In the July 7 post (“Risk and Return: Always Positively Correlated?”), I argued that the best returns are actually achieved by avoiding risk. Over the next several weeks the focus will narrow. At the “risk” of losing readers early on, I will explore human attitudes toward risk, generally, before examining how those attitudes magnify our vulnerability to Black Swans—a notion popularized by Nassim Taleb—in the context of portfolio management.

The Small versus Large Conundrum

Human attitudes toward risk are, strangely, typically upside down. They are antithetical to avoiding the very events really worth worrying about. There is ample evidence that we are adverse to the small losses germane to our everyday lives. Perhaps the threat of flooding the first floor prods a homeowner to hire a plumber instead of replacing the upstairs bathroom himself. Although not mandatory unless there’s a lien held against a car, many pay the extra premium for collision insurance to avoid an unexpected repair bill. A more abstract example, both emotional and immediate in the extreme, was the reaction of the S&P futures markets the morning after last November’s election—further evidence that we strive to avoid small loses.

It is large losses that seem to command so little of our attention. Many Californians buy casualty insurance to safeguard the relatively small monetary value stored in their cars. Few seek to guard against the much larger risks resulting from living on the San Andreas Fault.

While home insurance may protect a structure, no purchase can mitigate larger systemic dangers like a home market depressed by population movement, changing job options when an economy turns from production to reconstruction, or risks to physical health during natural disasters.

Improbabilities & Possibilities

The San Andreas ruptures, on average, every 100 years. The northern section has not gone without a quake for more than 200 years during the last millennium. It has currently been quiet for 160 years. History indicates that a significant seismic event, though not probable, is quite possible within the next 40 years—a time frame quite relevant to home ownership. The ultimate insurance against that risk would be to relocate. Since property values along the fault are not discounted for the possibility of such a disaster, moving would not even incur the loss of property devaluation.

This is not to say that humans are generally unconcerned with improbable events. In January of 2016, the Powerball Lottery jackpot hit $1.5 billion dollars. On the Friday and Saturday preceding the drawing, 48.5 million tickets were sold in California alone. Since the state’s population is just shy of 40 million people, that’s nearly one and a quarter tickets sold per person on average, regardless of age! Given that the chances of matching the proper numbers was 1 in 292 million, it is clear that the possibility of winning took mental precedence over the improbability.

Adverse & Advantageous

No matter how you parse the numbers, a lot of people were playing the lottery, hoping for the advantages such a windfall would entail. Whether an outcome is adverse or advantageous determines whether we concern ourselves with the “improbable” or “possible” portion of an improbable possibility. When facing opportunities for gain, as in lotteries, humans are clearly not averse to considering improbable events. Conversely, though major disasters are also possible, their improbability convinces most that prevention is not worth the trouble. To highlight the clear contradiction of this reasoning, the possibility of a San Andreas disaster is, in fact, much more probable than winning the lottery!

Capital Markets & Portfolio Management

Personal calamity and natural disasters aside, historical market movements alone demonstrate the point. There have been six major wealth-destroying market declines in the last 120 years. They include the bear market culminating in the depression of 1921, the stock market crash of 1929–932, the late depression/early World War II bear market from 1937–1942, the market swoon of 1973–1974, the dot-com bust from 2000–2002 and, most recently and most unnerving, the devastation visited on investors during the 2007–2009 financial crisis. The market was in bear mode 14% of the time. Though not precisely predictable, those episode were far from random. The common dismissal of adverse possibilities as improbable, combined with inattention toward guarding against large loses, would imply that far more Californians likely played the Powerball in January of 2016 than safeguarded their portfolios against any of the financial disasters within their lifetimes.

Black Swans

Nassim Taleb, a trader and philosopher of randomness, popularized the notion of Black Swans. Three attributes define the concept. First, Black Swans are outliers, events beyond the realm of regular expectations. Nothing in the past convincingly points to its possibility, aside from the fact that seemingly impossible events are the stuff of which history is made. Second, it carries an extreme impact. Black Swans are important precisely because of their magnitude, at least regarding the primary and collateral damage they precipitate. The actual trigger of the event may, in fact, be as silent as the last snow flake that starts an avalanche or as inconspicuous as the discarded cigarette that turns a forest into a conflagration. Third, in spite of outlier status, we retrospectively concoct explanations for the occurrence, making it explainable and predictable, even probable. This triplet—an outlier with extreme impact and retrospective predictability—characterizes the events that explain almost everything in our world, from the success of ideas and religions to the dynamics of historical events and even the direction of our personal lives.

Such events have increased in frequency since the industrial revolution as human societies and systems have grown ever more complex. Human attitudes toward risk only exacerbate the situation. Black Swans—possibilities with large scale extremely adverse effects—are scenarios we prefer not to consider. Further, however, they are only conceptual until they manifest. Without prior experience with a scenario, we can exercise no predictive power over it. In this they differ from earthquakes, which work well as an illustration but are not truly Black Swans because we can both conceive of their existence and assign them a probability. Randomness has degrees and the San Andreas is more a grey swan than black. This difference, however is a consequence of our expectations and abilities, not their prevalence; while not common occurrences, Black Swans are not, ultimately, extremely rare. This leaves us with only the knowledge that improbable adverse situations are possibilities, hardly a concrete call to action. Human attitudes toward risk make preparation for known possibilities difficult already. The response is even less proactive towards Black Swans. Their unimaginability creates a cocktail of intellectual inebriation that foolishly argues their improbability justifies inaction. This, however, is the opposite of wisdom and, in the context of portfolio management, the foundation upon which more than one financial house of cards has fallen when the ground begins to shake.

Next Friday’s post will not leave you in limbo, suggesting to investors a most unconventional way of protecting portfolios against those risks really worth worrying about.

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