“One way to deal with adverse tail events is to simply ride them out” (Michael Mauboussin)

FOREWORD to a conversation with Michael Mauboussin

Facing extreme events and the “tail” surprises in a transition phase, the best advice is to ride them out, to thrive through, to have agility do adapt. You can also profit from five advices that Michael Mauboussin, an investment strategist specialist and author of Think Twice (Harvard Business School Press, 2009), gave us in this interview.

Also take note that not all extreme events that take us by surprise and disrupt our lives are “black swans”, as popularized by the title of the essayist and financial expert Nassim Taleb’s book, with a second edition coming in May (Random House Paperbacks, 2010).

Analysts and journalists simply label every extreme event as a “black swan” – an unexpected great recession after 80 years of “moderation” in business cycles, a severe earthquake with catastrophic physical, economic and social disruptions, a surprising volcanic ash cloud blocking the euro airspace for a week. “This is simply not the case”, say Mauboussin. A majority of them are “gray” – “gray swans” are something that Benoit Mandelbrot or the same Taleb in the same book ask us to pay attention.

Invaded by “gray swan” events we have to understand the systems that feed them. Mauboussin give us some important clues.

A SHORT TALE: Black & Gray Swans

Taleb popularized the “black swan” metaphor used since Aristotle. Some extreme events are unpredictable and improbable because they are out of our knowledge, experience or memory. They are the unknown unknowns, by definition.

The black swan was a mythical water bird, only pure white swans are supposed to exist in the lakes, until in the wetlands of Western Australia they were first seen by Europeans in 1697, when Willem de Vlamingh’s expedition explored the Swan River. Later the naturalist John Latham described them scientifically. They turn the official state logo of Western Australia.

Taleb mentioned the WW1 or the emergence of Hitler as a “black swan” geopolitical event, or the 9/11 terrorist attack in NYC. The power projection of the Portuguese in the 1400s and 1500s were regarded as “black swans” by the incumbent geopolitical powers in the Mediterranean and the Indic. Taleb differentiates also from positive (random discoveries like penicillin or Viagra) and negative”black swans”.

But the author wrote also about another type of swan – the gray one, for a different metaphor: extreme surprising events that are “modelable” in some way. They are extreme events that emerge abruptly but are probable. It is not possible to completely figure out their properties and produce precise calculations and consequences. Benoit Mandelbrot, the father of fractals, wrote about this type of swan event. He pointed out that not all extreme and rare events are “black swans” – we can “gray” some of them, we can somewhat take in account. The late management guru Peter Drucker talked about trends that are running below our feet, but that most people do not see or sense. They are systemic trends that caught most people by surprise.

We can collect a few events that are “confusing”: maybe they are “black” or “gray”. For instance, the scenario of implosion of the Soviet Union was not “visioned” by Paul Kennedy in his major book The Rise and Fall of the Great Powers (1st edition published in 1988). The coup d’état against the Maoist gang of four in 1976, a mere month after Mao Zedong’s death, brought years later the surprising Deng Xiao Ping and his reform program that changed China and the world (as we see today).

Anyway, now, many economists consider the current Great Recession as a “gray swan” event and not a black one, despite the majority of economists ever thought of the possibility of a major global crisis in the last 30 years. The majority was addicted to a state of mind enveloped by a dominant complex system of myths, like the general equilibrium in macroeconomics, the abuse of Gaussian distributions where they are not appropriate, and the “great moderation” of volatility, and also due to contemporary statistics showing a diminishing average in months of recession periods after WW2. Many specialists in extreme financial events consider that the stock market crashes are “gray swans”, despite “this time is different” illusion of the financial mob.

Many researchers of this field blamed some features of human psychology, like group thinking, confirmation biases, addiction to narrative explanations, epistemic arrogance and tunneling, stress to make out patterns, inappropriate causation in history, induction method and faulty extrapolation from past results. Mauboussin considered overconfidence the biggest factor in poor decisions. As an antidote, Karl Popper used the principle of falsifiability – as Mauboussin explains in his article at The Futurist magazine (March-April, 2010): “Popper’s point is that to understand a phenomenon we’re better off focusing on falsification than on verification.”

Mauboussin gives a key to these complex problems: you have to understand how those systems behave even if you have no reliable way to predict any specific event or context where it will emerge by surprise.


Michael J. Mauboussin is Chief Investment Strategist at Legg Mason Capital Management. He is also the author of three books, including More Than You Know: Finding Financial Wisdom in Unconventional Places, named in the The 100 Best Business Books of All Time by 800-CEO-Read. Michael has been an adjunct professor of finance at Columbia Business School since 1993, and received the Dean’s Award for Teaching Excellence in 2009. His latest book, Think Twice: Harnessing the Power of Counterintuitionwas published by Harvard Business Press in the Fall of 2009. He has been an adjunct professor of finance at Columbia Business School since 1993 and received the Dean’s Award for Teaching Excellence in 2009.

INTERVIEW by Jorge Nascimento Rodrigues © 2010

Q: Extrapolation from past is a risky business. Faulty extrapolation is one common mistake as you mention. But can we learn from recurrent or cyclical patterns of history? In what sense is useful to learn from the past, to understand how geopolitical systems or the financial ecosystem behaves?

