The COVID-19 pandemic of 2020-2021 has been many things. Isolating. Heartbreaking. Economically destructive. Global. Persistent. Unforgettable.
But one thing that it wasn’t, or at least shouldn’t have been, was completely unexpected.
How can I say this, given that nobody seemed to see it coming?
Predicting the Unpredictable
One of the reasons I advocate for holding much higher levels of cash than most advisors advocate is because I know just how much I don’t know.
Donald Rumsfeld (Secretary of Defense under both President Ford and President George W. Bush) had a famous (and insightful) way of describing the problem of understanding what we don’t know.
Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tends to be the difficult ones.[1]
Donald Rumsfeld, February 12, 2002
The events that tend to devastate a person emotionally, physically, or financially, are the ones you don’t see coming.
This is a financial blog so I’m going to be focusing on how this concept of the unknown can affect you financially, and why this means you should be more conservative than most “experts” advise.
Black Swans
What is a black swan?
Nicholas Nassim Taleb wrote a whole book exploring the impact of the unknown, and if you haven’t read “The Black Swan: The Impact of the Highly Improbable” then I suggest you do so ASAP. It is required reading for anybody interested in personal finance.
The primary message of the book is that humans are terrible at understanding probability, especially for events than happen rarely. If the event is so rare that we haven’t seen it happen then we assume it can’t happen.
The term “black swan” was coined because for thousands of years in Western civilization all swans were observed to be white. Because nobody in the West had ever seen a black swan it was believed that black swans didn’t exist. A black swan was impossible.
Then, in 1697, a Dutch explorer saw a black swan in Western Australia. Suddenly, black swans WERE possible. Perhaps they were just very unlikely, or perhaps they didn’t exist in the area of the world previously searched, but they were clearly not impossible. Black swans did exist.
Impossible or very, very rare?
Human tend to assume that if an event hasn’t happened then it won’t happen. But maybe the event just hasn’t happened yet. Maybe the event is just very, very rare.
And there is a world of difference between an event that is very, very rare and and event being impossible.
Something that is impossible has a probability of 0%. Something that happens very, very rarely has a probability of higher than 0%.
This means that, given enough time, a very, very rare event will eventually happen. A very, very rare event might happen just once every million years, which means that a man with a lifespan of 80 years has a .008% chance of that event happening at least once in his life. But over the course of hundreds, or thousands, or hundreds of thousands of human lives, the chance that the event happens at least once becomes more likely than not.
A event or the event?
A specific event might be very, very rare. It’s unlikely to happen.
But there’s a big difference between the probability of a specific event happening and the probability of any event happening.
What the heck does that mean?
To understand that we need to take a brief tour through an astronomy concept.
The Drake Equation
For centuries philosophers and astronomers have been wrestling with a question – are we alone in the universe?
On one hand, it doesn’t appear that we’ve been visited or contacted by an extraterrestrial intelligence at any time in recorded human history (roughly 2,500 years). Perhaps that means we are alone?
Or maybe there are lots of intelligent alien species and they either haven’t found us, are trying to communicate with us and we aren’t receiving/understanding their messages, or they are avoiding us for some reason.
If we are alone in our galaxy then there’s no reason to waste time and money on trying to communicate with aliens. On the other hand, if there are thousands of intelligent civilizations in our galaxy then we should be trying much, much harder to communicate with them.
How can we estimate the number of alien species in our galaxy that are able to communicate with us? The American astronomer Frank Drake came up with a formula called the Drake Equation.
You can read the Wikipedia entry on the Drake Equation for the details, but essentially it involves listing all prerequisites that would need to be in place for an intelligent civilization to be capable of communicating with us, then multiplying the probability of each prerequisite.
This looks like this:
The number of alien civilizations capable of communicating with us = (number of stars in our galaxy) * (% of stars with planets) * (number of planets per star with planets) * (% of planets capable of supporting life) * (percent of those planets that develop life) * (% of those planets that will develop life) * (% of life that will become intelligent) * (% of life able to communicate) * (number of years the civilization will exist).
As you can see, there are a lot of variables in the equation, and for most of the variables the best we can do is make educated guesses. And since the estimates are all multiplied together, the predicted number of alien civilizations able to communicate with us varies by many orders of magnitude.
The key concept from this discussion is that we can get a reasonable estimate of the probability of an event by making educated guesses about the probability of the factors that lead to the event.
A Black Swan vs. THIS Black Swan
Let’s remind ourselves of a key concept I mentioned previously – there’s a big difference between the probability of a specific event happening and the probability of any event happening.
As investors, we aren’t just concerned about the probability of a specific negative event happening. We are concerned about the probability of any negative event happening.
A simple (but not quite accurate statistically) way to think about the probability of any event happening is the sum of the probabilities of all of the events.
To calculate the probability of any negative event happening we’d need to list out all the negative events and assign probabilities to them.
Probability of any event = (Probability of event 1) + (probability of event 2) + (probability of event 3) …
Combining Rumsfeld and the Drake Equation
Known Knowns
These are events that have happened and happen frequently enough that we can assign some reasonably accurate probability to. Here are a few risks I thought of off the top of my head and some rough estimates of their probabilities:
- War = 10%. Example calculation = the US has been involved in many wars over the ~250 years it’s been around, but the ones that had significant economic impact were the Revolutionary War, The War of 1812, The Civil War, WW1, WW2, and maybe the Vietnam War. That’s roughly 6 wars at an average of ~4 years/war = 24 years, or about 10% of the 250 years the US has been around. War is less common now than it was a few centuries ago, but it’s also more destructive.
