Black swans and other animals

You’ve probably heard the phrase “black swan event” over the last few years about the banking crisis. If you haven’t or are just not sure what people mean with that here’s the short version. In nature most swans are white, but every once in a while a rare thing happens and you get a black colored swan. The rarity of the event, a swan that is black, is what people mean with the metaphor. The phrase “black swan” sounds more friendly than the real definition of the problem: unmitigated systemic risk. That sounds pretty scary. See, swans don’t turn around and eat you even if they are black, but in the real world unmitigated systemic risk is like a lion that feasts on you like a delicious t-bone steak until everything is gone.

There is a life lesson in this mess that is extremely important. Even very smart people can be blind to the real and large risks. The financial industry employs thousands of analysts in a department called “Risk Management” and they are intended to be the watchdogs that clearly assess and quantify the impact of business decisions and practices. The sad reality of 2008 is that an entire class of smart people convinced themselves that risk no longer existed in the mortgage industry with all their new financial instruments, regardless of who got a mortgage. Now, if you’re shaking your head at a mortgage policy that makes no sense, you’re right.

Generalize this and you see this basic problem play itself out daily; it is a basic human nature problem. I get fixated on an attractive possible outcome and in the process downplay, ignore, or outright deny the consequence of the choice. Even good things can go too far as seen with the effect of fathers and mothers that in their pursuit of providing good things for their families work long hours but in the process don’t have enough time to be a parent to their children. Peer pressure is a huge source of blindness to risks. We often think of teenagers as prone to this but we see mature adults can do the same thing. A study by Temple University quantified the effect of just the mere knowledge of friends watching them during a simulated driving course. Just being told that friends were watching their performance (not present or even actually true), teens (age 14-18) ran stop signs 40% more often and had crashes 60% more often. You can read more about this here: http://well.blogs.nytimes.com/2011/02/03/teenagers-friends-and-bad-decisions/

This reminds me of a quote by Stephen Covey, a motivational speaker and business consultant, that is very intuitive but often overlooked or even forgotten:

“While we are free to choose our actions, we are not free to choose the consequences of our actions.”

and a companion concept that helps ground thinking that Covey is quoted as saying:

“There are three constants in life… change, choice and principles.”

Understanding the enduring principles of life and staying true to them is the greatest tool to a successful and truly happy life.

Pardon the interruption

I’ve been out of the country in Asia for the past couple of weeks. Part of the time was in Shanghai, China where I was hoping to get some time and catch up on some blogging. However, that plan was quickly changed when I found that all social media tools are blocked in China. Name it: facebook, twitter, wordpress, all b-l-o-c-k-e-d. It’s no secret as why either. Take one look at the revolutions in Egypt, Syria, and Yemen all started and are fueled by social media. In a Chinese culture where stability is the #1 priority, personal liberty and self expression takes a back seat.

This got me thinking about the contrasts between a country like China and the USA. The contrasts are stark but the problems largely the same. In China you are fed very carefully a stream of information. In the USA you have open access to any information. However, in the USA there is a hidden fallacy that open access of information equals truth. The problem is the same between the two countries: control of your point of view through manipulation of what you read, see, and hear. The means are as opposite as humanly possible. The conclusion is the same: culture is not a friend of truth.

And I was reminded of the words of Solomon:

“To the youth knowledge and discretion”   Proverbs 1:4

and I recognized why the two, knowledge and discretion, are linked. Knowledge enables one to see a good use or an evil or unwise use of the facts. Discretion is the practice of judgment to use that knowledge effectively. A simple example, knowledge of accounting can give a manager insight into his businesses finances and evaluate its performance (good) or it can be used as insight on how to conduct embezzlement without detection (evil). It is discretion that stands at the crossroad of the two choices.

Life has us make choices, constantly. Culture would have me believe a particular outcome is the best one, but “best” for who or to what end? Just asking the question I find is a giant leap towards seeing the real truth of a matter.

Don’t mind the man behind the curtain

This entry goes in the “Don’t believe everything you read and hear” bucket. I don’t appreciate being told one thing by politicians when the world around me tells me something very different. Take the recent debate about the level of Federal spending and how it relates to you and me. If you’re like me and just can’t reconcile the reality that the economy is putting a drag on your household budget but then told by politicians that “We can afford to do more”, here’s a bit of chart reality

and a good analysis of this data is here: http://finance.yahoo.com/news/A-Close-Look-Under-the-Hood-etfguide-3224305274.html?x=0&.v=1

The reality is that government spending has ramped significantly over the past 2 years as a function of personal income in magnitude that has not been experienced since Jimmy Carter was in office in the mid 70’s. But don’t mind the man behind the curtain, it’s all in your mind and you really can spend a lot more.

Yeah. Right.

A man lacking in sense pledges
And becomes guarantor in the presence of his neighbor. ”   — Proverbs 17:18

Don’t confuse me with the facts

I have a good friend at work that I often debate investment strategies when we meet. Over the years I’ve found a large number of engineers hold an assumption that scientific analysis can provide an “edge” in investing. Now don’t ask him what he needs to analyze, as I often do, but he holds onto this assumption in the face of very stark quantitative evidence. You can easily find data that compares the performance of active mutual funds to a benchmark index such as the S&P 500. For 2008, over 70% of all active mutual funds trailed the performance of the S&P 500 over the previous 5 year period. So, if a mutual fund manager that focuses on investor return every day of his life and a majority of the time underperforms, why does my good friend still hold on to the assumption that scientific analysis provides an edge in investing?

This story, and others like it, have given me a lot of food for thought about the underlying thinking of people and myself in particular. There is a stated assumption of microeconomics: individuals are rational. In other words a person will make the best decision weighing the benefit to themselves. But as my good friend demonstrates, people don’t always think or act rationally even in the presence of evidence. Why is that?

Another example is the buying behavior in the grocery store versus a car lot. I had a professor that used to own a grocery distribution business in Tennessee. To demonstrate this contrast he would describe how a typical consumer would go through the aisles and make decisions about what to eat based on only a few pennies difference in a can of green beans, price is king. However, take that same person and put them on a car lot and now decisions in the hundreds of dollars are no big deal because the style of the car is appealing. Yet, the choice of green beans bears a risk of health consequence but isn’t a factor in the buyers mind going down the grocery store aisle. I repeat this same pattern in decisions and choices all the time. I don’t always think or act rationally.

The same “rational person” problem exists in all sorts of subjects that have high emotion involved such as politics or religion. I don’t have to turn into Spock and purge myself of all emotion in the face of my moments of irrationality. Basic wisdom and truth are my best resources that will serve me in all situations regardless of subject, time, or place:

  • Learn how the world works – don’t be naive about people, places, and things
  • Learn discretion – how to assess the situation and make the best choice
  • Obtain prudence – foresight of what happens in light of my choices and decisions
  • Get good counsel – many points of view provide sound understanding
But Solomon beat me to this a few thousand years ago and said it far more efficiently when he said in Proverbs 1:
4 To give prudence to the naive,
To the youth knowledge and discretion,
5 A wise man will hear and increase in learning,
And a man of understanding will acquire wise counsel,