How we can thrive amidst volatility and not become complacent due to a false sense of stability.
In this episode, you’ll learn:
- What is the extended disorder family.
- What does fragile and its opposite mean.
- What does it mean to be fragile and antifragile.
- What is the danger of supressing volatility.
- Why it is easier to distinguish the signal from the noise if we measure less frequently.
- What is optionality.
- Why trying to predict the future is a sign of fragility.
- Why we need to be emotionally resilient.
Welcome to Money For The Rest of Us, a personal financial show on money. How it works, how to invest it and how to live without worrying about it. I’m your host David Stein and today is episode 56, it’s titled, “Why we need volatility.”
Last week episode 55 I discussed being fragile or it’s opposite, antifragile. And the term antifragile and the concept was developed by Nassim Nicholas Taleb. He introduced it in his book by the same name Antifragile, Things That Gain from Disorder. And Nassim has what he calls the extended disorder family, and here are things that would be similar to volatility or disorder, and here’s his list.
Uncertainty, variability, imperfect, incomplete knowledge, chance, chaos, volatility, disorder, entropy, time, the unknown, randomness, turmoil, stressors, error, dispersions of outcome. All those lumped together. When we read that it sounds like, “Why would we want that?” “Why would we even need that?” And that’s what I want to talk about today, how we can gain from volatility, from disorder, variability, and even error. But just as a refresher, fragile, as I defined last week, means that harm to you accelerates as bad things happen.
Examples of Fragility
And an example I gave was, if your income fell 20%, or you got a 20% raise, those are the two opposites. Compare what your lifestyle, how it would be impacted if you had that 20% cut or 20% raise. For most of us, the 20% cut would actually harm us more than the benefits we would get from the 20% raise. But then if we had a 50% cut in income, the harm would not be linear, it would not be twice as bad as a 20% cut, it would be even worse. It would be non-linear, because at that point we might not be able to pay hardly any of our bills, and we would be forced to file bankruptcy.
I gave the example of the investment manager that was shorting volatility. And so he wanted stability, needed stability in terms of the options strategies he was using, and I won’t go into the detail because I did last week. But the point was, as volatility picked up in the stock market, his harm to his firm accelerated to such a degree that he blew up the company. And they lost all their clients, and his livelihood and had to go do something else. And so that’s what fragile is, the harm accelerates.
We have what is known as negative asymmetry. The downside is way worse than the upside. I also gave the example of when I was a dishwasher, the champagne glasses with the narrow necks and delicate sides. And how when I was too volatile with them and putting them in the racks, the glass racks before shoving them in the dishwasher, they would break. And I broke a number of them until I realized that champagne glasses wanted stability. They were in finance parlance, short volatility. They needed that, whereas we want to be long volatility, and I’ll share why.
Examples of Antifragility
Now something that was antifragile was the conifer, and how the conifer takes the … can live anywhere, but tends to retreat to less vibrant, less fertile soil. Rocky cliffs, just away, and they let the faster growing angiosperms deciduous trees have the prime ground, and then at some point those angiosperms overproduce, and a forest fire comes through wipes out, and then some of those conifers have pine cones that are coated with resin that don’t even germinate till they’ve been burned a little bit, and their resin’s been burned off, and then they can germinate.
And the some of the seeds blow over within the fire, and then they take advantage of the newly burnt ground, and that stimulates those conifers. That’s antifragile. The more volatility, the more fires, the more conifers can thrive. They need that to thrive. But what about, often times back maybe 50, 60 years ago, naturalists tried to … I live in the west where forest fires can be quite common. The idea was to suppress forest fires, and there is still some suppression. In other words, we don’t clear the underbrush, we just let the this tinder, this fire material continue to grow. And if you suppress the land so you don’t have these natural fires, when they actually come they’re huge and much more severe than they would be otherwise.
The Need For Volatility
The same thing occurs in the financial markets. We need volatility. Think about if financial volatility was suppressed, and some would argue that central banks, the Federal Reserve has tried to suppress volatility. They’re always stepping in, and when market selloff significantly, often times they’ll try to stem the panic. But what if markets were completely stable all the time, and there was some mechanism that you could suppress all that volatility? Well what would happen then, if … And Taleb points this out in his book. That if it was completely stable, whenever there was just a little bit of volatility, people would panic, because they would think it was the end of the world. And so that would … if we’re so used to stability, what happens is it hides the hidden risk, and then we tend to overreact when something little happens.
