(This article first appeared in Real Estate Investor's Monthly.)
The 4/15/06 Wall Street Journal listed the five best books on personal investing. I was not interested in one, but I visited local book stores and bought three of the others. Last week, a subscriber sent me the same WSJ article to suggest I review the books.
The first one I read is Fooled by Randomness by Nassim Nicholas Taleb. Fortune called it “One of the smartest books of all time.”
It may be, but I am not sure because I cannot say that I fully understood it. If the book is not clear to me, with my Harvard MBA and 40 years in the investment business, who is it for? If the answer is grad students in statistics, why is it in the book stores?
Taleb is a smart ass who writes to impress as much as to express. For example, he uses French words and phrases without always defining what they mean. When he did translate them, I wondered why he didn’t just leave the French version out.
You’re only supposed to use foreign words when they convey meaning not available in English—like the German word Gemütlichkeit which has been used in Volkswagen commercials—and when you are sure that your audience knows that meaning. Otherwise, use of such foreign words is just showing off.
He also trashes MBAs continuously, in spite of being one himself. His trashing is based on the notion that all MBAs are identical and know nothing about math or science. My MBA classmates included many with math, science, and engineering degrees from MIT, GA Tech, IIT, and other top science and engineering schools. They were also all unique individuals. The collective merits of MBAs are not important. But Taleb would have you believe he is a logical, scientific guy. Not when discussing some things like MBAs.
Taleb also uses too much technical jargon from the statistical field. In short, the book needs to be translated another notch or two in the direction of plain English.
That having been said, the book makes many excellent points.
The main point is that most of what happens is random, not skill. As I have on many occasions, Taleb says that Warren Buffett, the purported “World’s Greatest Investor,” is merely the equivalent of the guy who always gets heads in a single-elimination coin flipping tournament. He is also not much impressed with Bill Gates whom he says mostly had the good fortune to be picked to provide IBM with its operating system. I am not as sure about Gates as I am about Buffett, but I would not rule it out either.
Taleb says that most “successful” investors are simply people whose invalid approach coincided randomly with the price movements of the period when they invested. He also says that almost no such “successful” investors will admit that they are incompetent beneficiaries of randomness.
I am avoiding the word “lucky” here. Taleb uses it, and I have in the past, but upon further review, I think it is incorrect. There is no such thing as luck.
In a single-elimination coin-flip tournament, every round would pit those who won every previous round against each other. But every round would also eliminate half the contestants for losing for the first time. Is the guy who wins the tournament lucky? No. For example, his probability of winning another round is 50%—the same as his probability of winning any of the rounds he won earlier.
The fact that he won all the rounds of the coin-flip tournament also has no meaning regarding whether he enjoyed attractive results from other multiple-outcome events in which he participated during his prior life. In other words, if he was truly lucky, he would be lucky across the board.
One of the technical phrases Taleb uses to condemn thinking “successful” investors are skilled is, “survivor bias.” That is that the public focuses only on those who won. In the single-elimination coin-flip tournament, it is impossible not to have one person win every round because only those who have won every previous round advance.
It is easy to make past events look inevitable and predictable by pointing to prior indicators. But that misleads us into thinking that events are more predictable and less random than they really are. Those engaging in hindsight bias are ignoring indicators they would not have known to ignore had they tried to predict the event in question before it happened.
You can choose a variety of economic activities. Some, like speculating on stocks or real estate, are random. In those, skill is irrelevant. Although you can have skill at, say, property management, you cannot have it at predicting local appreciation rates, which is almost all that matters if you are a buy-and-hope-it-goes-up investor.
On the other hand, other economic activities, like selling real estate as an agent, turn on skill. The unskilled property owner may profit from all properties in the area appreciating, but the unskilled real estate agent will starve in almost any market.
Taleb complains that we often reverse cause and effect. For example, he condemns the book the Millionaire Mind for saying that since millionaires seem to be disproportionately diligent and persistent, diligence and persistence makes you a millionaire.
The correct conclusion is more along the lines of not all persistent, diligent people become millionaires but your chances are increased if you have those qualities and are pursuing financial success in a non-random field.
The Millionaire Mind author also found that millionaires had a higher willingness to take risks. Taleb argues, and I suspect he is right, that a similar study of bankrupt people probably would have found an equal or higher incidence of willingness to take risks.
Another Taleb observation is that journalism is pure entertainment and not a search for truth as the journalists so self-righteously proclaim. It certainly is heading that way, but there are still journalists who are trying to find the truth.
Skill is the ability to forecast and/or cause certain results. Skill does not require 100% accuracy in either forecasting or causation. But it does require greater than 50% accuracy or intended results.
Good auto mechanics are skilled. They cause cars that are not working to resume working. The fact that they sometimes initially misdiagnose a problem does not prove that they are unskilled, only that their skill has room for improvement.
Good weathermen are skilled. Their predictions for the next five days are accurate more often than not, more than random forecasts based on nothing would be accurate.
Contrast that with proud, “successful” real estate investors. They typically claim they knew the values were going to go up. Fine. Ask them to predict prices for the next five years. They will go squishy. They did not know what was going to happen in the recent past. They hoped. Things turned out favorably, but there was no skill, just a big risk that could have gone the other way.
Taleb’s main point appears to be that we should protect ourselves against rare events that would be catastrophic to us. The more common behavior is to rely on the rareness of the event for protection. But that is no protection at all.
