Rational Advisor

From Harvard Business Review October 2009

Taleb (who wrote the best-selling books Fooled by Randomness and The Black Swan) and his coauthors argue that conventional risk-management textbooks don’t prepare us for the real world. For instance, no forecasting model predicted the impact of the current economic crisis.

Managers make six common mistakes when confronting risk:
They try to anticipate extreme events,
they study the past for guidance,
they disregard advice about what not to do,
they use standard deviations to measure risk,
they fail to recognize that mathematical equivalents can be psychologically different,
and they believe there’s no room for redundancy when it comes to efficiency.

Companies that ignore Black Swan (low-probability, high-impact) events will go under. But instead of trying to anticipate them, managers should reduce their companies’ overall vulnerability.

Of all the management tasks that were bungled in the period leading up to the global recession of 2008–2009, none was bungled more egregiously than the management of risk.

These same mistakes are made by investors - especially the dependence on statistical numbers like standard deviation.

We don’t live in the world for which conventional risk-management textbooks prepare us. No forecasting model predicted the impact of the current economic crisis, and its consequences continue to take establishment economists and business academics by surprise. Moreover, as we all know, the crisis has been compounded by the banks’ so-called risk-management models, which increased their exposure to risk instead of limiting it and rendered the global economic system more fragile than ever.

Low-probability, high-impact events that are almost impossible to forecast—we call them Black Swan events—are increasingly dominating the environment. Because of the internet and globalization, the world has become a complex system, made up of a tangled web of relationships and other interdependent factors. Complexity not only increases the incidence of Black Swan events but also makes forecasting even ordinary events impossible. All we can predict is that companies that ignore Black Swan events will go under.

Instead of trying to anticipate low-probability, high-impact events, we should reduce our vulnerability to them. Risk management, we believe, should be about lessening the impact of what we don’t understand—not a futile attempt to develop sophisticated techniques and stories that perpetuate our illusions of being able to understand and predict the social and economic environment.

To change the way we think about risk, we must avoid making six mistakes.

We think we can manage risk by predicting extreme events.
This is the worst error we make, for a couple of reasons. One, we have an abysmal record of predicting Black Swan events. Two, by focusing our attention on a few extreme scenarios, we neglect other possibilities. In the process, we become more vulnerable.

It’s more effective to focus on the consequences—that is, to evaluate the possible impact of extreme events. Realizing this, energy companies have finally shifted from predicting when accidents in nuclear plants might happen to preparing for the eventualities. In the same way, try to gauge how your company will be affected, compared with competitors, by dramatic changes in the environment. Will a small but unexpected fall in demand or supply affect your company a great deal? If so, it won’t be able to withstand sharp drops in orders, sudden rises in inventory, and so on.

In our private lives, we sometimes act in ways that allow us to absorb the impact of Black Swan events. We don’t try to calculate the odds that events will occur; we only worry about whether we can handle the consequences if they do. In addition, we readily buy insurance for health care, cars, houses, and so on. Does anyone buy a house and then check the cost of insuring it? You make your decision after taking into account the insurance costs. Yet in business we treat insurance as though it’s an option. It isn’t; companies must be prepared to tackle consequences and buy insurance to hedge their risks.

We are convinced that studying the past will help us manage risk.
Risk managers mistakenly use hindsight as foresight. Alas, our research shows that past events don’t bear any relation to future shocks. World War I, the attacks of September 11, 2001—major events like those didn’t have predecessors. The same is true of price changes. Until the late 1980s, the worst decline in stock prices in a single day had been around 10%. Yet prices tumbled by 23% on October 19, 1987. Why then would anyone have expected a meltdown after that to be only as little as 23%? History fools many.

