Recently I’ve been reading Nassim Taleb’s latest book, Anti-Fragile: Things That Gain From Disorder. I’ll do a full review at a later date, but wanted to share just a couple of his aphorisms.
The first is his classic turkey tale, it goes something like the following:
From a turkey’s perspective the farmer is a great man. Everyday the farmer brings the turkey food and takes care of its needs. Everyday the turkey is well fed is another piece of evidence that the farmer is his friend. The turkey goes on like this for a thousand days and is nearly 100% confident that he will wake up the next morning to a nice meal. Then one day the turkey wakes up and the farmer has his arms around its neck and a knife slicing through it, the evidence turned out to be false or misinterpreted.
What is the take away from this tale?
There are many, but sometimes the risk is in misunderstanding the evidence or mistaking evidence of absence for absence of evidence. The stock market sometimes works this way, it goes up a little every day and only occasionally drops, on average it’s always moving up or so it seems. Then, out of nowhere (Taleb calls it a Black Swan) an event happens that sends the market into a tale spin. Was the market not risky until the event, or was it always risky and you just didn’t see it?
Speaking of averages, Taleb tells another tale of a Grandmother, something like the following:
Your grandmother is to be put into a senior living facility and the caretakers tell you that the average temperature of her environment will be 70 degrees. This seems sensible to you, even pleasant and you consent. It never crosses your mind to ask what the deviation from the average temperature will be, it does matter.
Small deviations will result in your grandmother remaining alive, large ones…not so much.
Suppose half the time they keep the temperature at 0 degrees and the other half 140 degrees – on average your grandmother’s environment is 70 degrees, but she will be dead quickly. It’s the second question that matters the most and it’s the one that we rarely ask: what is the size of the deviations from the average expectation?
When we focus solely on return on our investments and ignore the deviation or expected/potential deviations we are not taking into account something that can have severe negative consequences on our portfolio. A return of 7% sounds wonderful, until you find out that in order to get that you may have to part with 50% of your money, at least temporarily.
This is not to say that risk equals standard deviation, but I think my point stands.
Famed Behavioral Scientist Daniel Kahneman would also point out in Taleb’s Turkey Tale that the turkey lived a pretty good life and that should count for something. Perhaps, but let’s not forget that the turkey at no point knew it was destined for slaughter, had it known, things may have been different.
Scott Dauenhauer CFP, MSFP, AIF