Personal Finance and The Black Swan

black swanRecently, I’ve been reading Nassim Nicholas Taleb’s book The Black Swan. Most of the book has to do with economics and mathematics and is not very relevant to personal finance at all, so I won’t bother doing a detailed review here. However, there are two pieces of the book that I think are worth talking about, so let’s dig in.

The Black Swan and Your Emergency Fund
The basic premise of The Black Swan seems like common sense: life is full of unexpected events. Big ones (like, say, 9/11), medium sized ones (like, say, a career shift), and small ones (like, say, your daughter wetting her pants just before you’re about to leave on an errand).

The Black Swan argues that our minds use a lot of tricks to hide these so-called “black swans” (his term for largely unpredictable and rare events) from us. We need to see the future as at least somewhat predictable, or else we wouldn’t bother making many plans at all. So, when we reflect on our past, it seems much more orderly than it actually was. Also, when we think about the future, we imagine something much more orderly than what will happen.

This idea makes a lot of intuitive sense to me. I know that quite often, when I think about the past, it does seem like an orderly progression of things. However, when I look at old diary entries and old videos, I see that there were actually a lot of “black swans” floating around. I didn’t see The Simple Dollar’s success coming at all, for one. When I went to college, I didn’t see myself working for a slightly eccentric German fellow who would basically set up my first career for me and also taught me how to pack effectively for business travel – he was a black swan.

Given that, I think there are a lot of things one can do in their own life that will prepare oneself for the arrivals of black swans of all magnitude.

Learn a wide variety of skills. I don’t just mean transferable skills, either. Know how to make things. Know how to build things. These skills will come in handy over and over again, often in unexpected ways.

Live frugally. I believe that’s one of the underlying messages here – frugality is a great economic and personal advantage. Knowing how to always maximize one’s resources makes one much more able to survive great changes in life – and also gives the person the ability to build up resources (as mentioned below).

Minimize your future costs. If you can use your money now to invest in things that will reduce your costs in the future, do it. The fewer resources required in the future to maintain your way of life means that fewer “black swans” can disrupt you.

Have a large, stable emergency fund. Having a large amount of cash reserves makes it possible for you to ride right through any small and medium-sized “black swans.” Your car unexpectedly dies? Not a problem. A career opportunity comes up? You can jump at it. You lose your job? Not the end of the world.

Have a good “opportunity” fund, too. Sometimes the unexpected comes along and it requires you to have resources. For example, there’s a large chunk of land near our house for sale. If it suddenly makes a nice drop in price, I’ll jump on it. If I happen to see the owner sometime soon, I may negotiate. It’s been up for sale for quite a while, so something nice may happen soon – not quite a black swan, but a good example. A real “black swan” might be that a neighbor is in a pinch and puts a sign on his car that says “$5,000 or best offer” and you can walk over there with $3,000 in cash, snipe it, then resell it for $5,000 with some footwork.

In short, keep some resources at hand, make yourself more useful, and minimize what you’ll need in the future.

The Black Swan and Investing
One particularly interesting point in The Black Swan comes when Taleb briefly discusses investing. His suggested portfolio for taking advantage of black swans is very unusual, yet it makes some sense.

He advocates putting 85-90% of your investment money into something extremely stable, like treasury notes. The other 10-15%, invest it in the riskiest things you can find – things where a black swan might make it go crazy.

So, let’s translate that into dollars. You have $10,000 to invest. You put $8,500 of it into treasury notes, which return 2% annually. You put the other $1,500 into Bangladeshi startups (for example).

At the end of the year, even if you lose all of the Bangladeshi money, you still have $8,670 – your total loss is only 13.3%. On the other hand, let’s say that your Bangladeshi startup goes bonkers and you get a 900% return on that investment, turning $1,500 into $15,000. You now have $23,670 – a 136.7% return.

Basically, Taleb’s argument is that, as I mentioned above, there are many more black swans out there than we initially believe there are, so one should take them for a ride without too much exposure to risk.

My feeling is this – if you have enough risk tolerance in your investments to put them into stocks, there’s some logic in using Taleb’s investment ideas. It puts a floor on the worst case scenario and gives a lot of upside.

Much of the rest of The Black Swan suffers from the same condition that befalls Taleb’s other books – lots of good ideas, but also lots of ego and self-congratulation. It’s thought provoking, but at times you want to go wash your hands.

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