“The Way of the Samurai is found in death. Meditation on inevitable death should be performed daily. Every day, when one’s body and mind are at peace, one should meditate upon being ripped apart by arrows, rifles, spears, and swords, being carried away by surging waves, being thrown into the midst of a great fire, being struck by lightning, being shaken to death by a great earthquake, falling from thousand-foot cliffs, dying of disease or committing seppuku at the death of one’s master. And every day, without fail, one should consider himself as dead. This is the substance of the Way of the Samurai.” Hagakure, by Yamamoto Tsunetomo
As a wave crashes into a sandcastle, scattering and washing it away, Covid-19 has crashed, scattered and washed away old certainties. The post-World War II economic expansion whose apogee was the Great Moderation, a period of ostensibly eternal growth and prosperity, where gross domestic product (GDP) was robust and steady, and inflation, unemployment and volatility were low, and to the minds of policy makers, economists, and investors “controlled”, was burnt to ash by the Great Recession. In place of this panglossian paradise, investors today behold an age in turmoil, old and new threats charging at the gates. A survey of economists by FiveThirtyEight points to a dramatically uncertain future -what many believe is that the Great Lockdown presages the greatest economic decline since the Great Depression-; forecasts on fatalities and when a vaccine will become available harken toward a long resolution to the greatest pandemic since the Spanish Flu of 1918; the importance of preparation for the many threats that we face has seldom been so evident -so urgent has the task of estimating our threats become, that, in lieu of a Worldwide Threat Assessment of the US Intelligence Community for 2020, Politico published a “Domestic Threat Assessment”-; core earnings continue to decline, accelerating a trend rooted in the pre-Covid-19 era as New Constructs and O’Shaughnessy Asset Management have shown; the unequally shared health risks and economic burdens of Covid-19 have highlighted the historic levels of inequality in the twenty-first century and a polarization of society so stark that how Covid-19 is perceived is split along partisan lines; economic problems ignored in the last decade intensify; the fracturing of the US-centric iteration of the world system accelerates as China adopts a more assertive foreign policy and the United States increasingly treats China as a hostile rival; meanwhile, governments across the world undertake unprecedented measures to shore up the economy; the way we work has changed in ways that will have profound consequences for the economic landscape; companies spend less and less time on the S&P 500; competitive advantages have become transient; and our old complacency has collapsed before the spectacle of uncertainty. Seldom has so much happened so quickly and with such consequence. Even as waves redound, Covid-19 will be defeated, sandcastles rebuilt, new certainties erected and …many will forget the lessons of 2020.
In his memo, “Uncertainty”, Howard Marks defines investing as the art of allocating capital to options that one thinks will benefit from an uncertain future and where success is measured against the performance of some absolute or relative benchmark. Marks goes on to say that the fundamental and I think irreducible uncertainty of the future makes forecasting devilishly difficult and often, as now, well-nigh impossible, making the challenge of out-forecasting the crowd of investors against whom one is effectively competing, extremely daunting. Of things unknown and unknowable, there are many.
A look at forecasting models of Covid-19 shows how hard it is to forecast fatalities a month from now; so to paint an accurate picture of the world in 2021 is impossible, because a theory of history -and of the future-, is inherently imperfect: firstly, because of facts and numbers we do not know but which we may come to know, what is known as “epistemic uncertainty”; secondly, because even if furnished with all the experimental data it is possible to gather, every emotion, every glance, all the economic, scientific, and social data imaginable, it would still not be able to explain everything and predict everything, because of the irreducible randomness that is inherent in historical processes, what we call, “aleatory uncertainty” -the union of all sets of knowledge is not equivalent to reality-; thirdly, because our perceptions drive our actions which impact the future, a shoelace process of history, so that the future is a constantly evolving predictive target, rather than a linear chain of fact to fact to fact; lastly, because cognitive biases impede our ability to understand the world regardless of how much information we have.
