Matt Franz : Zealous For Knowledge

How Not To Be A Turkey

Yesterday the Wall Street Journal wrote, “Saudi royal politics have gone from consensual to an unstable blood sport.”

This reminded me of a passage in Nassim Taleb’s The Black Swan:

Likewise, dictatorships that do not appear volatile, like, say, Syria or Saudi Arabia, face a larger risk of chaos than, say, Italy, as the latter has been in a state of continual political turmoil since the second war. I learned about this problem from the finance industry, in which we see “conservative” bankers sitting on a pile of dynamite but fooling themselves because their operations seem dull and lacking in volatility.

Timely right? Actually this book was published in April 2007.

In Antifragile Taleb adds to this idea:

A turkey is fed for a thousand days by a butcher; every day confirms to its staff of analysts that butchers love turkeys “with increased statistical confidence.” The butcher will keep feeding the turkey until a few days before Thanksgiving. Then comes that day when it is really not a very good idea to be a turkey. So with the butcher surprising it, the turkey will have a revision of belief—right when its confidence in the statement that the butcher loves turkeys is maximal and “it is very quiet” and soothingly predictable in the life of the turkey.

We all know “Past performance is not indicative of future results.” But how many people realize past volatility is not indicative of future volatility? Taleb argues that the absence of past volatility makes future volatility more likely.

Some degree of volatility or stress is critical for the long term success of an adaptive system. Consider a suspension bridge. It works because it is in tension. Without tension it falls into the water. It’s the same with politics and markets.

If citizens don’t have a forum for debate, all will appear calm until the day of the revolution. Then there will be an explosion of chaos. The mild chaos you see when reporters and interviewees shout over each other on CNN is the tension in the bridge which keeps us dry. History clearly shows that suppressing volatility does not work for long.

Suppressing market volatility also comes at a cost. If you buy puts every month against an S&P 500 position you will have lower volatility. But you will also have a significantly lower total return. Another example is currency hedging. Over time it’s reasonable to expect changes in most currency pairs to net out. Therefore the purpose of the currency hedge is only to smooth the ride out. But this comes at the cost of commissions, bid/ask spreads, and interest charges. I agree with Buffett when he writes in Berkshire’s 1996 letter “Charlie and I would much rather earn a lumpy 15% over time than a smooth 12%.”

Investors also run into trouble when they assume they can manage short volatility positions. Consider the spectacular rise and fall of Long Term Capital Management, which Michael Lewis wrote about in When Genius Failed. LTCM used huge leverage to make high probability bets. Naturally, these paid off most of the time, and LTCM appeared to be printing money. But then Russia defaulted on its debt. LTCM’s positions showed big losses. There wasn’t enough liquidity for LTCM to control the losses by closing the positions without creating even larger losses. The Fed eventually had to step in with a bailout.

I often wonder what will happen to the low volatility ETFs like USMV and SPLV in the next recession. These ETFs purchase the stocks in the S&P 500 which exhibited the lowest market volatility in the past.

If you’re buying a low volatility ETF, you’re what I’d call a weak hand. You’re probably very sensitive to mark-to-market volatility, which means that when there’s blood in the streets you’re going to sell. The minimum volatility ETFs have rounded up all of these people and put them together on the same boat. When there’s a storm, they’re all going to try to get off at the same time, which is only going to cause the boat to keel over more. I wouldn’t be surprised to see the minimum volatility ETFs exhibit above average volatility in a downturn.

Taleb says “So our mission in life becomes simply ‘how not to be a turkey,’ or, if possible, how to be a turkey in reverse—antifragile.”

Instead of thinking, “I’ve been fed every day for a thousand days and tomorrow will be no different” the turkey should be asking “What incentive does the butcher have for feeding me every day?” By looking past the day to day results and digging into the dynamics that govern the situation, the turkey will have a better grasp of possible future outcomes. The turkey might then realize he’s better off living in the wild with uncertainty over his next meal than a guaranteed meal from a farmer.



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