Patience is the companiion of Wisdom - Saint Augustine

Make all you can, save all you can, give all you can - John Wesley (1703-1791)

Shallow men believe in luck. strong men believe in cause and Effect - Ralph Waldo Emerson (1803 - 1882)

Manifest plainness, Embrace Simplicity, Reduce Selfishness - Lao Tzu (604 BC - 631 BC)

The cautious seldom err - Confucius

Start by doing what’s necessary, then do what’s possible; and suddenly you are doing the impossible. - St. Francis of Assisi

The man who moves a mountain begins by carrying away small stones - Confucius (551 BC - 479 BC)

he who knows that enough is enough will always have enough - Lao-Tzu (604BC - 631BC)

Reflect on you rpresent blessings, of which every man has many, not on your past misfortunes, of which all men have some - Charles Dickens (1812-1870)

What we anticpate seldom occurs; what we least expected generally happens - Benjamin Disraeli

“its in human nature to go to excess” - Warren Buffett

its what’s happening now, one of the scariest things is that people are going to excesses to try and recover their losses quickly. it’s scary as they now try to time the markets. Remember the markets like to make the greatest number of people into fools, at the most inopportune times.

People are forgetting the lessons to be learnt from last years crisis, and ponying up for more emerging markets, more scary ETFs, forget the plans and sticking to a disicipline.This can only end badly.

Just because things are going up does not mean that all of the investments that are going up are good. This is where you need to sort out what’s real and what’s not!

Avoid excesses!

You have to have 2 key things for a company to be successful
1) liquidity
2) Trust

If you do not have trust you are dead! it’s that simple.

Ask yourself do you trust looking at the balance sheets of the companies you are invested in or work for.

Realize that most companies out there have some debt. debt/Credit has been around in millennia. The creditors have to trust that the debtors will pay the money back.

Much of the problem we have in the markets now, is because of this lack of trust. Banks don’t trust that people will pay back the money that was lent to them, shareholders don’t trust executives who they lent money to build the companies.

We would never have gotten into this mess if we had trustworthy people, the Benjamin Franklins of the world.

The issue is that there are just too many people seeking the easy way, investment companies were too busy being the market makers, CEO’s and money managers were too eager to be the shakers and movers in the industry as opposed to good stewards of other people’s wealth. Investors were too eager to get instant returns and measuring investment managers by 3 mos, 6 mos, and even a year! it takes time for businesses to earn a profit - first they manufacture, then they market, then the sell, then the proceeds come back to the company and then you determine the profit! This does not happen in 3 mos!

One of the most important thing to realize is to know who are your friends - know who you can trust! Figure out who your friends are - and aren’t. This isn’t about who you like. Its about who you can trust with your back - no questions asked. If things get bad the second-to-the-last thing you want to be is alone - right before being around anyone who is less than 100% trustworthy. Think about this point long and hard - this doesn’t mean dumping acquaintances now, but it does mean knowing who you group with if you need to - and who you avoid.

Trust is wealth beyond measure.

If you are in an organization or belong to a group, or have someone you can trust - you have wealth beyond measure. And I am not talking about a moral or spiritual belief. I am saying that trust is wealth.

I trust many of the people around me, and they trust me - it goes both ways. You just can’t have trust one way. You have to live up to your end of the bargain, and do what you say even when it’s painful - that’s real wealth.

People are looking for people they can trust, and trust is a commodity in short supply, but high in demand.

I got an interesting question from an advisor today, all excited about buying or receiving stock in an new company, as opposed to the old company that they held before. The new company is a prt of the old company

I was a bit confused about the excitement level, and when things sound too good, my spider sense comes into play.

Here’s how I explained it, and you may want to take heed when trying to understand new issues of stocks based on old issuing companies

For this example I will use GM

The old GM went into bankruptcy, mainly because it’s dealership, products, costs, interest and benefits payments were wayyy too much. Also previous management did a terrible job.

So old GM was out, and then the Government (call them BIG person - one of the biggest in the industry - get my drift) takes over the company. Now they have put assets and monies into this company, substantial amount, although it is a rounding error in the larger amount of money that they have. BIG owner now takes over 100% control, old management ios out, although may linger on for awhile.