It is not enough to know long-term historical trends: historical processes are the work of a blind archer, they do not converge around some limit, they are Cauchian, have have many small movements and wild swings, results are not spread out smoothly –in 2018, Amazon, Netflix and Microsoft made up 71% of returns on the S&P 500; in the 1980s, 40% of gains came from just 10 days of trading on the S&P 500-, markets do not adhere to our time horizons -consider interest rates, which, when 10-year yields on US Treasuries were 2.5%, seemed low, but compared to Japan (0.56%), Germany (1.24%), or Singapore (2.3%), among other examples, were relatively high, or consider those rates against the long view of history: in the 1930s, according to A History of Interest Rates, the average was 2.98%, in the 1940s, 2.54%, in the 1950s, 2.99%; the normal of our short-term view is not the normal of the market, when we speak of mean reversion, against what mean? 100 year?
We have a hankering for certainty. Among the goals that drive the human brain, one is a need for certainty. The brain craves certainty and using the same neural networks, as it craves food, sex and other primary drives. Information in a time of uncertainty is like a feast for a hungry man. Uncertainty creates a threat or alert response in the limbic system that results in diminishing ability to focus on other things. Uncertainty hurts, certainty is soothing, and we yearn for it even when we are better rewarded by staying uncertain. The Ellsberg paradox: we prefer to bet on the outcome of an urn with 50 black and 50 green balls, rather than on one in which an urn has 100 balls whose proportion of black-to-green is unknown. Our aversion to uncertainty is ingrained in us. “Better the devil you know”, we say.
Uncertainty makes our brains ill-at-ease because it hurts its ability to make predictions. The brain makes predictions by inferring patterns from data, storing them as memories and using a combination of those memories are present events to predict future outcomes. Above all things, the brain is a pattern-seeking, memory creating, prediction-maker. When certainty arises, we feel rewarded and we want more of it. From organizing our playlist, to playing chess, we have a craving for certainty that makes itself felt everywhere. This drive for certainty is at the heart of an industry of experts whose forecasts are bunk but who still manage to rake in fortunes appearing in prestigious newspapers and TV shows and social media. This industry feeds what Scientific American Mind called an “information addiction”. Certainty, that rush of dopamine we get when we receive new information, makes us feel good, even though it may not be good for us all the time.
Having noted that contrarian forecasts must be right in order to be profitable and the difficulty of consistently making correct contrarian forecasts, it is clear that whether one takes the view that markets are always wrong but because of herding, a prevailing bias can impose itself on it; or that markets are mostly sort-of–right, except on the few occasions they go wrong, the opportunities for being contrarian and profitable are rare. How are we to navigate uncertainty?
Forecasting on the Good Judgment Project 2.0’s research project developed by Philip E. Tetlock and Barbara Mellers, has rewarded and punished me with an experience of how difficult forecasting is and how so few people, “superforecasters”, consistently out-forecast the crowd. In his book, Expert Political Judgment, Tetlock evaluated the predictions of experts in various fields and measured them against well informed non-experts and found that there is an inverse relationship between the confidence an expert has about a prediction and its accuracy and that the difference in skill between the prognosticating expert and a well-informed non-expert is negligible. The ghastliness of expert predictions does not end there: the predictions of experts performed with as much accuracy as randomly chosen bets, and many would have performed better by simply evenly splitting their probabilities between a base rate -a projection of the status quo into the future-, and the worst and best case. The experts proved as good as a monkey throwing darts at a board. “We reach the point of diminishing marginal predictive returns for knowledge disconcertingly quickly. … In this age of academic hyperspecialization, there is no reason for supposing that contributors to top journals—distinguished political scientists, area study specialists, economists, and so on—are any better than journalists or attentive readers of the New York Times in ‘reading’ emerging situations.” Let us throw fuel at the fire: recently, Epsilon Asset Management published a study that revealed that hedge funds’ “best ideas” did not do better than their other positions. Like a bee that has gathered too much honey, experts are weighed down by their own expertise. There are those who see in science something absolute, and definite, but even in science there are uncertainties, provisional truths, one must see science from a Lakatosian perspective – Peters and Ceci’s work on the peer-review process shows that even the most vaunted journals would reject their own work if resubmitted and decades after their findings, their conclusions about the fallibility of the peer-review process are still relevant.
