for their success, on the patience to wait for inflection points, reinforcing the message of taking a long-view.
How do we reconcile the fallibility of forecasting with the ability to profit from uncertainty, especially given that if something is well known, theory says that there cannot be an arbitrage opportunity there?
22. Michele Wucker, in her unheralded book, The Gray Rhino, posits the “gray rhino” as a counterweight to the notion of the black swan, defining it as, “…a highly probable, high-impact threat: something we ought to see coming, like a two-ton rhinoceros aiming its horn in our direction and preparing to charge. Like its cousin, the Elephant in the Room, a Gray Rhino is something we ought to be able to see clearly by virtue of its size. You would think that something so enormous would get the attention it deserves. To the contrary, the very obviousness of these problematic pachyderms is part of what makes us so bad at responding to them. We consistently fail to recognize the obvious, and so prevent highly probable, high-impact crises: the ones that we have the power to do something about.”
Some gray rhinos: Covid-19; the Great Recession; Buffett buying PetroChina; George Soros shorting the pound; the lung cancer diagnosis years after the doctor advised against smoking. Those high probability events that are generally ignored. Not just threats, but opportunities.
24. Nassim Taleb’s book, The Black Swan, popularized the problem of induction -“one single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans”-, throwing up a further problem that is significant outside dry epistemological discussions: the Black Swan event, an outlier of extreme impact for which, given the mind’s pattern-seeking nature, we retrospectively proclaim its predictability. Taleb proclaimed as the mission of his book, to reveal “our blindness with respect to randomness, particularly large deviations.” So revered is this book that The Times proclaimed it one of its post-World War II “books that helped to change the world”. Seldom has a book so often quoted been so badly interpreted, a sure sign of the death of the art of close reading.
There is an assumption by many that the Covid-19 crisis is a “black swan”, a thing unimaginable, a blood-dimmed tide loosed suddenly upon the world, drowning the ceremony of innocence. The Sequoia Fund proclaimed the Covid-19 crisis “the black swan of 2020”, despite a quarter century of warnings about the rising risk of pandemics, with a recent report explaining that, “Human encroachment into biodiverse areas increases the risk of spillover of novel infectious diseases by enabling new contacts between humans and wildlife … We found that species in the primate and bat orders were significantly more likely to harbour zoonotic viruses compared to all other orders”.
Bill Gates warned of the threat of a pandemic for years, saying in a 2015 TED Talk that, the world was “not ready for the next epidemic”, in 2018, that there could be a pandemic within the next decade, and in April, that a viral outbreak will likely happen “every 20 years or so”.
The World Health Organization (WHO) regularly warned of the arrival of “Disease X” and American administrations, most recently those of presidents Bush and Obama, wrestled with pandemic responses to what today has been deemed “unforeseeable”. The pandemic cycle made so compelling a case that the next pandemic was around the corner that in 2018 the Centre for Disease Control asked, “Are we ready for the next pandemic?”, and yet, many have found a reason to proclaim, as in the aftermath of the Great Recession, that, “no one saw this coming”.
As late as 2019, the Global Preparedness Monitoring Board report, A World at Risk, warned that, “there is a very real threat of a rapidly moving, highly lethal pandemic of a respiratory pathogen killing 50 to 80 million people and wiping out nearly 5% of the world’s economy. A global pandemic on that scale would be catastrophic, creating widespread havoc, instability and insecurity. The world is not prepared.”
Vaclav Smil, in his thoughtful book, Global Catastrophes and Trends, warned that the United States had not taken major steps forward after the 1958-59, 1968, and 2009 pandemics, and that, “The likelihood of another influenza pandemic during the next 50 years is virtually 100%, but quantifying probabilities of mild, moderate, or severe events remains largely a matter of speculation because we simply do not know how pathogenic a new virus will be and what age categories it will preferentially attack” .
In January, Taleb, Joseph Norman and Yaneer Bar-Yam, issued a warning that “Clearly, we are dealing with an extreme fat-tailed process owing to an increased connectivity, which increases the spreading in a nonlinear way”. Taleb, Norman and Bar-Yam advocated use of the general precautionary principle: fat-tailed processes are no place for conventional risk-management approaches, action must be taken swiftly to reduce the risk of ruin. “These are ruin problems where, over time, exposure to tail events leads to a certain eventual extinction. While there is a very high probability for humanity surviving a single such event, over time, there is eventually zero probability of surviving repeated exposures to such events. While repeated risks can be taken by individuals with a limited life expectancy, ruin exposures must never be taken at the systemic and collective level. In technical terms, the precautionary principle applies when traditional statistical averages are invalid because risks are not ergodic”.
