How A Cheating Spouse Can Teach You A Lesson In Investing
Understanding Black Swan, the universe of Extremistan and Mediocristan, and the ways to protect your portfolio
A Black Swan is an unpredictable event, that when occurs, has extremely severe consequences. It is rare and appears to be explainable in the hindsight.
The apt examples would be occurrences of natural catastrophes like the 2004 Indian Ocean Tsunami or Hurricane Katrina. Even the 9/11 terrorist attack which has had a huge impact on the human psyche can be categorized as a Black Swan event — extremely unpredictable but explainable in the hindsight.
The cheating spouse
If relationships were quantifiable, the most important parameter would be — How many times do you say “I love you” to your partner. That should hypothetically mean that your partner loves you and would never cheat you.
Your partner kisses you every night before going to bed and says “I love you.” That has been like a ritual for last, say, ten years. After ten years of a successful marriage, based on the past data of saying “I love you” every day, you find your spouse cheating on you. Shocking isn’t it?
But based on the past data of saying “I love you,” you assumed that your partner will never fall out of love. Hence, the cheating partner becomes a Black Swan event of your life.
Nicholas Nassim Taleb, in his book The Black Swan defines two universes — Mediocristan and Extremistan.
Understanding Mediocristan
Assume that Fat Joe is the fattest kid in the entire 2nd grade that consists of 60 students. Let’s say, the average weight of 59 kids (except Fat Joe) comes to 25 kgs. Add to that, Fat Joe who is 35 kgs, the average weight of the class will go up from 25 kg to 25.167 kgs.
From the above example, we follow that, although Fat Joe is an outlier, he doesn’t have a considerable impact on the sample, i.e. average weight of students. Even if someone like The Great Khali who weighs around 150 kgs enters the sample, the average weight will still be 27.32 kgs. The deviation from the mean is only 2.32 kgs. Despite that, even one of the known living giants is accommodated in the sample of 2nd-grade students.
Elements such as height, weight, size of a cupboard, size of an apartment, size of a car, etc; exist in this universe. No single data point will make a significant difference in a large sample.
A normal distribution is applicable in such a dataset.
Understanding Extremistan
Let’s assume that Fat Joe has rich parents so that they can afford to send him to a private school in NYC. Say, the average net worth of parents sending their kids to that private school is around $1 million. Sounds impressive, isn’t it? Fat Joe is no ordinary kid.
On one fine day, the school holds a Parents-Teachers meeting and Elon Musk happens to enter the hall with his kid. How will this impact the average net worth of the parents in that school?
While I am writing this article, Elon Musk’s net worth is approximately $147 billion. Even if we compare his net worth with the combined net worth of all the parents (60 students), it comes out to be 2450 times.
In the above example, Elon Musk is an outlier. But his entrance to the sample of net worths, even amongst the rich, makes a substantial impact.
The data point that can move the average of the sample by a huge margin exists in the universe of Extremistan. Most social matters exist in this space; such as net-worth, book sales, returns on individual shares, etc.
This set of the sample will always be prone to the Black Swan event. A normal distribution is not applicable for this dataset.
Black Swan events in stock markets
We have seen multiple market crash across the world. The Dot-Com bubble, the Black Monday crash of 1987, the 2008 Housing bubble crash, and the most recent one — Coronavirus crash.
The reason why Black Swan events are unpredictable is that they have never happened before, and when they occur, the entire dynamics of the stock market changes.
If you were a Japanese investor in the 1980s, you would have seen the Nikkei growing six-fold till 1990. It touched 38000 points in Dec 1989 and made a low of 7000 points in March 2009(80 per cent below of 20 years high). It has been 30 years since the Nikkei breached that level of the all-time high, so the common notion that markets will always move up in the long term does not apply. This event could be called the mother of all the Black Swan events in the history of stock markets.
So, when you invest in the stock market, a black swan event is inevitable.
Why Normal Distribution doesn’t work in Extremistan?
In Normal Distribution aka Gaussian aka Bell Curve, the occurrence of an outlier is highly unlikely. Say, the average height amongst women is 5ft 3 inches. The odds of deviation from the mean, i.e. 5ft 3 inches decline significantly.
For instance, the odds of someone being 5ft 5 inches is much higher than someone being 6ft 5 inches. Again, the odds of finding someone of 6ft 5 inches to 7 ft is way higher. So with every inch increase of height, the odds drop multifold. Hence, the Bell Curve works in Mediocristan. The odds of finding an 8 ft tall woman is literally one in a billion.
In Extremistan, the rate of change of probability remains constant when we move away from the mean.
The distribution of wealth of $1million in Mediocristan would most likely be $500,000 each. But, in Extremistan it would be $100,000 and $900,000. Hence, the events in Extremistan are more difficult to predict. Such as the stock markets. The distribution is more discrete in nature. The probability of a 20 percentage point drop in Dow could be same as 15 percentage point drop, unlike the way things work in Mediocristan.
How to protect your investments from the Black Swan?
As we have understood that stock markets exist in the universe of Extremistan, they are highly likely to get affected by Black Swan events.
There are two ways in which one can invest in the markets by providing protection from Black Swan events.
- Hyperconservative approach
- Hyperaggressive approach
In the Hyperconservative approach, you can invest 80 per cent investment in instruments that are regarded with the highest safety; for example, government securities. 20 per cent of your investment could be in the high-risk high reward instruments such as options and AIFs. Although, 20 per cent needs to be diversified across various products. This strategy is much more effective than diversifying your instruments across medium risk assets as we cannot predict the degree of risk in case of a Black Swan event.
In the Hyperaggressive approach, you can invest by diversifying your investments across high-risk products and insure your downside by using a put option or putting a stop loss. This approach is beneficial when you are expecting a positive Black Swan, i.e. a huge upswing in the stock or index.
Conclusion
- The spouse who says “I love you” for 10 years can cheat
- Fat Joe isn’t the richest kid in the class, he is the distant 2nd richest
- Stock markets fall in the universe of Extremistan where Normal Distribution doesn’t work
- Nikkei tells us that stock markets don’t necessarily move upwards in the long run (if 30 years is long enough for you)
- The Hyperconservative and Hyperaggressive methods of investing can help you protect yourself from Black Swan events
Here’s an article I wrote that you might find interesting,
