Extreme Events - getting your brain ready for Black Sawns

Extreme Events: Preparing Your Brain for Black Swans

“Antifragility is beyond resilience or robustness. The resilient resists shocks and stays the same; the antifragile gets better.”
Nassim Nicholas Taleb from “Antifragile” book

Nassim Taleb in his 2007 book “The Black Swan: The Impact of the Highly Improbable,” he 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.

In his 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 US stock market has just seen an explosion in volatility. Who could have seen the Corona virus coming? Not only was this unpredictable by prior events, but even what I personally did know early didn’t translate into positive action.

Chart showing market uncertainty due to coronavirus

The question I have for you – 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, sensations? How much trust do you have in yourself when there is chaos in the world?

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.

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.

Chart 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 systems that are more concentrated and fragile.

Let’s look at the list of contributors to fragility:

  1. Increased use of index funds such as ETF, index futures
  2. Uncertain management of the healthcare industry by federal regulation
  3. Uncertainty of the effectiveness of levers and results by the Federal Reserve.
  4. Unintended consequences of zero interest rates
  5. Growing unfunded liabilities from federal, state and local governments
  6. Massively unfunded pension funds at all levels of government and private industry and non payments to retirees
  7. Instant dissemination of information to trigger emotional contagion
  8. Possibility of new block chain currencies and monetary revolution
  9. International relationships driven by populist sentiment and nationalism
  10. Shifting tax and regulatory structure in an uncertain political environment
  11. Foreign trade as a political and emotional weapon
  12. Multiple funds use a similar risk management or investment strategy, hidden from each other that create unseen coordination
  13. Increasing violence for political gain
  14. Increased political divide with political results that careen from one extreme to another
  15. Rapid explosion of computer and biology technology (Singularity per Ray Kurzweil) that impacts every aspect of our lives
  16. Complex interdependent supply chains that require multiple links that can easily be broken

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!

  1. 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.
  2. Goldman Sachs stated the chaotic market price actions of early August 2007 were a “25 standard deviation event”
  3. In 2007, Citi’s chief financial officer claimed that the firm was simply a victim of unforeseen events.
  4. Brexit election in Great Britain
  5. Election of Donald Trump in 2016 (Except Scott Anderson, Dilbert creator. Read his book – “Win Bigly”)

“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.

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 to prepare your mind to act quickly when needed.

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:

  1. Multiple state, cities and municipalities declare bankruptcy or insolvency
  2. Oil stays below $30 a barrel for two years
  3. Collapse of the dollar
  4. Futures trading halt for 30 days
  5. Trading margins eliminated
  6. Housing prices sink 50% in the next 12 months
  7. Internet failure for 30 days
  8. Congress passes a balanced budget
  9. The Corona virus overwhelms our healthcare system
  10. The Corona virus turns out to be no worse than the flu in the US
  11. Korea nukes a U.S. territory
  12. Nuclear fusion becomes feasible
  13. Socialist dominate the 2020 elections
  14. Unemployment hits 30%

Make up your own!

Chart showing example of Extreme Event early warning

The next step is to create a timeline for each of the 3 unlikely events.

  1. What indicators would be likely to occur or necessarily occur before this event could happen?
  2. What are even small early indicators?
  3. Add labels for days, weeks, months or years before the event.
  4. What other events would cascade from this event? We often miss the complex interrelationship that can have exponential impact.
  5. What emotional contagion might occur creating mass hysteria?
  6. 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.

Next create a 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?

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

Chart showing 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.

As active traders, do we see the gorilla? Do we become habituated to seeing the patterns we expect? Do we focus on the card game and miss the force sawing on the table legs?

*Footnote: This is an updated blog first published at Market Psych in 2011 and in Mind Muscles in 2017.


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