You Can't Predict Who Will Change the World

Possibly the best article I've seen by Nassim Nicholas Taleb, which discusses the comparative advantages of the United States. One of his most important points is our culture of risk-taking and creativity, as he addresses the most common criticisms of America as a declining power in the age of globalization.

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Before the discovery of Australia, Europeans thought that all swans were white, and it would have been considered completely unreasonable to imagine swans of any other color. The first sighting of a black swan in Australia, where black swans are, in fact, rather common, shattered that notion. The moral of this story is that there are exceptions out there, hidden away from our eyes and imagination, waiting to be discovered by complete accident. What I call a "Black Swan" is an exceptional unpredictable event that, unlike the bird, carries a huge impact.

It's impossible for the editors of Forbes.com to predict who will change the world, because major changes are Black Swans, the result of accidents and luck. But we do know who society's winners will be: those who are prepared to face Black Swans, to be exposed to them, to recognize them when they show up and to rigorously exploit them.

Things, it turns out, are all too often discovered by accident--but we don't see that when we look at history in our rear-view mirrors. The technologies that run the world today (like the Internet, the computer and the laser) are not used in the way intended by those who invented them. Even academics are starting to realize that a considerable component of medical discovery comes from the fringes, where people find what they are not exactly looking for. It is not just that hypertension drugs led to Viagra or that angiogenesis drugs led to the treatment of macular degeneration, but that even discoveries we claim come from research are themselves highly accidental. They are the result of undirected tinkering narrated after the fact, when it is dressed up as controlled research. The high rate of failure in scientific research should be sufficient to convince us of the lack of effectiveness in its design.

If the success rate of directed research is very low, though, it is true that the more we search, the more likely we are to find things "by accident," outside the original plan. Only a disproportionately minute number of discoveries traditionally came from directed academic research. What academia seems more masterful at is public relations and fundraising.

This is good news--for some. Ignore what you were told by your college economics professor and consider the following puzzle. Whenever you hear a snotty European presenting his stereotypes about Americans, he will often describe them as "unintellectual," "uneducated," and "poor in math," because, unlike European schooling, American education is not based on equation drills and memorization.

Yet the person making these statements will likely be addicted to his iPod, wearing a T-shirt and blue jeans, and using Microsoft Word to jot down his "cultural" statements on his Intel-based PC, with some Google searches on the Internet here and there interrupting his composition. If old enough, he might also be using Viagra.

America's primary export, it appears, is trial-and-error, and the innovative knowledge attained in such a way. Trial-and-error has error in it; and most top-down traditional rational and academic environments do not like the fallibility of "error" and the embarrassment of not quite knowing where they're going. The U.S. fosters entrepreneurs and creators, not exam-takers, bureaucrats or, worse, deluded economists. So the perceived weakness of the American pupil in conventional studies is where his or her very strength may lie. The American system of trial and error produces doers: Black Swan-hunting, dream-chasing entrepreneurs, with a tolerance for a certain class of risk-taking and for making plenty of small errors on the road to success or knowledge. This environment also attracts aggressive tinkering foreigners like this author.

Globalization allowed the U.S. to specialize in the creative aspect of things, the risk-taking production of concepts and ideas--that is, the scalable part of production, in which more income can be generated from the same fixed assets through innovation. By exporting jobs, the U.S. has outsourced the less scalable and more linear components of production, assigning them to the citizens of more mathematical and culturally rigid states, who are happy to be paid by the hour to work on other people's ideas.

Let us go one step further. It is high time to recognize that we humans are far better at doing than understanding, and better at tinkering than inventing. But we don't know it. We truly live under the illusion of order believing that planning and forecasting are possible. We are scared of the random, yet we live from its fruits. We are so scared of the random that we create disciplines that try to make sense of the past--but we ultimately fail to understand it, just as we fail to see the future.

The current discourse in economics, for example, is antiquated. American undirected free-enterprise works because it aggressively allows us to capture the randomness of the environment--the cheap Black Swans. This works not just because of competition, and even less because of material incentives. Neither the followers of Adam Smith nor those of Karl Marx seem to be conscious of the prevalence and effect of wild randomness. They are too bathed in enlightenment-style cause-and-effect and cannot accept that skills and payoffs may have nothing to do with one another. Nor can they swallow the argument that it is not necessarily the better technology that wins, but rather, the luckiest one. And, sadly, even those who accept this fundamental uncertainty often fail to see that it is a good thing.