The Great Recession is another example of a black-swan-that-never-was. Dirk Bezemer has a wonderful paper that discusses the models of the economists who predicted that allegedly unforeseeable crisis. For example, economists of the post-Keynesian school, such as Wynne Godley, whom The Times called, “the most insightful macroeconomic forecaster of his generation”, and whose Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth is a complete account of his modelling approach; or Nouriel Roubini, who, in his Crisis Economics chiding the lack of long-term historical perspective and the lazy use of black swan theory, said, “the elements of boom and bust are remarkably predictable. Look into the recent past, and you can find dozens of financial crises. Further back in time, before the Great Depression, many more lurk in the historical record. Some of them hit single nations; others reverberated across countries and continents, wreaking havoc on a global scale. Yet most are forgotten today, dismissed as relics of a less enlightened era.”; and many Austrian economists such as Mark Thonrton, Peter Schiff and Kurt Richebächer, who predicted the recession “no one saw coming”, with Mark Thornton writing in 2004 that higher interest rates “should trigger a reversal in the housing market and expose the fallacies of the new paradigm, including how the housing boom has helped cover up increases in price inflation. Unfortunately, this exposure will hurt homeowners and the larger problem could hit the American taxpayer, who could be forced to bailout the banks and government-sponsored mortgage guarantors who have encouraged irresponsible lending practices.” Indeed, to this we can add the work of the Santa Fe Institute whose agent-based pricing models admit to greater fragility in the markets than standard theory allows, as well as the stunningly radical and brilliant contributions of Benoit Mandelbrot, whose book, The Misbehavior of Markets, building on his earlier work in cotton prices, gave evidence of financial markets riddled with “wild randomness”, whose price changes followed a Lévy stable distribution rather than the Gaussian distribution advanced by mainstream economists, and where, if an investor could remain calm during the wild swings of short term price changes, prices, “at longer time frames ..start to settle down”. He warned,
“If you are going to use probability to model a financial market, then you had better use the right kind of probability. Wild randomness is like the gaseous phase of matter: high energies, no structure, no volume. No telling what it can do, where it will go. The fluctuation from one value to the next is limitless and frightening. Mild randomness, then, is like the solid phase of matter: low energies, stable structures, well-defined volume. It stays where you put it. Slow randomness is intermediate between the others, the liquid state.
Real markets are wild. Their price fluctuations can be hair-raising – far greater and more damaging than the mild variations of orthodox finance. That means that individual stocks and currencies are riskier than normally assumed. It means that stock portfolios are being put together incorrectly; far from managing risk, they may be magnifying it. It means that some trading strategies are misguided, and options mis-priced.”
He would go on to add that, “Every so often, not so rarely, prices change dramatically, and today prices move much more quickly and these changes are much more important. But it has always been like that. There are stories in the Merchant of Venice by Shakespeare, and even much older books than that, which talked about the existence of a category of people, bankers, who knew very well from experience that ships sometimes went safely on a long trip and sometimes didn’t. And when they didn’t return, it was a big loss to their business. A single loss could very well sink a big company.”
Echoing him, Charlie Munger says:
“When people talk about sigmas in terms of disaster probabilities in markets, they’re crazy. They think probabilities in markets are Gaussian distributions because it’s easy to compute and teach, but if you think Gaussian distributions apply to markets, then you must believe in the tooth fairy. It reminds me of when I asked a doctor at a medical school why he was still teaching an outdated procedure, and he replied, ‘It’s easier to teach.’”
25. There is enough evidence, not just with the Covid-19 crisis or the Great Recession, but across many “unforeseeable”, high impact events, that the notion of a black swan does not apply. This is not a refutation of Taleb’s work, but a reminder that not seeing an event coming is not the same as an event being unforeseeable. Taleb has taught us to appreciate the role of randomness. Indeed, Taleb himself says the notion of a black swan has become “a cliché for any bad thing that surprises us.”. The degree to which one is surprised is no indicator of the unforeseeability of an event.