(This article first appeared in Real Estate Investor's Monthly.)
Nassim Taleb’s book The Black Swan is currently on the business best-seller list. Since the ideas in the book are so important, I will just discuss them, not review the book in the normal sense.
The phrase Black Swan refers to events that are unexpected and of extreme magnitude. Notwithstanding the often negative connotation of the adjective “black,” e.g., Black Tuesday, Black Swans refers to both good and bad big events.
The origin of the phrase was that black swans were originally thought not to exist, thus making them icons of extreme rarity, like a four-leaf clover. Turns out there are some in Australia.
Almost all human endeavor is subject to Black Swans including real estate investment. During my lifetime, some Black Swans in real estate have been:
As you can see, some of these were positive and some were negative. In some cases, whether it was negative or positive depended on your particular situation. I have often complained that politicians and news media characterize economic news as good or bad when in fact, economics is the study of transactions and it takes two to transact, so all economic news is good for those at one end of the transaction and bad for those at the other. E.g., higher unemployment is good news for would-be employers and bad for would-be employees.
Investors misperceive what makes and loses money. Stock market investors, for example, will talk of having invested for X number of decades and having averaged Y% return during that time. That is very much like the lake that averaged a depth of six inches.
In fact, half of the positive stock market returns of the Twentieth Century occurred on just ten trading days. In other words, if you invested in the stock market throughout the Twentieth Century except for those ten days, you would have half the money of those who were in the market on every day.
In other words, money is mostly made and lost on Black Swan days. As has been said about war, investment is months of boredom punctuated by moments of sheer terror. The moments of sheer terror are what investing is about.
The boring days in between are like grout between tiles. Yet real estate investors perceive themselves to be landlords who engage in day-to-day routine activities. That’s true. But the basic motive for investing is to make money, and that takes place mainly on the Black Swan days, as does losing money.
Investors see themselves as having expertise in their field. Real estate investors think they have expertise in real estate investing. They read books and newsletters like mine to increase that expertise. Fine. Filling that need is how I make my living.
But I have a news flash for investors. Part of expertise is knowing what we do not know. And what we do not know is massive. We know that Black Swans are the main factor in passive investment success and failure. And we know they are unpredictable.
Expertise is the ability to predict or control events. But Black Swans are, by definition, unpredictable. So already we have a situation where the main thing that is going on in passive real estate investment is beyond anyone’s expertise! Heck of a revelation! But that’s the way it is.
Most investment expertise is about a notch above the best way to arrange the deck chairs on the Titanic. That is, it would be like the seamanship skills of the crew of the Titanic. Those skills were quite valuable, until the Black Swan of the iceberg, at which time their skills accomplished little more than get the women and children and some crew into lifeboats and send a distress message.
Does this mean that investors should throw up their hands? No. It’s not that bad. It’s somewhat like cancer and mainstream medicine. We do not know everything and we cannot cure everything, but we have learned a lot and we are improving survival rates continuously.
There are two kinds of Black Swans: positive and negative. Although all Black Swans are unexpected and big, there are also two categories of unexpectedness: expected unexpectedness and unexpected unexpectedness.
Examples of expected Black Swans would be major earthquakes, tsunamis, depressions, disease plagues, and so forth. Those are uncertain only as far as timing is concerned. But there are also unknown unknowns, that is, future disasters and windfalls, Black swans, that no one can conceive of today.
If you consider the Twentieth Century, you can recall numerous major events that no one expected including technological developments like the atomic bomb, air planes, antibiotics, world wars, Nazis, the Soviet Union, Baby Boom, Cold War, lasers, organ transplants, radio, TV, computers, the Internet, and so forth.
You don’t need much prompting to recognize that these events, which were unknown unknowns in 1900, caused massive profits and losses as well as massive losses of lives and saving of lives.
Another way to think about Black Swans and the non-Black Swan world is insurance policies. In his book, Taleb rails against the bell curve from the almost the first page to the last.
The bell curve says a whole lot of things in life, when measured, reveal the so-called normal distribution, also called the bell curve. Taleb says that almost all predictive occupations, like real estate investors, stock market analysts, economists, and so forth, assume that the world is accurately depicted by the bell curve.
So if you can find some of the data points, which you know are part of a bell-curve shape, you can relatively easily predict the rest. That is incorrect. The bell curve does accurately depict the distribution of many physical variations like human heights or humans’ life spans when they are ended by natural causes.
However, and it’s a big however, the bell curve is not worth a damn when it comes to the human will. The problem is that vast numbers of “experts” are applying the bell curve and other similarly inappropriate statistical techniques like linear regression to human-will events like market prices.
For example, investors invest in stocks and real estate generally on the assumption that the recent past will be repeated in the future. That is a linear-regression trend line.
Is it a valid predictor of future market prices of stocks or real estate? Hell no! Every investment prospectus has a statement that past performance is “not necessarily indicative of future performance.”
A more accurate statement would be that past performance in market prices has absolutely no predictive value whatsoever. Try projecting recent market prices of stocks or real estate into the future as of September, 1929 and see how close the results are to what actually happened.
Height is predictable via bell curve. But weight, which is controlled by human will, (diet and exercise), is not.
