Volcanic eruptions, the turkey and financial markets

Arnau Vía

Today, Diari d'Andorra publishes an interesting opinion piece by Arnau Via, General Manager of VB Fons. Arnau offers us a reflection on positive and negative black swans.

You can access the publication of Diari d'Andorra on this link

 

Volcanic eruptions, the turkey and financial markets

Following the eruption of the La Palma volcano, I heard an “expert” debate where one of the participants said that “it was normal for people to live at the bottom of a volcano because it hadn't erupted for so long that no one thought that it would ever happen again”. By pure chance - a key concept in this article - I found myself reading a book by Nassim Taleb - the original author of all the ideas in this article - in which he explains the parable of the turkey, which goes as follows:

Consider the life of a turkey on a farm that specialises in supplying them for Thanksgiving. With each passing day, the turkey, in an attempt to control its existence, looks around and tries to make predictions about the future to adapt its behaviour. Since its hatching, it observes how a human being—whom it instinctively identifies as dangerous—feeds it, cares for it, and generally offers a safe environment in which to grow and live peacefully. To make the story less terrifying, let our poor friend be lucky enough to be a free-range bird and not cooped up in a cage where they can't move. When the turkey sees the human, it feels a certain fear, but as he continues to take care of it, the bird begins to consider the possibility that the purpose of human existence is to please turkeys. At first it is only a hypothesis, but as the days go by, the observed data (human behaviour) make the turkey believe that this is an accurate description of reality. It even finds the cage open one day, but quickly rejects the absurd idea of leaving paradise. Time passes and Thanksgiving approaches, the turkey greets the human being with whom it has forged a blind relationship of trust, but this time he doesn't bring food, and the next day, the turkey is roasted and served to a family celebrating the holiday. I suppose the reader notices that precisely the day on which the turkey's confidence peaked, and although its hypotheses were contrasted with historical data — as we do in many other fields, such as finance — is the day it discovers that this hypothesis was false, with disastrous consequences for its survival. It is also easy to see that the panellist who suggested that the fact that there had been no eruptions in the last 50 years was reason enough to be confident that it would not happen, follows the same faulty logic as the turkey's hypothesis.

These extreme events are what we call tail risks — or black swans — and have two important characteristics: (1) they are unpredictable and very unusual, sometimes happening only once in a lifetime, like a volcanic eruption, and (2) they tend to have extreme consequences, though not necessarily negative ones, such as winning the lottery.

Taleb's theory — which I particularly agree with — is that history is largely shaped by black swans and that therefore, part of our future depends on unpredictable incidents with an extreme effect. If we look back on our lives, we are sure to find a limited set of turning points that, proportionally, explain a very large part of how our history has played out: a decision on what to study, a change of job we weren't looking for, a relationship. How many things has Covid-19 changed in the way companies and social relations work, and how many people had predicted it? Zoom - unknown to most mortals just 18 months ago - owes all its success to the pandemic. Think of the poor Canary Islanders: what relative importance did they attribute, a few weeks ago, to living at the bottom of a volcano, in terms of their studies, work or football, and what do they give it now? Many must have lost everything in an event which they didn't even devote a minute to each year. The problem with extreme events is that we often only need one in our lives to turn it completely upside down.

In the realm of finance, this is even more evident: how many businesses, built up over years of effort and success, suddenly disappear due to technological change, an epidemic or a financial crisis? How many investors who have been building a retirement fund over a lifetime watch it vanish with a crisis like the one in 2008, excessive focus on fashionable assets (bitcoin, anyone?), or a type of assets with hidden risks (preference shares, MBAs). Taleb offers a solution. The barbell strategy is based on building a structure with two very different parts. The first limits the negative risk by making us immune to negative black swans, while the second seeks to have a high exposure to risk and potential growth through exposure to positive black swans. In other words, optionality. The parallelism in the case of finance would be to have a very, very safe part, for example government bonds or cash, and investing the rest in assets with great potential and risk through exposure to positive black swans, such as options or equity growth. Most importantly, the portfolio has potential, but has no chance of ending up being worthless. Often, when we analyse a client's portfolio, we observe just the opposite: portfolios that are narrowly focused on a single type of risk and that are typically neither active nor very safe (free of extreme risk) nor with much potential (with the ability to deliver positive surprises). This makes them highly sensitive to any unexpected event. Many, given that they have had a very good accumulated return in recent years, do not understand why we would want to exchange a portfolio with such good results for one with less risk and consequently less expected return. What they don’t see is that this expected return, which they don’t want to give up, doesn’t take into account the equivalent of a volcanic eruption in the financial realm, an event that wipes out all the accumulated return on their portfolio over so many years in just a couple of weeks.

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