Random tinkering is the path to success. And fortunately, we are increasingly learning to practice it without knowing it--thanks to overconfident entrepreneurs, naive investors, greedy investment bankers, confused scientists and aggressive venture capitalists brought together by the free-market system.

We need more tinkering: Uninhibited, aggressive, proud tinkering. We need to make our own luck. We can be scared and worried about the future, or we can look at it as a collection of happy surprises that lie outside the path of our imagination.

Nassim Nicholas Taleb is an applied statistician and derivatives trader-turned-philosopher, and author of The Black Swan: The Impact of the Highly Improbable.

Crashology 101

In the 2000 stock crash, which began to accelerate in fall of that year, the market bottomed in late 2002. That's about two full years, peak to trough. For the 1973 crash, the market began its slide in January and bottomed out in December of 1974. Again, about two years.

Here is a great Wall Street Journal page on stock crashes in general:

http://online.wsj.com/public/resources/documents/info-StockCrash_0710-14.html

Overall, stock crashes in the United States always seem to last about two years, peak to trough, even in the Great Depression. As Warren Buffett described that episode: “During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent.”

By this crude, two-year yardstick, the current market peaked in October of 2007, and we can expect it to recover sometime in late 2009.

Throughout this crash, I have realized why so many smart investors often end up with inferior results. The reason is two-fold: when the market is richly-valued, they accept small or nonexistent discounts in price relative to value. And then they become fearful or unable to purchase deep value securities when the market is in a state of chaos. It seems ridiculously obvious to say this, but we see distinguished investors falling into such traps nearly every day.

We’ve seen many examples of the first reason; there was no shortage of aggressive buyers in the markets for stocks, commercial real estate, and private equity in 2006 and 2007. And now, with investors fearful of macroeconomic disaster, they’re making decisions to do things like pile into gold at a thirty-year high.

As for the stock market, Buffett also wrote:

“Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

“You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.”

While I do believe that sharp macroeconomic vicissitudes will continue over the coming years – and, for that matter, throughout our lives – many stocks probably have already bottomed. And, as Buffett says, we will probably see a sharp advance in the market before the economy improves.

When I look over all the potential global-macro trades – commodities, currencies, fixed income, whatever – the best opportunities that I see, in terms of risk and reward, are currently in the stock market.

John D. Rockefeller

"Financier's Fortune in Oil Amassed in Industrial Era of 'Rugged Individualism'."

Here is the New York Times obituary of John D. Rockefeller; a historical document that is slightly difficult to read, yet it contains many invaluable insights. Similar to Benjamin Franklin or Warren Buffett, you can always find witticism and wisdom in Rockefeller's words:

http://graphics8.nytimes.com/packages/pdf/business/20070715_GILDED/20070715gilded.rockefeller.pdf

"One of the swiftest toboggans I know of is for a young man just starting in life to get into debt."

A Leaky TARP?

While plans for the financial bailout were inherently imperfect, criticism tends to ring hollow if one thinks back to the months of September and October. Many of the most seasoned financiers were gripped by raw fear as global markets imploded following the Lehman Brothers bankruptcy. Put yourself in Hank Paulson's shoes: it's September 16th, 9:45 AM, the market is open and the New York Fed is on the phone. Point blank: AIG stock is down 60%; they're facing a liquidity crisis and preparing to file for Chapter 11. This is uncharted territory for the financial markets and economy. Make a decision. What do you do?

With the benefit of hindsight, here is how it turned out, from Bloomberg News:

The Treasury secretary has made 174 purchases of banks’ preferred shares that include certificates to buy stock at a later date. He invested $10 billion in Goldman Sachs in October, twice as much as Buffett did the month before, yet gained warrants worth one-fourth as much as the billionaire, according to data compiled by Bloomberg. The Goldman Sachs terms were repeated in most of the other bank bailouts.

Paulson’s warrant deals may give U.S. taxpayers, who are funding the bailouts, less profit from any recovery in financial stocks than shareholders such as Goldman Sachs Chief Executive Officer Lloyd Blankfein and Saudi Arabian Prince Alwaleed bin Talal, owner of 4 percent of Citigroup Inc., said Simon Johnson, former chief economist for the International Monetary Fund.

Paulson said “he had to make it attractive to banks, which is code for ‘I’m going to give money away,’” said Joseph Stiglitz, who won a Nobel Prize in 2001 for his work on the economic value of information.