- Pandemic = 1%. The human race has experienced many plagues and pandemics over the last few thousand years. A look at Wikipedia’s list of epidemics shows a plague every few decades, but most of these plagues weren’t extremely deadly. There are 19 epidemics with 1M+ deaths over the last few millennia, so we’ll put this at roughly 1%
- Economic panic = 2.5%. There have been many economic panics over the centuries, and these inevitably lead to economic depressions. These seem to happen roughly every 25 years.
- Climate change destroying our ability to grow food = 1%. We are certainly on the past to catastrophic climate change, but I’m hopefully that technological advances will combine with an acceptance of the risks and will result in a solution.
I’ve only listed 4 possible event types here, but of course there are many more (maybe thousands) of “known knowns” that have happened in recorded history (or even our lifetimes) and that we can make reasonable estimates to the probabilities.
The odds that none of the events above happen in any given year would be: (90%) * (99%) * (97.5%) * (99%) = ~86%. And the odds that none of these things happen over a 10 year timeframe is just 22%. In other words, it’s almost certain that at least one of the events above will happen in the course of any normal human lifespan.
Known Unknowns and Unknown Unknowns
The next set of items are the “known unknowns” and “unknown unknowns”. Known unknowns include events that we know have happened in the past (meteor impact) or that we see scientific evidence of realistically happening in the future (climate change).
- Attack by an alien civilization
- Large meteor impact
- Fungus or pest that destroys crops that humans rely on
- Volcano erupting near major metropolitan area
- Huge (9+ on Richter scale) in major metropolitan area
This list could go on and on.
Each of these events is likely very improbable. A meteor large enough to wipe out the dinosaurs struck the earth about 70M years ago. Was that an abnormality or is it an abnormality that nothing else that large has hit us again in 70M years? We don’t know – the probability of one of these events is unknown.
Unknown unknowns includes risks that we’ve either never thought of or that seem so preposterous that we discount them entirely. Maybe Godzilla emerges from the Marianna Trench. Maybe gorillas develop a language, decide they are tired of humans, and pull a “Planet of the Apes” on us. Maybe an effort to achieve cold fusion instead creates a mini black hole and destroys part of the earth. Maybe we are living in a simulation and the computer system we are running on crashes.
In our minds, known unknowns and unknowns unknowns are so improbable that we assign them a 0% probability. Our internal math looks like this:
Probability of known unknown or unknown unknown event = 0% + 0% + 0%… = 0%
And of course the sum of an infinite number of 0% is still zero, so we set the total probability to 0%. But in reality, this looks like:
Probability of known unknown event = >0% + >0% + >0%… = >0%.
We don’t know the exact probabilities here, but the key is that the probability of each individual event is very, very small, but not zero, and the sum of a huge number of very small numbers is not zero.
The evidence is all around us
Think of all the sectors and individual companies that have been wiped out just in the last few decades by “unexpected” events:
- Enron – corporate fraud
- Kodak – digital photography
- Mortgage backed securities – nation-wide drop in property values
- Pay phones – introduction of cell phones
- Travel agents – Internet travel aggregators
- Book stores – Amazon
- Newspaper want ads – the emergence of online competitors like Craigslist, etc.
- US heavy industry/manufacturing (textile, steel, etc.) – introduction of lower-cost foreign competitors
By and large, these developments were unexpected.
Before the fraud was uncovered at Enron the company was a high flier.
Kodak owned print photography for 100 years until the introduction of digital photography and the introduction of camera phones put them into bankruptcy seemingly overnight.
Mortgage backed securities (previously rated as investment quality debt) tanked when a nation-wide drop in property values led to investors halting their mortgage payments (there had never been a nation-wide drop in property values before 2007).
Pay phones have more or less disappeared now that everybody has a cell phone, and travel agents are much less useful now that everybody can book their flights directly with the airlines. Amazon has pushed the major bookstores into bankruptcy.
Newspapers used to make money hand over fist from their “classified” sections, but most of that business has moved to the internet where there are no limits on the length of an ad and distribution is essentially free.
US manufacturing has almost entirely disappeared as China and other lower-cost producers are now able to manufacture the same goods at lower costs.
Nobody saw these things coming before they happened, and yet these kinds of things happen every day. A formerly invincible company is destroyed by a new technology, a leaner and meaner competitor, a shift in the political landscape, or one of many other factors.
No matter how safe an investment appears, there are always risks, some of which you won’t know about.
Diversify!
Since it is impossible to identify and calculate all the risks to your investments, the only thing you can go is to mitigate the potential impact of those risks. Proper risk management comes down to two things:
- Diversify your investments and income
- Hold more cash than you think you need
Proper diversification of your investments can be achieved with just 10-20 uncorrelated investments (i.e. owning 3 steel manufacturers would count as just one investment towards diversification).
Diversification of your income streams can including having 2 working spouses, having a main job and a “side hustle” to bring in some extra cash, or owning income producing investments.
Having enough cash means at least 6 months, and possibly 12 months of living expenses in cash or cash equivalents.
Conclusion
Just as generals are said to always be preparing to fight the last war, investors tend to position themselves to protect against the last crisis.
I’ve talked to investors who are determined to never buy hotel or airlines stocks again so they aren’t ruined by the “next pandemic”. I’ve heard people declare they will never buy rental properties again because they don’t want to end up underwater during the next nation-wide real estate slump.
But the fact is that the next crisis will almost certainly look very different than the last one.
Rather than protecting yourself against a specific “black swan” event happening again you should concern yourself with putting a strategy in place to mitigate the effect of any black swan event, whatever that may be.
Diversify your investments, diversify your income streams, and have enough cash on hand to protect against a much longer and larger impact than you think is likely.
You can thank me when the next black swan event happens.