Sunday, October 13, 2013

Bad advice: Why the future won't be like the past

It's easy to get bad advice from successful people. Here's why: Successful people assume that the same circumstances that prevailed while they were achieving their success will generally prevail while you are pursuing yours. But, your circumstances will almost surely be different, probably in major ways.

The second mistake successful people make is that they underestimate the role of luck in their success. As it turns out, financial rewards--and that's what Americans almost always mean when they use the word "success"--are distributed more randomly than most people at the top or even the bottom of the economic pyramid would like to admit. Who gets wealthy, especially really wealthy, is largely a matter of luck.

If your measure is fame rather than wealth, the story is the same. It's hard to imagine that the world's 10th best concert violinist is far less talented than the world's best concert violinist. Most of the difference in fame (and income) is in all likelihood due to luck rather than skill.

Luck can come in many forms, but it mostly boils down to three things: chance meetings, lucky guesses (about investments or a promising business venture or an artistic product such as a book or a song); and birth. The family you are born into, of course, greatly influences the opportunities available to you. My father once said of another man who had inherited considerable wealth that he "chose his parents well." My father was, of course, making fun of the idea that our successes come primarily from brilliant choices.

I cover this terrain because we are currently inundated with unsupported claims that our energy future will be continuously more abundant in line with our historical experience of the last 200 years or so. And, I've written about the actual risks we face. Guessing right in the past about the supply of a finite resource, that is, fossil fuels, is no guarantee that the next optimistic projection will be correct. In fact, the finitude of fossil fuels suggests that the day will come when optimistic projections will be wrong, and we will be caught unawares with devastating results. (Oh wait! Didn't that already happen when at the beginning of the previous decade wildly optimistic projections of ample, cheap supplies of oil turned out to be wildly wrong?)

But for this piece I have two examples of our failure to understand the limits of our knowledge from the world of finance: an overheard dinner conversation in my adopted home of Portland and a recent sad story from an acquaintance who entrusted money to a well-reputed investment management organization. The second story definitively illustrates my point. The first only illustrates it in principle since those receiving the advice have clearly not acted on it yet. We'll return to these stories in detail later.

But first, we must keep in mind that in general terms, the future--that is, the future down through history--has not monotonously repeated the past. In fact, history is the story of what changed, and we have lots of history. This doesn't mean that things cannot seem stable for long stretches, sometimes spanning several lifetimes. This isn't the rule, however, but rather the exception. In fact, when this does happen, it turns out that both in society and in nature long periods of stability are frequently followed by catastrophic change. Think 2008 market crash and the 2004 Indian Ocean tsunami.

We are delving now into the what the great philosopher of skepticism, David Hume, referred to as the problem of induction which is often illustrated as follows: Seeing white swans on thousands of occasions does NOT prove that all swans are white. It suggests perhaps that the odds are high that the next one sighted will be white; but, even this could be mistaken because we can never see all instances of swans everywhere throughout the expanse of time backward AND forward--which is just another way of saying that our sample size is actually quite small, whatever we may believe. In the end, Europeans who landed in Australia did find what seemed impossible up to that point: a black swan.

Now, finding a black swan was astonishing, but not necessarily damaging on an individual or societal scale. But, if your life, livelihood or entire society absolutely depends on the future being more or less like the past (as you and others have lived it), then you would be a fool simply to let things ride without further investigation. It only takes one black swan to invalidate the supposition that all swans are white.

The great contemporary authority on risk, Nassim Nicholas Taleb, puts it best in his book entitled The Black Swan: "It does not matter how many times something succeeds, if failure is too great to bear." Just what does this gem of brevity mean. In practical terms it means that we must consider not only the PROBABILITY of a future event, but also its possible SEVERITY. The possibility of getting a hangnail in the next week ought not to concern us much. The possibility of losing an arm ought to rivet our attention, even if the risk seems small.

Let me return to the overheard dinner conversation. An older man was counseling his son or more likely his new son-in-law about the wisdom of buying real estate no matter how high the market. The young married couple was considering buying their first home. The man used as proof of his point that he invested in real estate as a young man and never looked back. He always made money on every home when he sold it, and was able to live in better and better homes along the way. The older man counseled his son-in-law and daughter that things always turn out all right in the end--to which I can only add "OR NOT."

