Updated on 06.02.09

Personal Finance and The Black Swan

Trent Hamm

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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  1. Michael says:

    How likely is a “Black Swan” to disrupt the Treasuries?

  2. Yeah, Taleb’s ego is enormous–too large to get past sometimes.

    While his method of investing is certainly not for me, I do find it quite fascinating–and could see how it would be successful.

    In Fooled by Randomness he explains what, specifically, he does with the high risk portion of his portfolio: He buys puts that are very far out of the money (and as such are very inexpensive). He loses money almost all the time, but when he makes a profit, it’s huge.

    Again, certainly not for me. But very intriguing.

  3. sheehan alam says:

    great post, though I won’t be following it, we must be prepared for risky events that are beyond our own control.

    funny that you mentioned investing money into Bangladeshi startups lol, I am a Bengali-American working on my startup TweetyStock – a financial application for your iPhone. Follow me at http://www.twitter.com/tweetystockapp

  4. Ankit says:

    Interesting ideas. Especially whole investing idea. Also, the past looking orderly , and future being orderly but it is not.I will be looking for black swans!

  5. mike says:

    He was on CNBC this morning. I didn’t catch all of it. He was trying to explain about forcast and that most of the tir they are wrong.

    My black swan is energy. I’m into an alt-energy fund.

  6. Taleb certainly has developed a cultish following on the back of this book.
    However, there have been some rumblings recently about whether or not his investment history has been as successful as his books make out (see the Clusterstock website for more).
    Anyway, I did write an article on my own blog about Taleb’s own 10 rules to “Black Swan Proof” the world – there is more of a macro focus to them than in the article above. I even took the liberty of adding an 11th rule of my own!

  7. eMoneyLog says:

    I like your example of investing the 85-90% of money in safe investments and the remaining in a very risky one. I have personally been thinking of such a line of investing but have never identified the other sources of investments. I guess I have to look harder of may be i might be neglecting some of those investments. I will be on the watch out for some identifiable risky but potentially investments where the black swan phenomenon can occur. One which comes to mind is the stocks of the company that have recently been hammered if one could split the investment across a few firms there is better chance that one would recover to a great extent

  8. Charlie says:

    Ah the black swan. I think they’ve been mating in my backyard. The first part of your article really resonated with me. Had a couple of significant black swans today where I had to do a $3000 plumbing repair at one rental unit and then was told that a new rental unit was uninsurable till I put on a new roof, fixed the concrete walkway and driveway and fixed the structure of the detached garage. Having a terrific emergency fund and living frugally have made this situation not necessarily palatable, but manageable.

    I don’t really understand Taleb’s investment theory. If you lose all your money on the risky stock, are you expected to rebalance and try 15% in another risky stock? Seems like if you go on an unlucky streak, you’ll go through a large chunk of your money in no time. Of course, thanks to the half-life phenomenom, you’ll never go flat broke.

  9. KC says:

    I read this book and Fooled By Randomness. Both were interesting. I think his investing theory would be fun, but not sure I’d subscribe to it. Besides I get 2% from my bank, why would I go with Treasuries? Anyway it was an interesting read and certainly made more more aware that crazy things can happen. In fact when I look back on life I’ve had my share of black swans. I pride myself on being able to predict things and I do a good job, but then some things will just blindside you – I’m particularly referring to my career, but this can apply anywhere in life. Certainly this book will make you change the way you think about “history” and patterns.

  10. Quatrefoil says:

    I’m amused by this – where I come from (Australia) black swans are entirely normal and commonplace. The white ones are exotic foreign imports.

  11. JRS says:

    I like your blog and read regularly.

    However, re opportunity fund comment about offering $3000 only for a neighbor’s car that has $5000 or best offer, I find that difficult to swallow. To me that seems like taking advantage of someone else’s misfortune in a big way and doesn’t seem very ‘neighborly’ at all.

  12. Michael says:

    Quatrefoil, Australian black swans are the inspiration for the book’s name. The West thought all swans were white until explorers visited Australia. (It’s very rare that such a discovery is made, so the name doesn’t really make sense, but I guess it sounds nice.)

  13. Marsha says:

    Interesting. I haven’t read the book, but I see the subtitle is “The Impact of the Highly Improbable.” Of course it’s wise not to live on the edge and not have a good financial cushion, but I also don’t know how wise it is to in a sense “plan” for highly improbable events.

    Coming from the Gulf Coast, I see the analogy as building every structure to withstand a category 5 hurricane. Cat 5s almost never happen, and almost never hit land. And it would be outrageously expensive to build everything that strong.