Whereas, if you have day to day volatility in the stock market, nobody really knows is this the beginning of a major sell off, or is this the beginning of a strong bear market. It’s more dynamic. Everyone is on their toes, and so you don’t have necessarily the front running, because there’s this natural volatility, much of which is just noise. And one of the keys to investing is trying to figure out, what is a signal and what is noise? And that is very, very difficult to figure out. And that’s one reason that I do a monthly review of investment conditions, and I don’t do a daily review of investment conditions because, when you have a great deal of noise and not so much signal. And then you have a great deal of data, the more you look at it the more you’re exposed to noise, and the more you jump to conclusions.
Whereas I formally look at markets valuations, I look at economic trends, I look at market internals once a month. And so I’m looking at this 12 times a year. And then if there’s a big change in data from one month to the next, that signals to me potential signal and I need to adjust for that. And so, the world is full of all this noise and volatilities, we’re looking for the signals and then react. And sometimes it’s easier to do that if you’re not looking at it every day, for your investments. Don’t look at them every day, sometimes it’s just good to wait and look at them weekly or look at them monthly.
Now another example of being overly stable or stability hiding risk, is the difference between being employed and self employed. Think about a taxi driver that is self-employed, every day they have to go out and find new fares, and they can go anywhere. I’ve always been fascinating by taxi drivers, particularly because I used to fly a lot, and I’d see these taxi drivers that waited for hours in the airport just for the fare to drive, and make $40 to drive into the city. And I remember talking to one taxi driver in the city, and said, “Well why don’t you …” I asked him, “How your day’s going?” He said, “Well it’s been kind of slow.” And I said, “Well why don’t you go out to the airport and wait for a fare there?” And he says, it’s just not economical for him.
“I can make more money even on a slow day moving around and just taking people short distances, rather than the stability perhaps or the lengthy time of waiting at the airport for a fare.” But taxi drivers are self-employed, their income can vary day to day, yet unlike somebody that’s employed that has very stable income, they are fragile in that they could be fired and then their income completely wiped out. So what would be better, to have more variable income where it’s a little more dynamic or to have steady income, where you’re at risk any day to being laid off?
Now it depends on your situation, but at it’s surface it would be better to have the more variable plan. Now that’s … There’s certainly other emotional elements to self employment that … And I’m not saying self employment is better than employment, just that when you are employed, it’s better to have some type of buffer, redundancies, overcompensation such as savings, not having much debt, living well below ones means. So if the time comes that you get laid off, you’re not completely decimated. So you have to … If you’re in a more stable environment, you have to build greater redundancies and overcompensation.
I remember being employed back when I first started at the investment advisory firm when I was hired. And I would … been there about a year, I was working as an analyst, but I was also going out and meeting with endowment clients. And I’d been there about a year and a half. So in my first six months I got a small raise, but I had taken a pretty big pay cut to join this firm, because I was in corporate finance, I wanted to get into investing. I took about a … I think it was roughly a 30 to 40% pay cut to join this company. And they had led me to believe that I was going to get some significant raises if I had done well.
The first six months went by, I knew I was new so I wasn’t expecting a large raise. The next year I felt I had worked really, really hard and I was meeting with clients. I wasn’t bringing in new clients yet, but I just felt like I was no longer an analyst, I was more like a consultant. And I waited for my raise, and the woman that I worked with, a consultant I work with who’s based in Dallas, and so she wasn’t there to necessarily give me a formal review. And it was sort of the year pass, and it was January. I said, “Well what’s my raise?”
Well finally our CFO, our controller came in and just handed a slip of paper in a envelope. I open it up, like this is my raise. I’m expecting 10, $15,000 raise. I think I was making 40,000 at the time, and I looked at the paper and it was $1,500 increase in salary. And I realized that I was financially vulnerable here, because I didn’t control my destiny. And I made the decision right then, I’m leaving. I’m going to go … I’ve been here a year and a half, I know enough about investing. I can go start my own firm, and I started the process. We were going to move out west, and I was going to star my own company.
Well two months later the consultant I worked for in Dallas, and another one of our senior consultants left to start their own company. And that was such an eye opener to the founders of my firm, that they realized how financially fragile they were, and then at that point they wanted to do anything they could to keep that second line there. And so they … I remember the founder talking to me and saying, “Call me at my house.” which was shocking to me. He called me in the evening at my home, and said, “What can I do to get you to stay?”
