The Black Swan and High-Performing Investment Teams
I’ll get right to the point: Great investing is a matter of temperament. Warren Buffett acknowledges this point in his job description for a new CIO at Berkshire Hathaway: He wants someone with “independent thinking, emotional stability, and a keen understanding of both human and institutional behavior.”1 Nassim Taleb has some interesting things to say about these qualities in his recent book The Black Swan: The Impact of the Highly Improbable. This title refers to an event, like the occurrence of a black swan, that is:
- Extremely rare
- Has extreme impact
- Is explainable after the fact
For example: The terrorist attack on September 11, 20012
Taleb divides the world into two camps when it comes to thinking about black swans and dealing with the general issue of randomness:
- Skeptical empiricists (like Taleb)
- Platonic theorists (like most investors and Nobel Prize winners)
He lists the following characteristics for each camp:
|
Skeptical Empiricists |
Platonists |
|
Have the guts to say, “I don’t know” |
Respond, “you keep criticizing these models, but they are all we have” |
|
Think of black swans as a dominant source of randomness |
Think of ordinary fluctuations as a dominant source of randomness, with jumps (black swans) as an afterthought |
|
Prefer to be broadly right |
Are precisely wrong |
|
Do not believe that we can easily compute probabilities |
Build their entire apparatus on the assumptions that we can compute probabilities |
|
Develop intuitions from practice, going from observations to books |
Rely on scientific papers, going from books to practice |
|
Not inspired by any sciences, using messy mathematics and computational methods |
Inspired by physics, relying on abstract mathematics |
|
Ideas based on skepticism, on the unread books in the library |
Ideas based on beliefs, on what they think they know |
|
Seek to be approximately right across a broad set of eventualities |
Seek to be perfectly right in a narrow model, under precise assumptions |
From Taleb’s point of view, most investors are operating out of the Platonic camp, and they are fooled by randomness. But Taleb warns us over and over not to fall for the brain’s natural tendency to make causal links. He says, “Learn to read history, get all the knowledge you can, do not frown on the anecdote, but do not draw any causal links, do not try to reverse engineer too much − but if you do, do not make big scientific claims.” Inventing causal links can be dangerous for investors − especially with regards to the way we interpret the occurrence of a black swan.
As Michael Mauboussin points out, “Humans have a near insatiable desire to link cause and effect. Unfortunately, causality is often very difficult to deconstruct, even in retrospect. But coming up with a cause and effect story helps settle our minds, and provides a greater (albeit false) sense of control as we face the future.”3
The antidote to this erroneous thinking is to create a culture in which investment professionals learn to:
- Choose curiosity over defensiveness
- Separate Fact from Story
- “Hold their story lightly”
Curiosity
On the first point, Taleb comments throughout his book that intellectual curiosity is hugely important to superior investing. He warns that “scholarship without erudition and natural curiosity can close your mind.” Elsewhere he says of forecasters, “I wonder if [they] lack in intellectual curiosity or if they are intentionally ignoring forecast errors.” The opposite of a curious attitude is a defensive one. When people are defensive, they tend to get very serious and very committed to being right. Taleb cites examples of celebrated financial names who reacted in this way when challenged by Taleb: “I [Taleb] discovered Merton’s shortcomings from an angry and threatening seven page letter he sent me.” The defensive response to a challenge is to shoot off an angry letter. The curious one is to wonder what you can learn from it.
Fact vs. Story
Remaining curious and open ties into the second thinking skill: Separating fact from story. As humans we are always making up stories from the facts that we learn. For example, we learn that a colleague is leaving for another job, and our mind goes to work: “He got a better offer” or "He doesn’t get along with the boss” or “He must know something that I don’t know…what is it!?” Taleb says, “We are explanation-seeking animals who tend to think that everything has an identifiable cause and grab the most apparent as the explanation.” The key skill in world-class thinking is the ability to acknowledge which statements are facts and which are story.
In our work, we hear statements like the following all the time: “The fact is that value stocks outperform growth stocks.” Of course, this statement may be true for certain definable time periods, but it is highly debatable in general. Our rule of thumb for differentiating fact from story is simple: If one or more persons disagree, then it’s not a fact. Far too many investment teams burn up valuable time arguing statements like the one above, instead of simply clarifying the statement (say, by specifying the time period and then getting accurate data) or acknowledging that they disagree and moving on. Good investors get clear on the facts and then get curious about the stories surrounding the facts.
Light Handling
After agreeing on the facts, the final skill is to “hold your story lightly.” The idea here is that most of us are irrationally tied to being right. We defend a position as if our very life were at stake. Top investors are committed to learning, not to being right. Warren Buffet is clear on this point: He says that one of his great joys in life is disproving his best-loved theories.4 Taleb expresses it this way: “I like to stay light on my feet.” People who refuse to hold their stories lightly often are the subject of “intellectual comedy” at a later date:
"Heavier than air flying machines are impossible.”
− Lord Kelvin, 1895
“Everything that can be invented has been invented.”
− Charles Duells 1899, Patent Office director
“It is an idle dream to imagine that...automobiles will take the place
of railways in the long distance movement of people.”
− American Railroad Congress, 1913
"There is no likelihood that man can ever tap the power of the
atom.”
− Robert Millikan, Nobel Prize winner in physics, 1920
“Who the hell wants to hear actors talk?”
− Harry Warner, 1927
“There is no reason for any individual to have a computer in their
home.”
− Ken Olson, president of Digital Equipment Corp., 1977
The three behaviors that I’ve discussed here − curiosity, separating fact from story, and holding your story lightly − have proven time and again to be characteristics of a winning investor’s temperament. I think they would benefit the reader as well…but that’s just my opinion − and I’m holding it lightly.
1 Michael Mauboussin, “Turtles in Omaha” (Legg Mason, May 2007)
2 Nassim Taleb, The Black Swan: The Impact of the Highly Improbable (Random House, April 2007)
3 Michael Mauboussin, “Turtles in Omaha” (Legg Mason, May 2007)
4 Charles T. Munger, Poor Charlie’s Almanac: The Wit and Wisdom of Charles T. Munger (Donning Company Publishers, January 2005)