It's easy to see that the sample size here is very, very small. And, the specifics of real estate are actually very important versus, say, the specifics of a commodity such as oil or gold. Location, location, location are the three considerations said to be most important in valuing real estate.

I'm not opposed to owning real estate and have owned some in the past. But I have always considered it a very expensive consumer item, not an investment. I don't doubt there are some who are sharp-eyed enough to make money on real estate consistently. But the rest of us, I believe, are better served by regarding residential real estate as a method of providing living quarters. The most recent housing bust should have made this abundantly clear (but apparently it did not do so for everyone).

The above example illustrates what such advice sounds like before it is acted upon. The second example illustrates the effects of breaks from past. An acquaintance enlisted a well-known investment management firm to invest all his money. The acquaintance explained that he was a very conservative investor and valued safety over return.

The investment firm put him 45 percent in stocks through broadly-based mutual funds and 45 percent in bonds, much of them of the government variety. The remaining 10 percent was in a money market.

Historically, this allocation looked "safe" and quite conservative. After all, the firm explained, when stocks go down, bonds go up. And, when bonds go down, stocks go up. But in aggregate this strategy was supposed to offer steady, modest growth over time.

Almost immediately the stock market and the bond market tanked simultaneously. It wasn't supposed to be that way. The losses were not massive, but they were sudden and contrary to what the management firm had foretold.

The acquaintance sold all his stocks and bonds and put the proceeds into a money market account. Whether this will prove wise in the long run is unknown. But, the reaction was not out of fear of loses so much as fear that the future will not look like the past--that the promised steady small gains over time would not materialize because markets were acting contrary to past patterns.

If we cannot necessarily rely on past patterns to guide us, what does the voice of experience have to offer? The answer should actually be unsurprising. Since none of us can know the future, our task ought to be to make ourselves more resilient come what may. The usual advice is to get a good education (but not so much that you become a rigid thinker); maintain your health enough to do your work and the other things you enjoy; cultivate many relationships to increase your chances of meeting your needs and of doing interesting things and thinking interesting thoughts; and finally, be willing to fail while experimenting to discover the best path to your goals. There is nothing startling about all this.

We like to think that we shape our destiny rather than destiny shaping us. It's not so much that our choices don't matter as that we cannot accurately forecast their results. If those choices redound to our benefit, then we style ourselves brilliantly perceptive. If they dog us with failures, we blame it on the stars.

I am reminded of Michael Grant's pithy summary of Stoic philosophy in his wonderful short history The World of Rome: "So pray not for blessings, but for the power to do without them." That's the true meaning of a robust life: Living well even when fortune does not favor us.



michael said...

Thank Kurt...a great piece, from one of the most cogent voices in the din for quite some years now.


Dagny said...

I agree that following a formula will not guarantee success, however you define success.
But, there are things one can do that will greatly increase the odds of failure: get divorced, have children out of wedlock, gamble recklessly, get addicted to drugs or drink, ignore your health (physical and mental), have a poor work ethic, have a strong sense of entitlement, treat others poorly. There are more of course. And your grandmother warned you of the above, mine did.

fpteditors said...

Love your work. You may have meant "lucky" instead of "sharp-eyed."

sharp-eyed enough to make money on real estate

Jan Steinman said...

Are you too-narrowly defining "success" as "making money?"

I consider myself successful for living well on under $1,000 a month!

Success is not freedom from failure, but persevering through failure.

Bob Lapsley said...

First time viewer not yet finished with this article yet compelled to quibble. I applaud your aim, if in the end your bead is drawn on some morally defensible alternate organization of society.
But please consider “Many will fail, but the few that survive can be a benefit to society.”

The omission that those firms that succeed can also be a pernicious force to the detriment of society is screaming, shrieking disservice! The implication that good comes from more businesses as we have know them, living and dying, is conjecture and speculation predicated on now deposed cultural norms, the moral foundation of an anthropocentric materialism. Evolution is amoral. Those entrepreneurs in business are successful if the firm materially profits, regardless of consequences outside the intended profit. From my perspective it is clear historically more often than not such successes have had a pernicious effect to the detriment of society, but more importantly to the ecosphere, on which all our hope for a future hangs.

i hope, more I expect as I read on I will find your notion of profit will fall in line with a regenerative and robust environment and biosphere.