Katrina was rare, but that is small comfort to the dead or those who lost their home equity. Rather than rely on the rarity of such events, the residents of the area at risk of such hurricane damage should have either not lived there or had insurance or had structures that could withstand the hurricane.
Do we have rare events that are catastrophic in real estate? You bet. I have seen a number of them in my life:
And those are just the events during my life. Before I was born we had world wars, Depression, the Civil War. Taleb’s point is stuff happens and you need to protect yourself from the big possible, not just the common.
Taleb says to stop assuming these sorts of things will probably not occur. You have no idea whether they are imminently probable or improbable. The fact that something has not happened for a while is either irrelevant, or in some cases like earthquakes, may indicate an increased probability.
Forget the rareness or probability. Just protect yourself from them.
This is the way intelligent people use insurance. You insure from the top down. That is, you first insure against the disaster that you cannot afford. The last thing you insure, if ever, is the little stuff that you can afford. That is why high deductibles make sense. They lower your premium, but they let you cover the big stuff that you cannot handle.
With insurance, people tend to get it right. But with investments and other aspects of life, they essentially go naked insurancewise.
One of the surprising things I learned at Harvard Business School was that finance and insurance are two sides of the same coin. Investors need to take the same top-down approach to protecting themselves against investment risks as they do fire and liability. To quote Taleb, “…it does not matter how frequently something succeeds if failure is too costly to bear.”
Taleb is a trader. That is, he buys and sells stuff on Wall Street. He claims to be and knows and admires traders who play that game in such a way that they cannot “blow up”—his expression for losing everything, including their trading jobs. And he describes many he has known who were big “successes” for a number of years before they “blew up.”
As you would expect, the guys who blow up put themselves in a position where they can win or lose big. The guys who do not blow up forego the opportunity to win big so they can immunize themselves against losing big. Roughly speaking, this is a tortoise and hare comparison in the sense of, “slow and steady wins the race.”
“Characteristically, blown-up traders think that they knew enough about the world to reject the possibility of the adverse event taking place,” says Taleb. That sounds like a bunch of real estate investors with whom I have had arguments during real estate booms.
One of the traders Taleb points to as the right kind averages a million dollars a year income. Where does he personally invest? Nowhere but savings accounts and treasure bonds.
I was a fairly big success from 1969 to 1984, then I “blew up” in Texas losing $750,000 which was all the money I had made in rental properties until then. The blow up was caused by the oil glut, s&l overbuilding debacle, and the Tax Reform Act of 1986. My mistake was assuming no such thing could happen and putting myself in a position where I would be hurt if it did.
Taleb advocates neither maximizing income nor minimizing risk. Rather, his is a sort of insurance deductible mentality. I will accept some limited losses in order to get some limited wins, but I will not accept the risk of catastrophic losses to have a chance at spectacular wins.
Here is another passage where Taleb is describing the trader he admires.
Nero believes that risk-conscious hard work and discipline can lead someone to achieve a comfortable life with a very high probability. Beyond that, it is all randomness…Mild success can be explainable by skills and labor. Wild success is attributable to variance.
Actually, I disagree a little. In my Succeeding book, I said that in order to make it big financially, you need some sort of multiplier. Real estate investors would immediately say, “Like leverage?” No. Not like leverage. Leverage amplifies outcomes both good and bad. That is the opposite of what I mean.
Rather, I am talking about multipliers like the printing press, the Internet, and factory machines that mass produce widgets or copies of Microsoft Windows (the richest man in the world’s multiplier) and so forth.
If you just sell your time, like a lawyer or a doctor, you can make a lot but only so much. If, however, you are a doctor who writes a popular book, you can make a ton because the printing press can crank out more low-cost copies of the work without your spending any more of your time. To state it in MBA terms, a multiplier is a device that produces significant numbers of incremental copies at a relatively low variable cost.
For all his understanding of statistics and trading, Taleb needs to get out more before he pontificates on all the ways there are to make money. Bill Gates never took any big risk.
As others have, including me, Taleb says people should be judged by their decisions, not their results. The old saying, “You can’t argue with results,” is dead wrong. It would mean that lottery winners are financial geniuses. One of the main points of Taleb’s book is that most big winners in the investment sense of that phrase were just “lucky.”
Taleb condemns many journalists who write about financial matters, but not all. I think he’s right about them. He says they get paid to get your attention. “Like the lawyer…who does not care about the truth, but about arguments that can sway a jury whose intellectual defects he knows intimately, journalism goes to what can capture our attention…”
Real estate investors need to remember that when reading the mainstream media articles on real estate. The media is not interested in the truth unless it happens to sell papers or get ratings. Generally, it does not. While they do not tell lies, they can always find someone to give them a spectacular quote to fit some spectacular, pre-conceived story line. They lie and mislead by what they include and what they leave out.
I recommend that you read Fooled by Randomness although it is somewhat difficult.
My general conclusion from it and my own knowledge is that you should pursue a financial strategy that has profit opportunities, but limited downside. Generally that will limit upside, but not eliminate it.
To make big bucks, you need to acquire and apply skill to a situation where the numbers are big (e.g., commission selling of big-ticket items) or where there is a multiplier of your efforts. Taking big risks is not the only route to making big bucks. It is the only route to losing big bucks. JTR