    I have a feeling I’m missing your point, though. Maybe you were just using the “black swan” thing as a jumping off point?

  14. Sierra says:

    fascinating. it sounds like good basic advice for dealing with unexpected events, but I’m not sure about the investment strategy.

  15. ChrisD says:

    Re investment advice, this seems a more extreme version of what in index funds do anyway.

    @ marsha. It’s the same with the snow in the UK. Better to write off two days of snow chaos every 5 years then to invest in mostly unused infrastructure. However, if the unlikely event involves loss of life then you may need to adjust your strategy, e.g. don’t build every house to cope with the Cat 5 hurricane, but build one shelter that everyone could go to such a case.

    However, this is NOT what black swan is about. Black Swan basically says that all finance people assume that events have a normal distribution and plan accordingly. But events are not like this as black swan events can happen much more often that we think. Thus finance people have a deeply flawed model of the world/economy and this leads to them making equally flawed plans and decisions. I think it’s a good read.

    Example. Some casino people got him in to consult to make sure that no gamblers could cheat and rip-off the casino. But the two important problems came entirely outside the casino. 1) the owners daughter was kidnapped and the owner illegally dipped into funds to get the ransom money. 2) the person who was supposed to send forms to the IRS didn’t and they nearly lost their license. You can see the 1) would be covered by a big emergency fund.

    Hence you may not know WHAT will happen, but you can know that SOMETHING will happen.

  16. Kris says:

    So his investment strategy is to slowly lose the majority of your money to inflation and gamble with the rest? I think I’ll pass.

  17. Taleb’s strategy of playing the markets could be replicated easily. One does need nerves of steel in order to implement it however, since in most years you would be losing money. One rare event would make up for all the losses however. In 2008 some of the puts Taleb bought went up 50 times in value.. He does invest 95% of his funds in interest rate instruments and the interest income is being bet.
    I see this as smart betting. The most important thing for option traders is to stay as long as possible in the game. That way they increase their chance of winning.

  18. Bender says:

    To be clear – he doesn’t reccomend just any treasury as your safety fund (he generally speaks about TIPS, he probably has nominal treasuries as well but likely hedges them).

    From and individual investors standpoint – one problem with the strategy is that it is much easier to execute when it is your full time job and you have hundreds of millions to allocate, much more difficult for the non-pro with hundreds of thousands.

  19. jc says:

    I think his ego makes this book hilarious.

    The thorough evisceration of normal-curve abuse in statistics is very powerful. Basically, it doesn’t matter whether the tails are “fat” or “thin”–what matters is that somewhere way out each tail are outcomes that no one wants to imagine.

    Ultimately, neither his investment advice, nor Trent’s valiant efforts to put the main idea into ordinary recommendations really does his argument full justice. Translating Taleb into Rumsfeld/Cheney parlance, a black swan is an “unknown unknown” which by definition cannot be planned for, only ridden out like a perfect storm.

  20. tammy says:

    Get point about how being frugal can keep diasaster at bay. My sister and I were chatting recently and we realized no matter what happened with work and the world, because we are frualists, we would figure things out. Frugality is a mindset as well as a spending ( or not spending) habit!
    I haven’t read this book but honestly, it doesn’t sound like something I might like. I like real, practical advice and applications….like I find at The Simple Dollar!

  21. Mike says:

    Well I’ve had my own Black Swan I guess. And I was right about energy. My power has been out for 16 hrs.

    I guess I should have invested in a generator.

  22. Joe L. says:

    “You’ll never know what we are going to get in life but always remember it’s a box of chocolate” – Forest Gump (paraphrase)

  23. mellisa says:

    Small drops make big ocean, hence any investment in SIP would definitely help people to plan for their retirement.

    Every month you park little amount and dont disturb it till you retire and you would feel the good it does for you


  24. Taleb’s investment idea is very much like Prof. Zvie Bodie’s ‘safe retirement portfolio’:

    95% in TIPS (US Inflation-Protected Treasury Bonds)

    5% in 12 month call options over the stock market

    He argues that this produces a similar result to the increase in the stock market in good years, and limits your total downside to your portfolio to 5% (instead of the recent 40%+) in bad stock market years … AND protects 95% of your portfolio against all inflation risk, to boot!

  25. Cj says:

    This is a really great review – but what are these “wide variety of skills” which one should learn that you were talking about? Please widen it Mr. Trent?

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