Published On: May 4, 2020
Written by: Ben Atwater and Matt Malick
“You never count your money / When you’re sittin’ at the table / There’ll be time enough for countin’ / When the dealin’s done” – Songwriter Don Schlitz (1976)
A black swan describes an event that comes as a surprise, has a major effect, and is rationalized after the fact with the benefit of hindsight. Nassim Nicholas Taleb developed the idea in his 2007 book, appropriately named, The Black Swan. The title derives from the fact that for generations Europeans did not know there were black swans because they had only ever seen white ones. (Dutch explorers discovered black swans in Australia in 1697.)
A black swan occurs as a surprise to the observer. So, what is a black swan for some may not be for others. For Taleb, COVID-19 is not a black swan because, in his view, another pandemic was nearly certain to eventually occur. But, for most observers, COVID-19 is most definitely a black swan. This essay is not about COVID-19 itself, rather it is about better understanding the nature of the unpredictable.
In his book, Taleb walks us through a great example of how we misunderstand risk (the unpredictable).
Think of a casino. We associate gambling and casinos with risk. But in casino gambling, the probabilities are known and largely computable. We tend to overestimate the role of luck in games of chance. But, in real life, we grossly underestimate the role of luck. Computable risks are largely absent in real life.
A casino’s internal risk management primarily concerns itself with two things. First and foremost is cheating. Casinos go to great lengths (using science fiction-like surveillance) to stop cheaters. The second is managing whales (very large dollar gamblers who casinos fly-in from around the world). In the case of whales, casinos need to attract enough of them so that one unlikely winner does not tip the odds away from the casino. Casinos go to great lengths to manage these two risks.
But, using The Mirage in Las Vegas as an example, we will see that, although the casino needs to manage its known risks, it is unknown (and unmanageable) risks where the real problem lies.
The highest grossing show in the history of Las Vegas was Siegfried and Roy, a Mirage property. When Roy’s tiger attacked him and maimed him, Mirage lost more than $100 million. Although in hindsight it seems like a pretty obvious risk, it was not one anyone had considered. After all, the tiger frequently slept in the same bedroom as Roy. The casino had conceived of tigers attacking audience members, but not of the tigers turning on their trainer.
Next, an injured and disgruntled contractor attempted to dynamite the casino in a failed terrorist attack that the Mirage foiled, but nonetheless, posed a catastrophic threat to its very physical structure.
Third, a Mirage employee, who was responsible for reporting gambler winnings to the IRS, did indeed complete the forms, but never submitted them to the government. Rather he accumulated them in boxes for years. This resulted in a very large (but undisclosed) tax penalty and the near suspension or loss of the casino’s gaming license.
Another threat to the Mirage gaming license occurred when a kidnapper abducted owner Steve Wynn’s daughter and Wynn improperly “borrowed” funds from the casino to pay the ransom.
Lastly, as we are seeing right now, the closure of the Mirage and all the other Las Vegas strip casinos due to COVID-19 also poses an unknowable and existential threat to these venues.
As you can see, these five “off-model hits” to the Mirage were unanticipated, had major effects, and now that you know about them, seem infinitely possible. But nobody ever predicted any of them.
Many of us tend to learn about and associate probability with gambling, but what happens in the gambling itself is sterile, while what happens outside of the gambling is what is truly unpredictable.
We can make this analogy to securities, e.g. stocks and bonds. Think of a security as a table game where the fair value can be estimated based on long-used quantitative methods (present value of future earnings, book value, dividend discount model, free cash flow to equity, Gordon growth model, etc.). But much like the Mirage, it is the events (unknowable and unpredictable) that occur outside the securities where things get tricky.
Our entire current financial system as it exists, including investing and retirement planning, are antithetical to Taleb. He advocates tearing the whole system down and starting over. But, for us, that is academic, not realistic.
Instead, what we can do in response to the unexpected is threefold:
We work hard to do all three of these things for our clients. It is easier said than done, but in the world we live in, stick-to-itiveness is everything.
During this crisis, numerous clients have asked about sharing our messages. We truly appreciate the positive feedback and would encourage you to forward these notes to family, friends and business associates. Given the current climate, we are open to adding additional recipients to our communications. If you know someone who would like to receive these essays directly, please let us know.