“The worst aspect of this is that they were designed not to do what they were supposed to do,” he said in a telephone interview from Paris Jan. 7. “In many ways, it’s not only a giveaway, but a giveaway that was designed not to work.”

The Treasury would have held warrants for 116 million shares of Goldman Sachs under Buffett’s terms, which would be equivalent to a 21 percent stake when added to those currently outstanding. Instead, the dilution is 2.7 percent under the Treasury plan. Blankfein is the company’s biggest individual investor, with 2.08 million shares worth about $178 million today, according to Bloomberg data. His 0.47 percent interest would have declined to 0.36 percent under Buffett’s terms and would be 0.44 percent if the Treasury’s warrants were exercised.

The government has received warrants valued at $13.8 billion in the 25 biggest capital injections from TARP, according to Bloomberg data. Under the terms Buffett negotiated for his $5 billion stake in Goldman Sachs, the TARP certificates would have been worth $130.8 billion.

[Ten times as much!]

If Goldman Sachs rises to its five-year average price of $147, Buffett will be able to profit by $1.4 billion from exercising his warrants. The government warrants will be in the money for $294 million, or about a fifth as much for twice the investment.

Stiglitz said finance professionals at the Treasury possessed expertise on warrant pricing that members of Congress didn’t. As a result, Paulson gave lip service to the lawmakers’ intent on TARP without gaining much value for taxpayers, said Stiglitz, a Columbia University professor who described the pricing mechanism as “a gimmick to make sure that they were giving away something worth nothing.”

“If Paulson was still an employee of Goldman Sachs and he’d done this deal, he would have been fired,” he said.

A Philosophy of Market Efficiency

I would define financial market inefficiency as a breakdown in the fundamental relationship between risk and reward. If an asset is priced such that one has a very high probability of excess gain and a very low probability of loss, then this is an inefficiency or undervaluation.

Conversely, if an asset is priced such that one has a very high probability of loss and a very low probability of gain, such as dot-com shares in the late 1990s, then you have another inefficiency, or an overvaluation.

This is associated with the participant’s bias, meaning that most market agents have a flawed view of reality and thus believe that the asset is correctly priced. In other words, they are either undervaluing or overvaluing reality, as a result of their own perception.

The mainstream and variant perceptions all have different views on an asset, and the price clears because most people do not see whatever the true inefficiency is. Thus, to have an inefficiency, most participants must vote that the market is, in fact, efficient.

Other elements come into play: boom-and-bust processes, self-fulfilling prophecies, information cascades, dysfunctional pricing models, barriers to exploitation, panic, euphoria, and so on.

To define it academically, one would need to draw from research in dynamical systems, behavioral finance, game theory, and other disciplines. One must look at the history of financial theory to recognize its flaws, and the flawed framework upon which it was built.

Financial theory and much of economic theory was modeled after 19th century physics; yet with the birth of quantum mechanics and relativity, physicists no longer look at the world in the same way. The logical underpinning of financial thinking remains outdated by two-hundred years.

Buffett on Buying

We try to price, rather than time, purchases. In our view, it is folly to forego buying shares in an outstanding business whose long-term future is predictable, because of short-term worries about an economy or a stock market that we know to be unpredictable. Why scrap an informed decision because of an uninformed guess?

We purchased National Indemnity in 1967, See's in 1972, Buffalo News in 1977, Nebraska Furniture Mart in 1983, and Scott Fetzer in 1986 because those are the years they became available and because we thought the prices they carried were acceptable. In each case, we pondered what the business was likely to do, not what the Dow, the Fed, or the economy might do. If we see this approach as making sense in the purchase of businesses in their entirety, why should we change tack when we are purchasing small pieces of wonderful businesses in the stock market?

Before looking at new investments, we consider adding to old ones. If a business is attractive enough to buy once, it may well pay to repeat the process. We would love to increase our economic interest in See's or Scott Fetzer, but we haven't found a way to add to a 100% holding. In the stock market, however, an investor frequently gets the chance to increase his economic interest in businesses he knows and likes. Last year we went that direction by enlarging our holdings in Coca-Cola and American Express.