Time spent reading the opinions of experts could be profitably spent reading fiction, without loss of wisdom –indeed, Vladimir Lenin’s understanding of Imperial Russia’s frailties was formed through his reading of Russian literature, Shakespeare and the Latin classics. The power of fiction terrorized Soviet officials. Perhaps the most revealing criticism of the intelligence community meted out by the 9/11 Commission, was that it failed to “connect the dots” and that its “most important failure was one of imagination”.
Whereas it is possible to predict one thing, to predict with any accuracy a combination of things is harder, and, in the era of the Great Lockdown, more is palpably uncertain than in any time since Hitler’s Panzer divisions invaded Poland. In the kind of historic moment we are in now, to predict a combination of events that gives rise to the future, and is not merely a hopeful and habitual projection of the pre-crisis past into the future, would be a feat of conjuring, not intellectual genius.
Marks remarks in “Uncertainty II”, that we often think of the future as something given, already there, like a tree whose fruit hangs invitingly but which we are too blind to see and grasp, but which a happy few, the “experts”, can see with remarkable clarity and taste of its fruit. We are ill at ease with uncertainty and we grasp at expert opinion to assure ourselves over the future.
Mencius, Confucius’ greatest disciple, held the view that the world is fickle, and our expectations of it idealistic, too linear and deterministic, making us complacent in our expectations, unwilling to do the work. Good men do not always triumph; the best often “lack all conviction, while the worst/Are full of passionate intensity”; competent women often lose to incompetent men; riches often fall upon the stupid; the good that we do is often interred with our bones while the bad lives on; the arc of history does not always bend toward justice; inequality may rise as society gets wealthier; a company with low returns on invested capital, and no discernable moat can soar in value year after year after year, leaving stronger companies in its wake; competitive advantages can quickly erode; in the long run, all businesses end in failure –the most valuable business in history: the Dutch East India Company, with the widest moat in history, paying 5-7% in dividends over 200 years, still ended in failure; …. Whereas we seek stability and endurance, the world is ever changing, creatively destructive, always in ferment, we are simply unaware of it or fighting it most of the time. The clear skies many imagined in December 2019 as they looked to 2020, are a warning that even when everything appears settled, it can all be suddenly flung into a maelstrom of uncertainty.
In 1956, at the final stretch of the Grand National, Devon Loch, seven strides in front of the nearest horse, ESB, was storming to victory before he suddenly and inexplicably belly flopped, allowing ESB to win.
We conflate the appearance of certainty with intrinsic certainty and the confirmation of our views of stability with the lack of risk when we first judged the situation. Yet, the future is a series of paths, each forged by tiny, interconnected decisions and the interplay of human action is a choosing and rejecting and creating and destroying and interlacing of paths. If in one year the future appears to glimmer with the promise of stability and a year later, one’s views are confirmed, this was not inevitable, there were paths untaken and risks unseen and one merely erred favourably. To quote Napoleon: “Fort bien, mais a-t-il de la chance?” (“He is very good, but is he lucky?”). Better the lucky idiot than the genius whom fortune spurns.
Nassim Taleb, in his treatise, Silent Risk, reminds us that there are “(consequential) hidden risks, those tail events undetected or improperly detected by statistical machinery. … The difference between ‘models’ and ‘the real world’ ecologies lies largely in an additional layer of uncertainty that typically (because of the same asymmetric response by small probabilities to additional uncertainty) thickens the tails and invalidates all probabilistic tail risk measurements models, by their very nature of reduction, are vulnerable to a chronic underestimation of the tails”.
