Extreme Events: Preparing the Brain for Black Swans

“The voyage of discovery is not in seeking new landscapes but in having new eyes.”
Marcel Proust


The US stock market has just seen an explosion in volatility moving from a steady climb to a waterfall.

S&P index recovering after a nose dive

The Crypto Currencies have collapsed at a “bit” more orderly pace.

The question I have for you – Is your mind prepared to handle this information? Or will your brain downshift into its default survival patterns?

Could Native Americans see the Spanish ships? There is an apocryphal story in the personal transformation movie “What the Bleep.” In that story, the Native Americans were unable to see the Spanish ships on their first arrival because they had no concept of them. Although this story has gotten some play, there is no way that we can know this is true. However, the metaphor is helpful as we consider why extreme events seem to catch everyone surprised and unprepared.

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.

Let’s start with simple perceptions. Take the time to experience these simulations because we will build on your personal experience. Watch this video which measure perceptions. Your task is to correctly count the number of basketball passes by the members wearing the white. Can you get the correct answer? This requires some focus. Click here to watch the Youtube video and many other studies about our visual perceptions.

How are you at perceiving a sleight of hand? Check out this video.

You can also experience the McGurk Effect. Even if you know the illusion, it doesn’t matter. When our brain handles conflicting information, it defaults to a single result to maintain a coherent interpretation.

Are extreme events going to be on the rise? A couple of 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.

Image showing Leptokurtic Kurtosis

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 concentration of economic decision power.

Let’s look at the list of contributors:

  • Increased use of index funds such as ETF, index futures
  • Uncertain management of the healthcare industry by federal regulation
  • Uncertainty of the levers and results by the Federal Reserve.
  • Growing unfunded liabilities from federal, state and local governments
  • Massively unfunded pension funds at all levels of government and private industry and non payments to retirees
  • Instant dissemination of information to trigger emotional contagion
  • Emergence of new blockchain currencies and monetary revolution
  • International relationships driven by populist sentiment
  • Shifting tax and regulatory structure in an uncertain political environment
  • Foreign trade as a political and emotional weapon
  • Multiple funds use a similar risk management or investment strategy, hidden from each other
  • Increasing violence for political gain
  • Increased political divide and intense political results.
  • Rapid explosion of computer and biology technology (Singularity per Ray Kurzweil) that impacts every aspect of our lives

These shifts in our cultural and political environment have the potential to create an emotional contagion. How do we as 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!

  • Long Term Capital Management calculated the odd of their own failure at “1 in 3 billion” and almost took down our financial markets in 1998 and required a 3.6 billion dollar bailout.
  • Goldman Sachs stated the chaotic market price actions of early August 2007 were a “25 standard deviation event”
  • In 2007, Citi’s chief financial officer claimed that the firm was simply a victim of unforeseen events.
  • Brexit election in Great Britain
  • Election of Donald Trump in 2016 (Except Scott Anderson, Dilbert creator. Read his book – “Win Bigly”)

Extreme Event Exercise:

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 not to predict the future or to replace risk management systems, but to prepare your mind to act quickly when needed.

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.

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 state, cities and municipalities declare bankruptcy or insolvency
  • Social Security / Medicare fail to make payments
  • Oil at $300 or $25 a barrel in 30 days
  • Collapse of the dollar
  • Collapse of U.S. Treasury Bonds
  • Futures trading halt for 30 days
  • Trading margins tripled
  • Housing prices sink 50% in the next 12 months
  • Internet failure for 30 days
  • Congress passes a balanced budget
  • Trump is impeached by the House and convicted by the Senate
  • Korea nukes a U.S. territory

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 happened?
  • 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 impact.
  • 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 give 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.

The next step is to create incremental early action plans as early indicators crop up on your timeline.

Black Swan Extreme Event early action

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.

From the earlier videos, as active traders, do we see the gorilla? Do we become habitualized to seeing the patterns we expect? Do we focus on the card game and miss the massive changes in the background?
These exercises will help your brain see developing Extreme Events that most people miss.

How can Mind Muscles™ support you? As always, we at Mind Muscles™ Academy are ready to help you in this process with our in-house training, private coaching, our online courses and Mastermind groups. Please contact us to learn more about how “Extreme Event Training” can help your company.

Please join us for our next complimentary webinar, “Winning Minds” on February 13 at 4:30pm ET. Click here for registration and details.