The Black Swan, a book by Nicholas Nassim Taleb, attempts to poke holes in modern economic theory. It should worry investment bankers, I thought while reading, whereas I was safe from harm. I was like the hero of an action flick, who sees himself as beyond the clutches of a villain.
Inevitably, a terrible realization dawns on the movie's protagonist, perhaps that a loved one is held captive. My own growing unease stemmed from the fact that I invest virtually all of my money in stocks and bonds, and am therefore not immune to Taleb's foretold market catastrophes. Even more troubling is that I had recently opted into the Wealthfront Risk Parity fund, which stands upon all the economic theory that Taleb was tearing apart. I decided to take a thorough look at his arguments, canonical investment wisdom, and my portfolio.
To first explain The Black Swan, the book takes its name from the fact that people once assumed that swans could only be white, as they had never seen a black one. He explores instances where people similarly rely on past knowledge in attempting to understand the future. To explain when this is appropriate, and when it's not, Taleb uses the analogy of two make-believe places, Mediocristan and Extremistan. In the former, populations have characteristics that are dominated by the normal, with outliers having little importance. For instance, human height is from Mediocristan - if you take a sample, no individual will greatly alter the mean. Contrast this with an Extremistani variable, which is dominated by the extreme. When sampling human wealth, the mean is very different depending on whether or not you include Bill Gates.
Taleb asserts that when financial experts create risk models or attempt to forecast, they use statistical tools and past data only appropriate if the subject is from Mediocristan. In reality, financial outcomes are dominated by the outlier - in the last 50 years, the ten most extreme days in financial markets represent half the returns. Looking forward, there is a possibility of an unpredictable, catastrophic event, which he calls a Black Swan. For this reason, he argues markets are not a suitable repository for the common investor's savings.
While this brief summary does not do it justice, the book itself is fairly convincing. By the end, I felt the cognitive dissonance of continuing to invest even while sympathizing with his argument that past stability does not rule out future catastrophe when dealing with a variable from Extremistan, market returns.
I wanted to counterbalance Taleb's position by learning how a financial expert justifies participation in the market. In The Little Book of Common Sense Investing, John Bogle, founder of Vanguard, lays out the case for index investing. While I read it for counterpoint, his ideas had more overlap with those of Taleb than I expected. Bogle actually acknowledges the other author's book about randomness, and nods at uncertainty with a quote from J. M. Keynes, "it is dangerous ... to apply to the future inductive arguments based on past experience, unless one can distinguish the broad reasons why past experience was what it was."
Where Bogle boldly strikes his own path is in saying he understands why the market has steadily risen. He explains that market returns are comprised of what he calls "investment return" (profitability of companies) and "speculative return" (investor demand for stocks). While the latter is unpredictable and highly variable across decades, he uses data since the 1900s to show that the historical 9.5% annual market return was driven almost exclusively by investment return. As long as American companies continue to be profitable, index investors will earn their share.
Taleb would be quick to point out that no past period of economic growth, regardless of the length, can guarantee future growth and market returns. He frequently compares such thinking to a turkey which feels increasingly safe each day its captors feed it, despite nearing its demise. This is theoretically true, but I found Bogle's explanation reasonable in explaining how profitable companies can maintain market returns. Taleb would have us primarily rely on extremely safe assets like treasury bonds due to the possibility of market failure; Bogle reminds us that this must be weighed against the opportunity cost of staying on the sidelines, as there is no certain catastrophe.
I'm keeping my investments, but I'm making some changes. I believe both authors would be skeptical of the Risk Parity portion of my portfolio. Earlier this year, I was convinced by Wealthfront's economic models and backtesting to make this allocation. The Black Swan reveals that such models smooth over market unpredictability, and backtests rely on the future mirroring the past. The investment fees for the Risk Parity fund are about five times larger than those for traditional indexing.* Bogle very reasonably argues that if indexing is about guaranteeing one's share of market returns, then minimizing fees is paramount. Add to this the fund's double-digit losses this year, and the case for avoiding higher-cost, complex financial products is clear.
Both books encouraged me to deeply consider unpredictability in the market and otherwise, a worthwhile endeavor. Are there instances where you're relying on past behavior and expert predictions to make important decisions? Those who build their lives around the increasing comfort of each white swan are in for an unfortunate discovery when a Black Swan appears.
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The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a licensed professional for investment advice.