Now BIG owner does not want it’s money stiuck in this company that is going to have a tough time getting revenues up, so what do they do? in a couple of months, they issue stock to the public in new GM, based on its new models coming out - new GM will be launching ten new models in the next 18 months. Lots of razzamataz.

And the publc will be buying these new GM shares, why? because its now a new entity, backed by a BIG partner, and does not have the handcuffs of the old GM. it’s based on a better revenue model etc, and people are all a buzz about how they better get in on this on the ground floor. Meanwhile BIG partner gets the money they put in back from the buyers of new GM shares, but BIG partner keeps major owenership. So in a few months, they get their money back plus they get future revenue streams, if any, and who gets stuck with the stock the general public. And all because they forgot to read the details.

This is what happens when people get excited about a story of some future share offering, without understanding the maths. Before you make any decision on purchases or receipt of stocks understand the maths.

A company does not issue stock for no reason, it does not want to give up future revenue stream, unless they can get it for FREE. Or, they will issue new stock because they are in trouble. But, never do they issue new stock for the benefit of mankind!

A good idea is to look at the track record of the BIG partner in purchases they have done in the past, have they improved those companies, has management been improved, did they change things for the better. Companies do not change their stripes so easily. A corporate pattern stays around… pay attention to it..

Measure twice cut once. Don’t get carried away.

Here’s an excellent quote that we shoudl allkeep in mind, from a very well respected person

“Economy and finance, as instruments, can be used badly when those at the helm are motivated by purely selfish ends. Instruments that are good in themselves can thereby be transformed into harmful ones. But it is man’s darkened reason that produces these consequences, not the instrument per se . Therefore it is not the instrument that must be called to account, but individuals, their moral conscience and their personal and social responsibility.” – Pope Benedict XVI, in his 144-page encyclical Caritas in Veritate (Charity in Truth), explains how financial markets and the market economy aren’t bad in themselves, it’s just greedy people who messed things up (again).

An excellent thought to contemplate. Investments are made from companies that strive to generate profits. What’s happened is that over the last deceade or so, its CEO’s with their greed for bonuses, Analysts with their greed for bonuses and getting deals, and investors with their greed for instant wealth, that has made these otherwise good investments look bad.

“For tomorrow belongs to the people who prepare for it today” - African Proverb

People act based on internal models and also look to confirm their preexisting internal axioms.

Please consider a few points…

1. Confusion results when there is too much information as compared to knowledge, a trend that will continue exponentially. A good investor can control this by mapping the information back to fundamental principles, knowledge and wisdom. This will greatly simplify what needs to have a process, and Simplify!

2. Investors must continue to think fundamentally and resist adopting trends simply because momentum has been gathered behind them. Think objectively and collaborate with other objective thinkers.

3. While there are multiple perspectives behind any decision: financial, short term, long term, approach, etcetera, there is only one end. Make sure that your fundamental analysis considers all the camps appropriately and is not steam-rolled by a single perspective.

I do not agree that managing by short term intervals is a robust answer. Companies are highly coupled dynamic feedback systems. Our state today is a result of actions years ago. There is a time when short term controls are needed, mostly reactive, but long term principles are what will govern company success and investor successes. One can not cost-cut to success. One might even argue that if you found yourself in need to cut costs, then a mistake was made earlier. Most investors tend to mistakenly think that the cheapest cost is a better product - this is a mistake as was seen by the cheapest cost vehicle last year equity market ETF’s having some of the greatest drops TSX index -35%

“Decision is a sharp knife that cuts clean and straight. Indecision is a dull one that hacks and tears and leaves ragged edges behind it” - Gordon Graham

Too many times in ouor investment management we over-analyze and become indecisive about investment processes and choices. We do this all for the right reasons, so that we don’t make mistakes. But, invariably this indecision is another cause of problems.

Investment managment is best handled by having a philosophy, understanding that volatile times will always be around. Sticking to your sound intellectual framework And lots of patience.