Machiavelli was so stricken with the fickleness of fortuna that he believed dominating fortuna is the key to the “achievement of great things.” Danger is everywhere, everywhere, even if one does not see it. “All courses of action are risky, so prudence is not in avoiding danger (it’s impossible), but calculating risk and acting decisively. Make mistakes of ambition and not mistakes of sloth. Develop the strength to do bold things, not the strength to suffer.” Machiavelli’s ideal prince had to embody certain qualities, virtù, in order to dominate fortuna, yet, often success was the happy meeting of virtù with fortuna so that one was successful in one situation but thoroughly overwhelmed in another, an example of which is the group of “Big Shorts” who dazzled with their prescience in 2008 and muddled through the last decade. True excellence, for Machiavelli, is in constantly adapting to the wildness and fluidity of fortuna, like a rider taming a wild horse.
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.
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…
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.
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.
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”
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.
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”.
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.
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?
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.
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.’”
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.
Roubini refers to the Great Recession as a white swan, saying, “Crises, we argue, are neither the freak events that modern economics has made them seem nor the rare “black swans” that other commentators have made them out to be. Rather, they are commonplace and relatively easy to foresee and to comprehend. Call them white swans.” Noting how spoilt the developed world has been in the post-World War II expansion, he says, “In most advanced economies, the second half of the twentieth century was a period of relative, if uncharacteristic, calm, culminating in a halcyon period of low inflation and high growth that economists dubbed the “Great Moderation.” As a result, mainstream economics has either ignored crises or seen them as symptoms of troubles in less developed economies. To gain a more expansive way of viewing and understanding crises of the past, present, and future, one must go back to an earlier generation of economists.”
Didier Sornette, whose Why Stock Markets Crash is a work of remarkable clarity, poses another paradigm: the Dragon King Theory, which refers to high impact events that are outliers to their peers, originating as they do from reflexive processes within complex systems, processes which amplify Dragon Kings to extreme levels, for example, positive feedback loops can send valuations to extreme highs or a death spiral. Studying these processes makes them more predictable. Like Wucker, Sornette argues that most of the threats we face are indeed predictable to some degree. For example, a critical mass of people knew a pandemic was coming, but not when, or how broadly and deeply it would affect the world; also, at the most basic level, we know that there will be a pandemic after Covid-19, euphoric valuations and depressive crashes in the future, that a war between great powers is inevitable, etc, because 6,000 years of history tells us to expect these things. What is perhaps impossible to predict is “when”. What we know is that certain events are regular, frequent, predictable and high impact. A perspective that treats human history as if it began in 1945 yields distorted expectations of the future and an instinct to deny crises at a point in human history when we are more capable than ever to deal with them.
Roubini, Sornette and Wucker’s theory of the foreseeability of many high impact events stands against the common feeling that they are unforeseeable. Indeed, even Taleb’s work on black swans suggests an element of foreseeability: we may not know what black swans will come, but we do know that they will come, and as the world becomes increasingly connected, the frequency of black swans increase. Historical processes are more open than we expect, episodes of extreme events are more frequent than we fathom, and their import more impactful than we imagine. What distinguishes Wucker’s gray rhino theory is the added layer of “ignored” in spite of flashing signals.
Known and knowable and yet ignored: the knowledge of these things is not constitutive of the actions taken by government officials, investors, and others who are in a position to prepare for them and who yet respond in a dully sluggardized manner. This brings to mind a key distinction made by Aristotle:
“But since we speak of knowing in a twofold sense (for both the person who possesses knowledge but does not use it and the person who uses it are said to know), one will differentiate the person who possesses knowledge but does not attend to it – and even attends instead to the things he ought not to do – from the person who possesses knowledge and attends to it. For the latter [if he still acts wrongly] seems bizarre, but if he does not attend to his knowledge, he does not seem bizarre. … For we see in possessing-and-not-using a diversity of disposition, so that in a way it is possessing-and-not-possessing …. Uttering the statements based on knowledge signifies nothing. … Incontinent people must be supposed to speak in just the way that actors do.”