And I said, “Well, I need more money and I want to move back west too …” Well not back west. Move to Idaho where my father-in-law had just passed away, and my wife wanted to move back to where her family was. And he gave it to me, he said, “Yeah, whenever you want we can work it out. Here’s your raise.” And we didn’t move for several years, but in a couple of years later I became a partner, and was on our management committee. And I realized that I just didn’t want to be in the situation where somebody could say, “Here’s your raise,” and not necessarily knowing what I had done or the contribution I make.
Because when you’re running a firm you have 30, 40 employees it’s hard to say, well who’s doing what? So I developed the compensation plan for our consultants that were out servicing clients and bringing in clients that was tied directly to the revenue. You got X% of revenue for each of your clients, and if you sourced the sale and built a relationship you got a higher percent. If it was through our firm’s marketing efforts you got a lower percent. And that was something that is still in place.
I got my partners to adopt it, and so then when I moved out west, even though the compensation plan was more variable, it was actually more robust. So you had more volatility but you had more control because you could control your destiny better. You weren’t tied to the opinions of someone else that might be right or wrong, it was very transparent. Here’s what you make based on what you did. At the same time we introduced client surveys. We hired somebody to just call up clients all the time, and ask them, “How’s your consultant doing? Give us feedback.”
And so there was another mechanism, a qualitative mechanism to assess consultants. So between that and the revenue, that’s how they were paid. It was a much more variable but dynamic way to compensate an employee. So being self employed is more antifragile than being employed. But if you are employed, there’s ways to structure your compensation to become more like your self-employed, and essentially be like an entrepreneur within a company, and be very highly valuable. And if you are very, very skilled you always have the option to leave. And that is another dynamic or aspect of being antifragile.
If you’re antifragile, you have options. And I gave a definition of option last week. In fact I misspoke, I said option is … Well an option is a right but not the obligation to buy something or to act in a specific way. I think I said an option is a right but not the option. That’s not it. It’s … option is a right, but not the obligation to move forward. When you are good at what you do, at your job you have options. And I’ve always … I remember when I first started that job I’d ride the elevator, and I would see the employees, essentially clerks in their early 50s working for the bank that was in their same building.
And I would listen to their conversation, they would complain about their jobs. And I remember distinctly saying, “I don’t want to be in that position when I’m at that age. I don’t want to be that financially fragile. I want to …” I didn’t use those terms, but I just … In my gut I said, “I don’t want that vulnerability at that age.” And so there’s ways to structure life so that you have those options, because optionality is very very important. The more options you have, the more antifragile you are. If we’re traveling next week into Norway. We’re traveling by car within the country instead of by train. One reason we’re doing that, is cars are … It turns out to be cheaper to rent a car, but you have more options when you travel in a car, because you can go different places. Which means you don’t need as much information in terms of when you make the decision.
We can make many of our decisions once we’re there, because we have the option of a car. So optionality is very very important. In fact with options Taleb points out, that you’re less concerned about the average outcome, only about the favorable outcomes. Because when you have an option, you’re protected against the downside, because you don’t have to act. You can choose to act if you have the option, and you can always choose the more favorable outcome. An example is, I was biking the other day and I’m kind of a slow biker these days. And so I got caught up by an acquaintance that … We weren’t even biking together, he just kind of came up and caught me, because we were on a hill.
And so we bike together for the next hour, and he talked about some of his experiences investing and buying individual stocks, how someone worked out and some hadn’t. Well he works in the potato business, and what he started doing is he noticed that the chemical companies are used in agriculture or in growing potatoes would drop their prices at a certain time of the year, because these chemical companies would need to raise cash. And so this man said, “Well I have an option. Why don’t I just buy this chemical when it’s cheap, and then I’ll just stockpile it, and then sell it when the price goes up. He has optionality.
So he buys his cheap, but then has the option to either keep it for a longer period time or to sell it at the right time. And he does it in such a way, its worst case scenario, if the price stays down, he eventually will be able to sell, because he uses it for his clients. So he has the optionality. Now there are financial options, derivatives securities such as puts and calls, that when we traditionally think of options, they’re certainly available. But because so many people are aware of them they can be very expensive, the premiums can be high versus the benefits you get.
Sometimes they’re helpful, but sometimes because everybody believes the market’s going to fall, the price for puts to protect against falling stock market can be quite high. The best options are those that are free. And so I’ve really tried as I look at my life find all the options that I have, that are that are free that I can take advantage of. Another aspect of being fragile are those that rely on prediction, in terms of their ability to predict the future and their livelihood is based on that.
