Friday, July 04, 2008

Living life in an uncertain world

There seem to be a healthy discussion about the recent book review which I did, ‘The Black Swan’ by Nassim Nicolas Taleb. I crossed swords with Kennynah on Huatopedia regarding the applicability of normal distribution on everyday occurrences. The comments I received for the review is also very encouraging for me. All in all, a great experience!

I promised durio I’ll share the practicality of the things I’ve learnt from the book. I’ll try to put most of the practical advice towards investing and finance, but I stressed that the advice is equally applicable for the broader aspects of life. After all, life is much more than just the financial aspects.

1. Make a distinction between positive black swans and negative black swans. Black swans events can benefit or cripple. Once identified, expose yourself maximally from positive black swans, and limit exposure to negative ones

There are some situations where you do not want black swan events to happen, as it will cripple you. There are others where you sit around, waiting for black swans to happen, as the benefits are worth all the waiting.

For instance, networking is one thing that benefits from positive black swans. You never know (and can never expect) that the least likely person is the one who will pass you the contacts that will benefit you the greatest. Since there is no significant negative effect for not making the right contacts, one should expose oneself maximally to meeting different kinds of people.

In investing, we all try our best to be minimally exposed to negative black swans. Even though we’re ‘very sure’ of the prospects of a company, do not invest a substantial portion of your capital in. If we do that, we’re really hoping that the negative black swan events do not happen. Hence, there are many methods to reduce the consequences (but not the probability) of such events, such as strict cut-loss discipline, margin of safety, fundamental analysis etc. Different methods, but same underlying principle of preventing catastrophic losses.

In my tuition business, I’ll try to expose myself maximally to all different kinds of students. I’ll never know which student will be the one that will jump from F9 grade to A1 grade, and thus pass all the positive word-of-mouth advertising to potential future students. Downside (where student gets catastrophic results of A1 to F9 type) is actually minimized. How? That’s my little secret.

2. Invest in preparedness, not in prediction

I find the value investing philosophy ties in greatly in this. Didn’t the great gurus of the financial market say about gearing one’s portfolio towards bear market, not bull market? By thinking about the pessimistic scenario, one can avoid chasing the price but one’s capital is protected. Trading philosophy also mentioned about protecting the downside, and the upside will take care of itself.

3. Seize any opportunity, even those that looks like opportunity. This is the same as exposing one to positive black swans. Work hard, not in grunt work, but in maximizing one’s exposure to opportunities.

This is the same thing as point no.1 – exposing oneself maximally to positive black swan and minimally to negative ones. Perhaps here, I’ll mention one more example.

I’ve received very positive feedback that I’m a good writer and reviewer. It’s all very flattering until one looks at the ‘silent evidence’. I’ve written nearly 600 posts in this blog, perhaps only 10 such posts have very positive comments. Thinking in such a way, first of all, humbles me. But the point I’m making here is this: write more, you’ll hit one good article that everyone loves (and everyone remembers). If other articles are not as good, at most there are no comments, thus no significant negative consequences.

What should one do given such outcomes? Expose oneself maximally to opportunities where others can love your work – write more. I’m not saying skills are unimportant, I’m saying that skills are not the ultimate leverage in one’s success.

4. When caught between unknown probabilities of choices presented to you, focus on the (known) consequences of each choice and not on the probabilities. It’s also known as Pascal’s Wager.

Pascal’s wager is actually a debate on whether God exists. The consequences of not believing in God’s existence when there is actually God are much more severe than the consequences of believing in God’s existence when there is actually no God. The probability is incalculable and unknown; one should focus on the consequences of one’s choices, rather than the chances of the choices happening.

That is why one should cater one’s portfolio for the bear market, not for the bull market. The consequences of having big losses when one’s portfolio is too ‘optimistic’ are more severe than the consequences of not making big money when one’s portfolio is too ‘pessimistic’. Assuming one cannot tell the probabilities, the consequences matter more.

When one is stricken down by diseases that cannot be cured by western medicine, should one try alternatives methods? The consequence of not trying the alternative method when it does in fact work is more severe than the consequence of trying the alternative method when it does not work. The worse that can happen when one tries alternative method is that nothing happens.

Here’s a few lessons I learnt from the book:

1. Do not have a reductionist mindset, or what the author calls ‘Platonicity’.

2. Think about the silent evidence – evidence that show the contrary but are not widely publicized

3. Expose oneself maximally to positive black swans and minimally to negative ones

4. When presented with unknown probabilities of choices, focus on the consequences of each choice

5. Do not be quick to judge. Treat empirical data as it is and do not theorize too much. Be skeptical

6. Most importantly, be open minded


Anonymous said...

LP, thanks for taking time to share your thoughts

i do agree with the need to have an open mind to explore opportunities. but i felt that it is with "reductionist mindset" / Platonicity that we could finally simplify decision making & not making our lives any messier.

Platonicity = "the focus on those pure, well-defined, and easily discernible objects like triangles, or more social notions like friendship or love, at the cost of ignoring those objects of seemingly messier and less tractable structures."

so do we not choose our social circles based on similarities of interests OR investment models based on objectives?

Anyway, i feel that ability to adapt is more useful than an attempt to fool around with randomness (since it's uncertain). :)

la papillion said...

Hi durio,

I agree with you that reductionist mindset can simplify many decisions in life that requires split seconds to make. It's impossible to live life if we're so exactly detailed and unable to generalise.

(There is a true story of a man with a certain brain function lacking - he can remember everything to his detriment, since he cannot recognise a person's voice as the voice changes slightly from day to day!)

This instinct of generalising had helped us in the past. However, we're ill-adapted in investments because of that. Financial markets only appeared very recently (with respect to human appearance on earth). This ability to reduce things to platonic levels makes us unable to have an edge in the financial markets. That is our failing.

You'll find that the best minds in the finanical world - those that made the most - are usually those who have their own thinking, their own contrarian (usually) way of avoiding herd instincts.

That is the point I want to share.

FML said...

yeah totally agree ... the 80/20 rule.

la papillion said...

Hi finding mr lazy,

Regarding the 80/20 rule, I think it's the idea that counts. I read somewhere (perhaps it's in Black Swan) that the rule isn't that accurate. Why not 65/35, or 90/10? But as I said, it's the idea that counts! :)