Our history with American Express goes way back and, in fact, fits the pattern of my pulling current investment decisions out of past associations. In 1951, for example, GEICO shares comprised 70% of my personal portfolio and GEICO was also the first stock I sold – I was then 20 – as a security salesman (the sale was 100 shares to my Aunt Alice who, bless her, would have bought anything I suggested). Twenty-five years later, Berkshire purchased a major stake in GEICO at the time it was threatened with insolvency. In another instance, that of the Washington Post, about half of my initial investment funds came from delivering the paper in the 1940's. Three decades later Berkshire purchased a large position in the company two years after it went public. As for Coca-Cola, my first business venture – this was in the 1930's – was buying a six-pack of Coke for 25 cents and selling each bottle for 5 cents. It took only fifty years before I finally got it: The real money was in the syrup.

My American Express history includes a couple of episodes: In the mid-1960's, just after the stock was battered by the company's infamous salad-oil scandal, we put about 40% of Buffett Partnership Ltd.'s capital into the stock – the largest investment the partnership had ever made. I should add that this commitment gave us over 5% ownership in Amex at a cost of $13 million. As I write this, we own just under 10%, which has cost us $1.36 billion. (Amex earned $12.5 million in 1964 and $1.4 billion in 1994.)

Warren E. Buffett, 1995

Some Thoughts on Short-Selling

With the backdrop of this year’s historic short-selling successes, I was recently asked why I rarely engage in this practice.

After thinking about it for a while, my answer is basically this: It is too difficult to be consistently right on timing and other factors. Timing matters much more with selling overvalued assets that you expect to depreciate, as opposed to buying undervalued assets that you expect to appreciate.

Over time, stocks generally increase in value, and holding long-term short positions is costly. Moreover, the possibility of unknown, intervening events gives shorting a different risk profile: for example, a weak company might get bought out, leading to a dramatic increase in the stock price.

Sharp surges in price are much more dangerous for the short-seller than are sharp declines for the stockholder. In the latter case, if one does not use margin, volatility scarcely matters as long as the equity remains attractively valued and the fundamentals have not deteriorated.

By contrast, to look at successful short-sales, consider that Bill Ackman had been short MBIA since 2002. In other words, he thought it would fail during the last recession. He took losses over an entire business cycle for the company to finally break down. David Einhorn waited a similar period of time with Allied Capital, as the stock rose smartly.

You can't get a margin call on equity. Or, in other words, the reverse of shorting is buying equity on margin. Imagine buying a stock at $50 and having it drop to $20 – being forced to sell – and then having the stock sharply rebound. This type of thing happens with shorting all the time, making it dangerous to short technology stocks or commodities or whatever else. Highly overvalued assets can get insanely overvalued, long enough for you to get tapped out.

The other option, no pun intended, is to use puts. The problem here is that equity doesn't expire worthless. But with puts, you can be exactly right with your decision, wrong on timing, and the put option expires worthless. (And then, the next day, the stock plunges to $0.) In my view, anything time-sensitive is absolute rat poison, unless the terms are exceedingly generous.

You want to look at it the way Warren Buffett looks at insurance: unless rates are incredibly appealing, relative to risk, then you simply do not write business. As he says, success at investing is all about temperament. The best action is often to take no action at all.

Where Do We Go From Here?

Something that always fascinates me is peoples’ inability – often extremely smart peoples’ inability – to have a true sense of context in history and an imagination outside of the time in which they live. There is a tendency to make absurd extrapolations of the future based on the recent past. Hence, some of my favorite “dumbest things ever said”:

“Everything that can be invented has been invented.” – Charles H. Duell, Commissioner of the U.S. patent office, 1899

“In ten years all important animal life in the sea will be extinct. Large areas of coastline will have to be evacuated because of the stench of dead fish.” – Paul Ehrlich, Stanford biologist, 1970

“Almost all of the many predictions now being made about 1996 hinge on the Internet’s continuing exponential growth. But I predict the Internet will soon go spectacularly supernova and in 1996 catastrophically collapse.” – Robert Metcalfe, 3Com founder and inventor of Ethernet, 1995

Bets against a brighter future, bets against growth, bets against innovation, bets against human ingenuity – these have never turned out well. The reason is that they are almost always relative to the recent past, and forecast the future based on whatever happens to be the current fad, fear, or state of affairs.

But what about the person in the early 1800s, sitting in a pasture – in the dark, in a world without electric light – who looked up at the moon and said: “In 150 years, we will travel there.” What about Wilbur Wright, who looked at the birds and remarked “for some years I have been afflicted with the belief that flight is possible to man” – that we could fly across countries or even the world.

They would have been ridiculed beyond belief.