Many of those in the financial industry it’s based on prediction, their ability to see what’s going to happen in the future. When we invest we don’t want to have our success as investors to be based on prediction. Because one, we could be wrong. There’s errors in our model, and sometimes when we’re right because we’ve used a model or prediction we tend to be overconfident. I recall back in the mid ’90s long term capital was a hedge fund created by John Meriwether, Myron Scholes and Robert Merton, they were … Scholes and Merton were academics, Nobel Prize laureates, and they were going to use the models they had created, highly leveraged. Remember leverage is definitely a sign of being fragile, but very much dependent on predictions, and they were wrong, and their models didn’t work.
And they realized there were linkages between their different bets that they made that compound it during the Asian crisis. I think this was in ’97 and ’98, and the Federal Reserve had to come in and bail them out, because there was such systemic risk. They had gotten too big to fail. Being very, very big and large, and making top down decisions is very, very fragile, and can lead to catastrophic outcomes. It is better to be bottom up. And it’s better to not have your errors linked to each other. You want to make … We want to go into a period of always trial and error. I mean that is a sign of being antifragile. You are trying thing, taking advantage of randomness, taking advantage of the chaos, experimenting but then keeping your error small, and making sure that one error isn’t linked to another, doing independent test.
I recall a book I read by Karl Popper called Objective Knowledge. And he says the method of science, is a method of bold conjectures and ingenious and severe attempts to refute them. What he’s saying is, we come up with a theory and we don’t know if a theory is right or not, but we do everything we can to disapprove our theory, to find errors, to find the mistakes. And then, if we’re objective, we’ll learn from them and then that will help us with our next thing. But the idea is to keep tinkering, keep trial and error. And then taking what we know, and building on it, and learning and little by little that’s how you learn, that’s how you pick up a language.
You don’t pick up the language by just studying it in a book, you actually go to the country, and you make mistakes. And you get into situations where you just … your desire is to communicate, and you’re willing to make the mistakes and that’s how you pick up a language. It’s the small errors, none of which are catastrophic. So one other aspect of being antifragile, is emotional resilience. It’s this idea, it’s sometimes related to Stoicism. It’s realizing that things might not go well. You might lose an investing or a new business venture, a small business venture might run into problems, or I’ve mentioned in the past some situations with our farm and how they’ve opened up a gravel pit across the road, and that’s caused us some financial heartache, because potentially our farm value is impaired.
One way I’ve dealt with that, is I originally said I was going to sell it, and then we decided, “No, why sell it? Let’s wait until the next bubble, and in the meantime enjoy it. And we’ll continue to deal with the gravel issue, we’ll deal with the county and figure it out.” But sometimes procrastinating is very antifragile, because it continues … your options are always in place. We have the option to sell anytime we want, but we can also delay that and enjoy the farm. We don’t need the money, and it’s just this equity that we have, and in the meantime we’ll enjoy it.” But at the same time I’ve accepted the fact that maybe it went down in value. In other words I’ve already accepted a potential loss. I haven’t realized it, but I have emotionally excepted it, I’ve written it off. And so if we do sell, and we don’t make as much money as we thought or we lose some, that’s okay. Because I’ve already written it off.
So part of being antifragile, is being emotionally resilient. It’s in our mind, sort of writing things off, realizing that if things don’t work out, we can still survive. So to be antifragile is to look for optionality, where you’re protected against the downside but you have the option to partake of the upside. To be antifragile is to be emotionally resilient. To recognize that things might not always workout, but you’ve already accepted that fact and you’re prepared for it. To be antifragile is to worry much more about your exposure to bad outcomes, and try to do everything you can through overcompensation, through redundancy, through savings, through low debt levels, through living below your means to protect against the downside.
Because then you can welcome volatility and variability, because then you can use your option to capture the upside. To be antifragile is to be always involved in little experiments. Trials and errors. Learning from your mistakes, but being pleasantly surprised and capturing those unexpected consequences of things you just didn’t realize, simply because you’re trying new things and then you learn, and you grow and you benefit from the randomness and the sheer unpredictability of the world.
We need volatility in our lives, we don’t want fake stability. Some stability is nice, but if it’s stability that is artificial, and is really hiding below its surface potential risk, that is not the type of stability that we want.
So that’s episode 56.