Possessing information is not the same as using it as part of a decision-making process. The market as a collective may possess all the information in the world, but still not utilize vital information efficiently, as Berkshire Hathaway’s PetroChina trade shows. By way of example, the market ignores rising populist anger over inequality and racism and consequently, the political risks that may derail even the best run company, a historical analogy of which is the breakup of Standard Oil. The International Monetary Fund (IMF) recently said it believes markets have generally ignored the increasing frequency of natural disasters over the last 50 years, a view shared by James Anderson of Baillie Gifford. What counts is not the information but whether the information is used in making a decision. A man may be warned off cigarettes by his doctors, but when he picks up a cigarette as he leaves the doctor’s, his decision to smoke is taken without his doctor’s warning being constitutive of it thus of his actions. Thus, it is possible to profit from what is well known if what is well known is ignored. Everyone had access to PetroChina’s annual report, and Berkshire Hathaway operate at a “disadvantage” to trading desks and hedge funds with armies of analysts, but by picking a well-known piece of information and exercising a longer time horizon than the market at that moment, Berkshire Hathaway was able to profit handsomely.
Action is often waylaid by institutional imperatives such as a culture that sees change as aberrant and to be warded off; executive compensation packages tied to short-term performance; a focus on shorter-term measures, such as earnings per share; and other incentives that reward short-term thinking even when the actors are aware that long-term thinking is the best mental framework for their decisions. Cognitive biases developed to bring succour and reduce stress, work against us, making us push to the back of the mind negative thoughts. So pervasive is this knowing-but-not-acting-according-to-that-knowledge, that, not only are threats ignored or shilly shallied with, but, they rouse managers to destroy long-term shareholder value or pass up value-creating opportunities. In chasing short-term performance, they make the enterprise riskier in the long-term and more likely to fail. In 2006, a comprehensive survey of 400 chief financial officers found that, “The results show that the destruction of shareholder value through legal means is pervasive, perhaps even a routine way of doing business. Indeed, the amount of value destroyed by companies striving to hit earnings targets exceeds the value lost in recent high-profile fraud cases”. 80 percent of the CFOs admitted that they would reduce discretionary spending on potentially value-creating activities in their pursuit of short-term earnings targets. Further to that, 39% said they would give discounts to customers to prod them to spend in the current quarter rather than the next.
To free our minds from the illusion of a linear march of time, we must see uncertainty from a Mencian perspective. Amy Webb, a quantitative futurist, and author of , The Signals Are Talking: Why Today’s Fringe Is Tomorrow, offers a fertile approach to thinking of uncertainty: the “Axes of Uncertainty”, which external and internal uncertainties are explored, placed on opposing sides of the axes, with each quadrant categorised to describe how that state would look if it happened, and the process used to discover actions to take. This framework throws open existential risks that were hidden, and opportunities that were ignored. In thinking of the future as a series of possible paths, rather than a straight line, the mind becomes looser in its thinking, more flexible, more prepared. The typical superforecaster learns to think in terms of options, of possible scenarios, ours is to bring this optionality to our approach to uncertainty. The benefit of this wide-ranging thinking, this willingness to probe the future for the worst and the best outcomes, is that we can prepare for gray rhinos before they become serious threats.
The lesson of history is even under radical uncertainty there are threats and opportunities we can prepare for, even though we may not know when or to what extent they may occur. Ours is to explore uncertainty for threats and opportunities and to take bold and decisive action. The most elementary thing we must remember are cycles and their permanence. The ancients understood this, from the Mexican Day of the Dead, to the Buddhist practice of maraṇasati, the ancients knew the benefits of reminding themselves of the cycle of life and death. Tertullian claimed that during his triumph, the victorious general would have someone, while holding a crown above his head, whisper in his ear the words, “Respice post te. Hominem te memento” (“Look after you [to the time after your death] and remember you’re [only] a man.”).