Turkeys and Black Swans

By Bob Gariano

At this time of year experts in financial management and investing post their lists of the best stocks to buy to gain above average returns in the New Year. Many of these lists overlap and many are contradictory. Still, they are often accompanied by compelling arguments about why particular companies or securities will do well in 2011. By the end of the year we will look back on the most successful of these forecasts and give those analysts credit for their astute methods and results. Many of us will kick ourselves because we did not take advantage of the sage and prescient advice offered.

Tenacious Forecasters

The less accurate predictions will fade from memory. Unless they find other, more constructive, jobs as plumbers or welders, those same unsuccessful forecasters will be back in early 2012 with another prediction. Their tenacity will yield results overtime and even the worst planners will eventually have a year when their forecasts are successful. They can use that year to advertise their services as financial managers.

Even though the complexity and chaos of the world does not lend itself to our traditional empirical and logical approach to forecasting events, we continue to fervently hope that things will be happen with predictability and momentum. We hope that the good things that happened before will continue and we hope that bad things are predictable and maybe even preventable. We are taught these ideas of logic and rationality throughout our school years. Unfortunately, from weather forecasting to investment planning to cultural trends, it is most often the unexpected and unpredicted events that have the most important impact on our lives and fortunes.

Black Swans

Nassim Taleb writes about such unexpected events in his book The Black Swan: The Impact of the Highly Improbable. Taleb was educated as a financial analyst and brings a background of statistical and mathematical training to his writing. His empirical skepticism tries to prepare us for the discontinuity and expected events that are part of our world. By example, in the book, he tells the story of the turkey that relied too much upon the momentum of the past and the seemingly logical continuation of the status quo.

A little turkey was taken from his mother soon after hatching and put into a separate pen by the farmer. Even though the little bird was frightened by humans he learned over the months to trust the farmer who cared for him. The farmer brought fresh straw for bedding every morning and a big bowl of grain for dinner each evening. The turkey grew fat and healthy on this regimen and he learned to look forward to hearing the farmer’s footsteps each day. All this abruptly and unexpectedly changed on the Tuesday before Thanksgiving. The turkey had encountered his own unforeseen black swan event.

Classical Empiricism

We are taught through out our schooling about the scientific method and the value of rational thinking and the scientific method. We base our confidence on a centuries old Western tradition of rational philosophy that uses the writings of Francis Bacon, Thomas Hobbes, John Locke, and David Hume as its foundation. The stone busts of these luminaries are further testament to the reliance we place on mankind’s rational control of the clock work universe. We feel confident that what preceded will follow. We are sure that we can drive a car down a mountain road and safely navigate by looking only in the rear view mirror.

We use the past to predict the future even in the most sophisticated approaches. Black Scholes modeling, for all the elegance of its stochastic mathematics and partial differential equations, bases all of its predictive power to forecast commodity and options prices on historical trends and values. In spite of this recognized limitation, history is all that we have to guide us. There is not much else that can be quantified and relied upon, since the future has not happened yet.

Faith and Leverage

How should we handle the unforeseen and improbable events that will change our world? Joseph Campbell, in his six volume work, The Power of Myth, writes that religion and faith provide that solidity in an uncertain world. The enduring role of myth and beliefs is the elasticity between chaos and injustice of the real world and the rational expectations of its inhabitants. Published in 1988, Campbell’s work continues to provide a basic sociological theme about mankind’s interaction with an illogical and chaotic world.

More practically, we can try to understand whether we can endure and survive the worst of unforecast events. We do not plan for them to happen, but we know that we can find refuge and safety if they do. Have I saved enough money to endure the financial hardship if my company downsizes me? In personal investing this could mean something as simple as avoiding financial ruin if the worst happens. Prudent investors avoid overleveraging and spread risk by diversifying portfolios.

Entrepreneurs and risk takers might risk everything on one bet but the average investor should think like a tournament chess player. What would I do if bad things happen?

During the long holiday weekend after Thanksgiving 2011, if I am still, as the old cowboy said, “on the right side of the sod”, I plan to get out my file of January 2011 financial forecasts and see which crystal balls have been accurate and why. As usual, I will find some that are right on target and some that widely missed the mark. Some forecasters, like the roast turkey just consumed, will presume that the farmer always brings a full bowl of grain. Others will be prepared in case he comes with his hatchet. Without losing our optimism, we should try to be prepared to endure if the unexpected occurs.

Bob Gariano is President of RGA, an executive search firm that recruits senior executives and board members for public and private companies. Bob can be reached at rgariano@robertgariano.com