How to prepare for the next black swan you can’t predict
“Antifragility is beyond resilience or robustness. The resilient resists shocks and stays the same; the antifragile gets better.”
-Nassim Nicholas Taleb from “Antifragile” book
The human brain repeats our fallible behaviors.
With the example of SVB, the Silicon Valley Bank collapse, and how other financial institutions may have the same risk profile, we are all now on the alert for economic upheaval.
Our senses are on maximum alert for threats to our financial future.
But…it takes an extreme event to jolt us out of our self-made bubble and allow us to even see the possibility of the bullet coming out of the fog and aimed at our forehead.
Nassim Taleb in his 2007 book “The Black Swan:
The Impact of the Highly Improbable,” focuses on the big impact that unexpected events have on our world. Taleb popularized the term “Black Swan” as a label for these unexpected events. According to Taleb, a “Black Swan” event is unpredictable not because it is random, but because our ability to see the possibilities is limited.
Are we in a fragile state?
In Taleb’s more recent work, “Antifragile” he creates a new lens to see the world…by looking at systems that are diminished with chaos and systems that thrive with chaos, he shows how creating an antifragile mindset and portfolio is a blueprint for living in a chaotic world.
The failure of the Silicon Valley Bank is an example.
Who could have seen the failure coming?
Not because the information wasn’t there, but because our brains filter extreme events. Not only are we unable to see it, but more importantly, we are unable to take action to prevent an extreme event.
Your brain shuts down.
The questions I have for you are:
- Is your mind prepared to handle this information?
- Or will your brain downshift into its default survival patterns?
- Is your own mindset fragile or antifragile?
- How robust are your thoughts, feelings, and sensations?
- How much trust do you have in yourself when there is chaos in the world?
- Are extreme events going to be on the rise?
Several years ago, I gave a presentation to the “Insurer Investment Forum XI” in San Diego produced by Strategic Asset Alliance. One of the concerns of the investment arms of insurance companies is the increased potential for sudden market movement.
Risk is moving from a wider distribution and diversification to a more systemic concentration.
This produces what statisticians call “leptokurtic kurtosis.”
This means more of the variance in price distribution is the result of infrequent and more extreme deviations, as opposed to more frequent modestly sized deviations. This means both a higher peak and fatter tails in event distribution. The anticipation of more extreme events is driven by systems that are more concentrated and fragile.
Let’s look at the list of contributors to fragility:
- Uncertainty of the effectiveness of levers and results by the Federal Reserve.
- Unintended consequences of previous zero interest rates
- Growing unfunded liabilities from federal, state, and local governments
- Massively unfunded pension funds at all levels of government and private industry and nonpayments to retirees (even foreign pension funds!)
- Instant dissemination of information to trigger emotional contagion
- International relationship breakdown driven by populist sentiment and nationalism
- Shifting tax and regulatory structure in an uncertain political environment
- Foreign trade as a political and emotional weapon
- Multiple investment funds/companies/banks use a similar risk management or investment strategy, hidden from each other that creates unseen coordination and mass upheaval.
- Increasing violence for political gain
- Increased political divide with political results that careen from one extreme to another
- The rapid explosion of computer and biology technology that could develop both cures and contagions.
- Complex interdependent supply chains that require multiple links that can easily be broken
- Emotional contagion now has social media. These shifts in our economic, cultural, and political environment have the potential to create an emotional contagion.
How do we as entrepreneurs, business people, money managers, investors, and traders manage the potential for more extreme events?
Our neurology isn’t made to conceive of and prepare for extreme events when things feel normal. Our minds want to extrapolate the nature of the current environment into the future, especially if we can’t conceive of solutions to the problems brought by these extreme events.
They didn’t see it coming!
- 1987 – Market crash triggered by portfolio insurance
- 1998 – Long Term Capital Management calculated the odds of their own failure at “1 in 3 billion”
- 2000 Tech bubble crash
- 2016 – Brexit election in Great Britain
- 2016 – Election of Donald Trump in 2016 (Except Scott Adams, Dilbert creator. Read his book – “Win Bigly”)
- 2019 – Covid 19 and the government responses
- 2023 Silicon Valley Bank Collapse
Extreme Event Exercise:
“Alice laughed: “There’s no use trying,” she said; “one can’t believe impossible things.” “I daresay you haven’t had much practice,” said the Queen. “When I was younger, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”
“Alice’s Adventures in Wonderland” by Lewis Carroll.
Build your anti-fragile Mind Muscles.
