Buddies, Black Swans & Buckets
By Josh J. Miles
I
Daniel Kahneman and his long-time associate, Amos Tversky are credited with creating the study of behavioral economics. Michael Lewis writes about this unlikely pair of Nobel Prize winners in his book, The Undoing Project. “Unlikely” because their collaboration paired a classically trained psychologist (Kahneman) and an economist (Tversky) which produced some of the most influential work in economics over the past five decades including the idea of “prospect theory.” Prospect theory helps us understand why we place different values on losses and gains, and thus users make decisions based on perceived gains instead of perceived losses. For example, most people prefer winning $50 with certainty rather than taking a risky bet in which they can toss a coin and either win $100 or nothing.
Daniel Kahneman won the Nobel Prize for Economics (2002) after his long-time collaborator, Tversky, passed. Kahneman credits his fascination with psychology to an event early in his life as told in his biography for the Nobel Prize Foundation: “In one experience I remember vividly, there was a rich range of shades. It must have been late 1941 or early 1942. Jews were required to wear the Star of David and to obey a 6 p.m. curfew. I had gone to play with a Christian friend and had stayed too late. I turned my brown sweater inside out to walk the few blocks home. As I was walking down an empty street, I saw a German soldier approaching. He was wearing the black uniform that I had been told to fear more than others – the one worn by specially recruited SS soldiers. As I came closer to him, trying to walk fast, I noticed that he was looking at me intently. Then he beckoned me over, picked me up, and hugged me. I was terrified that he would notice the star inside my sweater. He was speaking to me with great emotion, in German. When he put me down, he opened his wallet, showed me a picture of a boy, and gave me some money. I went home more certain than ever that my mother was right: people were endlessly complicated and interesting.”1
It was this experience that helped Kahneman understand that the theory of the rational person, which up to the point of their groundbreaking research, was thought to be the standard by which financial decisions would be made. Investing, for example, cannot be distilled down the rational decision. Investing is NOT a math equation to be solved. 2 + 2 is 4 for a trust funder, just as it is for a working single mother. However, a good risk for one may be a terrible risk for the other. Most financial decisions are made by people, not by a spreadsheet. Kahneman’s brush with the SS soldier helped him understand we are all people, walking this world and seeing it through the eyes of our own collective experiences and then making decisions based on what we believe to be true.
II
Speaking of risks, this is the fundamental question we are tasked with managing as we work with each of you. How can we balance the tension between having enough savings to live in the moment while also being confident in our ability to reach our long-term goals? This gets to the fundamental reason for investing – to provide freedom and independence, to do what you want, when you want – without the worry of risking your or your family’s long-term well-being.
Morgan Housel, author of The Psychology of Money, borrowing from the work of Kahneman and Tversky was recently quoted as saying, “we should not aim to be rational, because people are not rational. The goal should be to be reasonable.”
That brings me to the work of Nassim Nicholas Taleb. For years, Taleb has studied how we fool ourselves into thinking we know more than we actually do. We restrict our thinking to the irrelevant and inconsequential, (think; what is the Fed going to do? Or what is today’s consumer sentiment number?) while large events continue to surprise us and shape our world. In his revelatory book The Black Swan, Taleb explains everything we know about what we don’t know. He calls these risks of the unknown or unknowable – a black swan.
A black swan is a highly improbable event with three principal characteristics: It is unpredictable; it carries a massive impact; and, after the fact, we concoct an explanation that makes it appear less random, and more predictable, than it was. The astonishing success of Google was a black swan; so was 9/11. For Taleb, black swans underlie almost everything about our world, from the rise of religions to events in our own personal lives.2Why do we not acknowledge the phenomenon of black swans until after they occur? Part of the answer, according to Taleb, is that humans are hardwired to learn specifics when they should be focused on generalities. We concentrate on things we already know and time and time again fail to take into consideration what we don’t know. We are, therefore, unable to truly estimate opportunities, too vulnerable to the impulse to simplify, narrate, and categorize, and not open enough to rewarding those who can imagine the “impossible.”
Kahneman simplifies this idea by saying, “When you are surprised, the correct lesson is the world is surprising.”
III
As students of behavioral finance and students of market history, we have developed a discipline that anticipates black swan events and more importantly, the impact those events have on our psyche (and often, our behavior). We have lived through the Dot.com bubble and crash, 9/11, the Great Financial Crisis and the global COVID pandemic. True to the definition of a black swan as described by Taleb, we can concoct an explanation to make those events seem less random, if not predictable, but the reasonable conclusion for us has been to build a strategy to help our clients through these events.
We call that discipline our “Bucket Discipline.” Essentially, we allocate assets based on when you need your money. In this discipline, we set aside 3 to 5 years of expected outflows from your portfolio in preservation strategies where the focus is to ensure you have the dollars you need – when you need them – without having experienced a loss. Once we have those goals addressed, we can then work on prudently growing the longer-term assets that will be available to harvest for longer-term goals or to simply grow your legacy.
For those of you we already work with, we are 20 months into this recent downturn. History suggests that downturns of -20% to -30% (which would include this downturn) average about 2 years and 3 months to fully recover.3 Now we are not assuming we will back to new highs by the first quarter of 2024, but it is as good a guess as any other prognostication. The key is, we have the cash set aside to make sure you can take the trip or replace the roof we planned for back in 2021 because it is still sitting in your 0-3 year bucket and your cash is finally earning you interest while it waits to fulfill your goals!
As always, we welcome your thoughts, comments or questions. In the meantime, we hope you all enjoy what is left of summer!
Best Regards,
Notes:
- https://www.nobelprize.org/prizes/economic-sciences/2002/kahneman/biographical/
- https://www.amazon.com/Black-Swan-Improbable-Robustness-Fragility/dp/081297381X
- Source: Factset, Dow Jones 12/31/2021. Graphic: Invesco – Compelling Wealth Management Conversations 2022
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