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THE MAIN STORY: BLACK SWANS, GRAY SWANS, AND TURKEYS

Overview

Are there really any learnings we can take from the Thanksgiving turkey’s short life?

Well, according to Nassim Taleb in his popular book The Black Swan, there are.

If you’re unfamiliar with Taleb’s work, a black swan is an unexpected event with extreme consequences. These events blindside us and flip our paradigm upside down.

Examples include 9/11, the 2008 Financial Crisis, and the emergence of Covid-19.

Swans and turkeys

These could also be “gray swans,” and the difference depends on your perspective. See, a gray swan is a known event that’s ignored since it’s considered a very low probability.

To investors on Wall Street, the housing defaults that triggered a crisis in 2008 were a gray swan, meaning they knew the risk was possible but saw a real estate crisis as very unlikely.

To most Americans, though, the crisis was a black swan because the degree of risk taken by Wall Street firms was unknowable. So, the crisis came as a shock.

Returning to our turkey metaphor, consider that, say, the average turkey lives for 1,000 days before being slaughtered for Americans’ annual Thanksgiving tradition.

From the turkey’s perspective, things are great for its entire life in those 1,000 days. It’s well-fed and provided for, and the humans that tend to it increasingly earn its trust.

False security

Over time, as the turkey grows fatter and fatter, its hypothetical risk-management department sees less and less reason for concern. Every new day validates that its farm is a safe place to live and that the humans have no interest in eating it.

This seems logical, and we can see how the turkey would delude itself over time into thinking it was safe.

Of course, a few weeks before Thanksgiving, everything changes. The turkey realizes its grave mistake in assessing risk and is taken by the butcher.

The meaning

When our worldview is defined only by our past experiences and recent memories, we make ourselves vulnerable to an unknowable future.

Ironically, with more observations each day, the turkey believed his risks were diminishing while he was actually passing closer to his demise.

Assuming that with greater foresight, the turkey could change its circumstances and avoid slaughter, this linear thinking was a catastrophic mistake.

For the turkey, thanksgiving is a black swan, yet it happens every year.

As investors, we cannot allow ourselves to be turkeys. Don’t just blindly extrapolate the risks you’ve experienced in your lifetime to the future.

While history doesn’t repeat, it often rhymes. A good investor will study enough history so that no risk is an “unknowable” black swan.

A great investor will effectively weigh the risks associated with knowable but unlikely gray swan events.

What gray swans lurk in the world right now?

This could range from inflation expectations becoming unhinged and causing inflation rates to be chronically higher, to China invading Taiwan, or even the U.S. Treasury defaulting on its debt due to a partisan clash that blocks the debt ceiling from being raised.

I don’t want to go through all these risks today because, well, it’s a holiday, and that’s depressing.

Though I hope to emphasize that investment risks are hardly ever black swans to well-read students of history, they are often gray swans. In other words, the risks are known but dismissed and can be just as consequential.

This means not ignoring low-probability, high-impact events.

Takeaways

I learned this lesson after buying ETFs that tracked Russian stocks in early 2021 to bet on a commodity boom, only to foolishly (in hindsight) dismiss the possibility that Russia would invade a European country.

If you remember that time, even as Russian troops built up on the Ukrainian border, few predicted a full-on war that would sever all ties between the West and Russia.

At least, I certainly didn’t think so until my positions had already hugely lost value.

On top of this, my thesis that oil prices and commodities would soon take off in price was correct, just executed in a very risky way with exposure to Russian energy companies.

This is an egregious example, but most people, even professional investors, as we learned in 2008, underestimate a number of gray swan events threatening their portfolios.

What to do

Reducing counter-party risk and employing conservative strategies are great places to start.

For FTX customers, counter-party risk turned out to be a very real and harmful black/gray swan, and now they may never see the funds they deposited there again.

This isn’t just a criticism of adventurous crypto investors.

If you think you invest in gold as a hedge against social and geopolitical turmoil or currency collapse, but you own a gold ETF where the physical holdings are custodied outside of your control, what good does that do you when the crisis you’re anticipating hits?

More on this tomorrow and, specifically, the role that physical precious metals can play for you as an investor.

Enjoy your turkey today!

SEE YOU NEXT TIME!

That’s it for today on We Study Markets!

See you later!

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