The goal of this exercise is to build Mind Muscles™ that gives us a new willingness to acknowledge rare events. Once acknowledged, we can prepare for them as we see increasing evidence of their viability.
This is the basis for one of my favorite exercises at longer workshops. The purpose of this exercise is to prepare your mind to act quickly when needed.
Can you conceive of unlikely events?
Write down 3 events that although unlikely to happen, would significantly change your life. It could change financial opportunities, risks, and profits for your industry, company, or trading environment. Make at least two of the events highly unlikely.
For example, some of the events could be:
- Multiple states, cities, and municipalities declare bankruptcy or insolvency
- Oil collapses below $30 a barrel or explodes to $200 a barrel for two years
- The collapse of the U.S. dollar
- Futures trading halt for 30 days
- Trading margins set at 100%
- Housing prices sink 50% in the next 12 months
- Internet failure for 30 days
- Congress passes a balanced budget
- Second wave a virus
- Russia declares war
- Korea nukes a U.S. territory
- Nuclear fusion becomes feasible
- Socialists or Neo-nazis dominate the 2024 elections
- Unemployment hits 30%
- Long bonds trade at 15%
- Inflation climbs to 20%
Make up your own!
The next step is to create a timeline for each of the 3 unlikely events.
- What indicators would be likely to occur or necessarily occur before this event could happen?
- What are even small early indicators?
- Add labels for days, weeks, months, or years before the event.
- What other events would cascade from this event? We often miss the complex interrelationship that can have exponential impacts.
- What emotional contagion might occur creating mass hysteria?
- What feedback loops might get caught in an ongoing spiral?
This visualization will build new Mind Muscles™ that gives you the ability to see events that few others will be able to notice. As these events unfold, you will have already been down that path. You will be able to see the end! You will not be frozen but will have the ability to act.
This exercise will not only build visuals for specific events but give your brain the ability to visualize consequences for additional events that you did not consider.
Now, visualize action!
Define and create your list of “tells” that are likely or needed to occur before the Extreme Event.
- What would have to happen?
- What would most people dismiss on the way to the Extreme Event?
- What action is appropriate at each tell?
The next step is to create incremental early action plans as early indicators crop up on your timeline.
With each “tell” what is the appropriate action?
- With early tells, perhaps no action other than an alert and watching for additional tells.
- Then, with additional tells, look at low-cost risk mitigation or opportunity development.
- Then, as the tells accumulate, look at making a major shift in your lifestyle and financial planning.
- By starting with low-risk and low-cost actions, you create a shift in your brain to be able to take major changes before the panic rush sets in.
Develop your brain capacity.
Our brains create patterns to make sense of the world. As your brain visualizes several unlikely alternatives, it will develop the capacity to see these and other unlikely alternatives develop. If there is no pattern, evidence of a changing landscape is hard to see. So, create more patterns, build those Mind Muscles™, and become more creative and decisive as we approach the next extreme event.
You won’t do this, will you? Let’s look at why.
How do brilliant people repeat the cycle of financial boom and bust? Why don’t we learn?
I just recently watched the movie “Margin Call”. It is one of the few movies that give a realistic sense of the financial markets in a collapse.
“The Hour Between Dog and Wolf – How Risk Taking Transforms Us, Body and Mind.” John Coates demonstrates how our biological systems and brain chemistry shifts when we are on a winning streak.
- Imagine a context where you are powerful, successful, and admired.
- Your success is envied.
- Your self-worth has become dependent on your social status.
- You need success to create meaning in your life.
- You have proven to yourself that you are invincible
- Your brain has been rewarded with dopamine for behavior X month after month and its brain chemistry has changed.
- Can you even see the obvious risk? No.
- You can’t afford to consider the financial risk.
- In that context, the risk isn’t available to your brain.
- To acknowledge risk is to lose the rewards and the rush of the context of power, success, and admiration.
- The risk of interest rates going up?
- Lending long and borrowing short?
- Social media contagion?
- Peer pressure in your firm?
- Your own financial career?
Now, we can judge SVB, the Feds, and regulators who didn’t prepare for this extreme event. But the real revolution is preparing our own brains for the next extreme event. Most of us will stare at the financial screens and watch…
If you would like to participate in an extreme event exercise, email email@example.com by March 30, 2023.
*Footnote: This is an updated blog first published at Market Psych in 2011 and in Mind Muscles in 2017. Nothing has changed in our human behaviors and it is updated for March 2023.