A: At the core of this excellent question is what philosophers call “the problem of induction.” At issue is the natural tendency to generalize about the properties of a class-—say, stock price changes—-based on a limited number of observations. When we only look at the favorable part of a distribution of outcomes, we get lulled into a false sense of confidence. This is why Karl Popper, a philosopher, insisted that falsifying ideas is more important than affirming them. Past patterns can be helpful if you consider a large enough sample of outcomes. However, we tend to anticipate only good things after a favorable time in markets and only bad things following a challenging period.  One clear example of where the past can help you in the future is with asset bubbles. If you see large increases in an asset price, lots of public excitement, theories of why higher prices are justified, and lots of debt, you can be reasonably sure that the future returns from that asset class will be unsatisfactory.

Q: To have an overview of the past is it important for thriving in critical moments, in complex situations, in a stressed environment? To have historical knowledge is important for a long term thinking to avoid immediacy, for a counterintuitive way of thinking?

A: There’s a fascinating line of research studying the effects of stress on people. Take animals to start. Their stress response comes frequently from a physical threat—-for example, a lion chasing a zebra. The zebra elevates its heart rate, pumps blood, and turns off its long-term systems including digestion, reproduction, and immune system. Given the life-or-death threat, the zebra becomes focused on the present. Most stressors for humans are not physical, but rather psychological: deadlines at work, concerns about finances, issues regarding relationships. But the psychological stresses trigger the same physiological response—our bodies think that there’s an emergency. And here’s where the issue comes back to your question: when we are stressed, we have very difficult time thinking about the long term. There may be decisions that appear very sensible for the long term, but the stressed person does not select that way.

Reduce stress as a first step

Q: How we can deal with those circumstances?

A: The first step is to take action to reduce stress. Here, the advice is common but not always heeded: eat well, get sufficient sleep, exercise, and spend time with family and friends. Another step is to consider what’s going on in a broader context. What can history teach you about difficult situations? In many cases, the lesson is that “this too shall pass.”

Q: Surprise is always typical of transition phases, even if we have certain knowledge of ongoing trends. How management and company leaders, or politicians, can deal with surprise? In a severe stressed situation it is not easy to think twice…

A: Phase transitions occur when a small scale perturbation leads to a large scale change in the system. The classic example, of course, is the phase transition from water to ice. At 1 degree Celsius you have a liquid. One degree cooler and you have a solid. Dealing with these transitions is very hard, precisely because they are unexpected. But there are some things you can do. First is to learn a great deal about the system you are dealing with. Often if comprises many interacting parts, it will be susceptible to a phase transition. Second is to constantly think about the downside. Lots of “what if” thinking can help businesspeople and politicians prepare for scenarios that they wouldn’t consider naturally.

Q: You refer gray swans, picking the other “image-concept” from Nassim Taleb (usually only referred for the black “unmodelable” swans). Gray swans are “modelable”, so to speak. How do we develop that capability to “modelable” certain extreme, “gray”, events?

A: This strikes me as an empirical question. There are many systems—some with very extreme outcomes—that can be modeled. Earthquakes are an example. While it’s difficult to predict with any certainty where the next big earthquake will strike, it is not too difficult to characterize the distribution of earthquakes over time. Social systems are inherently more challenging, and in many cases we don’t really know what the exponent of the power law is. But I mentioned gray swans in my book because I was concerned that people were labeling every extreme event a “black swan.” That is simply not the case.

Transitory challenges

Q: The ongoing Great Recession was a surprise for most of the economists and politicians. And it seems it has more surprises – like the debt crisis and the default risks in “rich” countries. It seems the “tail” of this gray swan has more extreme events than the expected. How we deal with this strange “tail”?

Q: I’m afraid this important question has no simple answer. But I have some thoughts. First, a very healthy mindset for an investor is to recognize that when things go well for some time, they are less likely to go well in the future, and vice versa. Bubbles burst from high levels of asset prices, not depressed prices. And bull markets begin following a period of difficulty. As Hyman Minsky suggested, stability breeds instability. Second, it is very important to consider the role of incentives. On a very basic level, the makings of the Great Recession can be traced back to poor incentives. If people are well-paid to ignore to what could go wrong, you can be sure they will ignore it. The use of debt, or leverage, exacerbates the problem. So as a society we need to give some thought to if, or how, we can reorient incentives. Finally, I would mention the role of time. Events like market crashes, wars, or recessions are certainly very trying for the people who live through them. But considered over the span of time, these events appear much less consequential. So one way to deal with adverse tail events is to simply ride them out. Know in advance bad things can and will happen, and be prepared to sit through the inevitable, but also transitory, challenges.


5 short advices from Mauboussin

1- Avoid extrapolating in a pessimistic or optimistic mood

2- Avoid immediacy stressed decisions; think twice

3- Do not be prisoner of the “inside view”, and of the group thinking; opt out for the outside view and the counterintuitive approach

4- You have to learn how to deal with contingency; simply ride them out when black swans suddenly emerge in the lake

5- You can understand “modelable” gray swans; keep in mind not all extreme events are black swans

One Response to ““One way to deal with adverse tail events is to simply ride them out” (Michael Mauboussin)”

  1. You have a typo here: then/them

    4- You have to learn how to deal with contingency; simply ride then out when black swans suddenly emerge in the lake

    Should be:

    4- You have to learn how to deal with contingency; simply ride them out when black swans suddenly emerge in the lake

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