March 3rd, 2020
- Probability of rare events (Black Swans) is impossible to predict
- Only seeing white swans does not disprove the existence of black swans.
- Instead, focus on preparing for consequences rather than try to predict/time probability
If there is one thing I have learned through studying economics and social human behavior, it’s that we do not like uncertainty.
So much so that experts in nearly every field will consistently produce forecasts about the future and build complex narratives or models to make sense of this randomness in life.
Cited as one of the most influential books ever written, Nassim Nicholas Taleb’s book The Black Swan is an excellent primer on how to approach uncertainty and probabilities.
The flaw that humanity’s approach to probability is that we confuse lack of evidence with proof of certainty.
For example, not every person who has cancer will show immediate or noticeable symptoms, Ie there is a lack of evidence of the disease. But a lack of evidence does not entirely rule it out – rather, it means we should widen our search and expand our knowledge.
A lack of evidence of black swans (I have not seen a black swan) thus does not prove black swans do not exist, even if we see 1000 white swans, or 1,000,000. We confuse more evidence of white swans to our probability models and convince ourselves black swans do not exist – yet, every additional white swan does not do anything to disprove the existence of a black swan. When we widen our search, however, and look at Australia, we will then find our black swans.
THE TURKEY PROBLEM
Taleb also uses this turkey analogy.
Imagine you are a turkey.
Every day, a human comes to your room, and you fear that he may harm you. Instead, he feeds you.
The next day, you again are hostile, but again the human feeds you instead of harming you.
This goes on for 999 days, and every day, you believe the probability that the human will kill you decreases. You convince yourself that lack of evidence = proof of certainty. Unfortunately for you, on day 1000, it’s Thanksgiving.
You convinced yourself that every additional day that the human feeds you decreases the probability that he harms you, when actually it’s the inverse. Every additional day he feeds you increases the probability that the human will kill you (ie, reach day 1000).
HOW DO WE APPROACH UNCERTAINTY?
This Turkey Problem applies to many aspects of life and can be potentially very dangerous if we are not aware of the fact that we are all turkeys in this universe.
The egregious mistake comes when you have convinced yourself to be invincible, when in fact, you should be more paranoid, and diligent in preparation for uncertainty.
Every day the stock market goes up increases the probability it will crash the next day. (Don’t trick yourself that the economy only goes up).
Every day we escape a global pandemic brings us closer to the next potential one, and so the covid-19 strain of coronavirus has emerged from Wuhan, China. (Is this the beginning of the end?)
And every day that you don’t meet your soulmate actually brings you one day closer to meeting them. (You’ll meet him/her/them eventually!)
So how exactly should we approach these uncertain, Black Swan events?
Taleb notes it this way: stop focusing on the probability, but rather the consequences of these events.
As much as we like to build fancy models and create a narrative on the probability of events to assuage our fear, such as acts of terrorism or global pandemics, the fact of the matter is that this charade is just that, a charade. Attempting to identify the probability of seeing a Black Swan, having only seen 1000 other white swans as historical data, proves to be impossible, which gives us the Black Swan fallacy and the only logical conclusion that black swans don’t exist. The historical data here tricks us.
CONSEQUENCES OVER PROBABILITY
We visualize the potential consequences (which we have a better understanding of in imagination, based on past experiences and data), and then we buy insurance against those range of results.
I don’t know when or the probability of a stock market crash/correction. It could be tomorrow, it could be next month, or it could be in 2-years (apparently it would be the final week of February 2020). Instead, let me envision the highest degree of consequences I am able to withstand, perhaps I can sustain a -20% decline, and then I buy insurance against that. I can do a multitude of things, like purchase treasuries, alternative assets, commodities, gold, water, protective put options and derivatives, or diversify across countries and sectors, just to name a few. Adjust accordingly to your risk-tolerance and consequence matrix.
In the case of global pandemics and the covid-19, it is up to society as a whole to build insurance against these potentially devastating diseases. And in a way, we have done so by building organizations such as the CDC and WHO, improving medical research and innovation, building infrastructure, and amassing data for future AI/ML usage. Post-SARS 2002, Hong Kong saw an entire generational shift in approach to cleanliness and infection, implementing extensive disinfecting practices (disinfecting escalator handles), hand sanitizers everywhere, and screening for fevers for entering-exiting Hong Kong. Surely, organizations have pre-built strategies and operational checklists. I should hope not China is just making up these quarantine plans entirely up along the way. Though, if they are, then building up two entirely new hospitals up from scratch is one amazing feat. My heart goes out to all those affected by the virus, my family in Asia, and around the world. Only in time will tell if enough insurance was built.
Now, in the final case of meeting your soulmate tomorrow, which I wouldn’t necessarily call a consequence. The potential encounter could lead to a life of happiness and long-lasting connection. The insurance that you are personally preparing for is every action you have done up to that point of encounter – your insurance in presenting the best version of yourself. You make conscious decisions every day in building insurance. You don’t know the probability of meeting that person tomorrow, but you do know that the consequences of presenting a lesser version of yourself wouldn’t work. It follows that old cliche of people who decide to finally “work on themselves” will ironically meet their significant other soon after.
The opposite side of this pendulum is an overestimation of consequences, and a potential paranoia approach to life, an equally dangerous mistake as ruling out the existence of black swans.
And so, I hope that society continues to broaden our scope of knowledge and research and continue building insurance against the worst possible consequences humanity may face in the challenges of socio-political turmoil, climate change, and innovation. Ultimately, I have not yet ruled out the existence of flying pigs, and neither should you.
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I am not a professional financial advisor or planner as much as I’d like to be. All thoughts on the DTF Website are strictly my opinions unless otherwise stated. I understand there may be errors in my writing. My articles are not meant to be offered as professional advice, as I am currently learning a lot about finance myself. Please always do your own research and due diligence when it comes to financial decisions. Money is very important! I may own some stocks discussed in this article.