To forecast the future, you need actuarial tables. That is, lots of data about what has happened in the past regarding the event in question. Life insurance is the classic example. There are well established actuarial tables that show the ages at which people die. It follows a bell curve which is one of the classic identifiers of a predictable variable.
So life insurance makes sense. The insurance companies know how many of their policyholders are going to die each year.
But life insurance companies also have to worry about Black Swans. And they do. But they don’t call them black swans. They call them exclusions. Why do they exclude them? They are too rare to enable actuaries to produce actuarial tables that depict them. They are also huge in impact. Huge and unpredictable = Black Swan.
In life insurance, a common exclusion is an exception for accidental deaths caused by “act of war” or “while in active military service.” Suicide, nuclear accident, and piloting planes are others. But insurance company exclusion clauses only cover known unknowns, that is, events whose occurrence possibility we know from the past but whose date of future occurrence we know not. There are other Black Swans, the unknown unknowns that could cost the life insurance big time if one occurs, like an asteroid hitting the country where the company writes all of its policies. Such an event would cause lots of deaths of policyholders, but would not be excluded in the policy.
While Black Swans are unpredictable, and many are not insurable, there are some things you can do.
Bankruptcy planning generally gives you some protection from almost all negative financial Black Swans. Excluded are things like taxes, recent student loans, alimony and child support, criminal fines, drunk-driving-related debts. Bankruptcy planning just means learning the property types that are protected from creditors in your state and putting as much of your assets into those categories as possible.
Bankruptcy planning is asymmetrical. That is, it puts a sort of floor on your losses but places no limit on your profits. As such, it is a useful, negative Black Swan-protection technique.
Insurers and lenders generally are also in an asymmetrical situation, but one that is the opposite of bankruptcy planning. Insurers and lenders can lose big, like lenders are in the current sub-prime market. But neither insurers nor lenders can win big.
Real estate investors are in a situation that is opposite of that of insurers and lenders in one respect: real estate investors can win big. Smart Black Swan strategy. But their situation is not asymmetrical. They can lose big, too.
Venture capital is better than real estate in this respect. Venture capital limits downside by use of incorporation. Liability limiting structures like LLC are less useful in real estate because the owners are generally also day-to-day managers rather than mere passive investors.
Taleb makes too much of one factor, but it should be mentioned. That is the propensity of humans to, after a Black Swan, use their 20/20 hindsight to see how easy it would have been to see it coming had they only focused on this or that variable.
9/11 is a classic example. It was so easy to see the signs after the event.
I thoroughly researched another such event: Pearl Harbor. In fact, prior to Pearl Harbor, there were a zillion signs of pending war, but although there were signs pointing to Pearl Harbor, there were a zillion other signs pointing at other things. 20/20 hindsight failed to see how difficult the Pearl Harbor signs were to pick out of the false signals.
The same is true of 9/11, notwithstanding Democrat criticism of the Republicans. Almost certainly, 9/11 would have unfolded the same if Gore had been elected in 2000. And the same is true of foreseeing booms and busts in real estate.
After the fact, it seems relatively easy to see the indicators that one or the other was going to happen. But that illusion is almost like the diabolical design of the games in Vegas—letting you win sometimes to keep you going so you lose more money overall. The real estate version is to let you understand, or seem to understand, what caused a particular boom or bust after the fact so you mistakenly think you can forecast the next one. Such understanding seems tantalizingly close.
But do not be fooled into thinking Black Swans can be predicted by the ease with which one can see the warning signs in retrospect.
Taleb actually urges readers not to try to precisely predict Black Swans. After 9/11, he says the military and the government tried to predict such Black Swans precisely. Taleb told them it was a bad idea because you cannot do it and it makes you more vulnerable to the actual Black Swans that you were unable to predict.
In an NFL Films blooper tape, coaches yelled out to their players, “Watch the screen! Watch the waggle! Watch the draw!” Finally, the head coach got disgusted and yelled, “Watch everything!” That is hard to do, but it is the closest thing to correct advice when it comes to Black Swans.
In football for example, if you “watch the screen” and the play that comes is not a screen pass, you are more vulnerable to the actual play because you were leaning—at least mentally—in the direction of stopping the screen pass. The more the actual play is unlike the screen, the more watching the screen screws you up.
What Taleb advocates is that you keep an eye out for good Black Swans and when you seen one, seize the opportunity. When U.S. soldiers unexpectedly captured the Remagen bridge across the Rhine river in World War II, General Eisenhower ordered damned near the whole U.S. Army to cross it ASAP.
But sometimes what appears to be an opportunity is a mirage like when one of my grad school classmates bought real estate in inner-city Baltimore based on insider knowledge of a future urban renewal program. The program was canceled and he lost money on the property.
Taleb also urges increasing your chances of serendipity which lead to spotting positive Black Swans. I did the same in a chapter on that subject in my book Succeeding. He says to do it by living in a major metropolitan area rather than an isolated small town. I said to “get out of the house.”
Taleb’s main point is that we cannot forecast the timing or nature of Black Swans but we can focus usefully on the benefits of the good Black Swans and the harm of the bad ones. Then we need to try to position ourselves to benefit from the former and minimize damage from the latter. JTR