| 10 September 2008
Like many people, I enjoy a good mystery novel, especially in the summer. At the same time, I have to deal with a steady flow of trade journals that come across my desk in order to keep up with developments in the financial services industry. Because of these competing interests for my eyeballs, it can be difficult to carve out time for other reading – but I try also to tackle more expansive non-fiction works to help me become a better financial advisor.
During the last couple of years my reading has emphasized investment strategy, which has led to a revised investment policy. In my article the Myth of Active Management I explained how my research led me to the conclusion that a low-cost passive portfolio is the best strategy for most people. More recently, I posted a write-up to my web site called Self-Directed Portfolio Management to dispel the notion many people hold that they need an expert to actively manage their portfolio. I believe strongly that an average person with a little guidance can do better than a professional money manager.
For me to be an effective advisor, though, I need to go beyond technical research and look at the bigger picture. This summer I read The Black Swan by Nassin Nicholas Taleb and the Age of Turbulence by Alan Greenspan. These books are about as different as can be, but they both provide a context to better understand the nature of financial markets, economics and forecasting.
The Black Swan takes its name from the observation that for many years only white swans were known to exist until one day a black swan was spotted in Australia. Taleb’s theory relates to the nature of randomness and the inability of economists and scientists to predict the future using quantitative models. More importantly, it’s the futile effort to do so that causes the problem because it gives us a false sense of security. The things we should worry about the most are the extremely improbable and unpredictable events.
The attacks of 9/11 were a black swan because nobody envisioned such an event could happen. Hurricane Katrina is another example of a black swan because even though hurricanes have hit our shores before (just recently Hurricane Ike) the degree of devastation was beyond imagination. The current financial crisis, which began with the sub-prime mortgage fiasco, is a once in a lifetime shock with such extreme consequences that it also qualifies as a black swan.
The nature of mankind leads us to try to understand the unknown, but Taleb argues that the greatest risks and uncertainties cannot be modeled using conventional techniques. Taleb would rather we learn to live better in a world that we don’t know very well, and identify ways to turn lack of knowledge into smarter decisions.
The Greenspan book held special interest for me because a few years ago I read Maestro by Bob Woodward, which is a biography of Alan Greenspan. This new book is Greenspan’s personal account of this career spanning over fifty years where he has witnessed and helped shaped many significant financial events, especially during his nearly twenty years as chairman of the Federal Reserve Board. He was at the helm during events such as Black Monday (the stock market crash of 1987), several international currency crises, the technology stock bubble and the economic aftermath of 9/11.
Greenspan is the epitome of the established economics community. The Maestro’s job was largely to make forecasts in order to comprehend a complex economy and formulate effective monetary policy. Taleb provides a diametrically opposing view that attempts to predict the future are pointless because the world is random.
How do these and other thought provoking books affect the nature of advice that I render to clients? For one thing, Taleb’s philosophy affirms for me to some degree my planning methodology (which is quite different than most planners) which refrains from making specific forecasts. What I think Taleb is saying is that we don’t know how much we don’t’ know. This is an important concept to embrace in my work as a financial advisor because I am essentially in the risk management business. In fact, I’m in the process of reading The Complete History of Risk by Peter Bernstein.
Also, I feel more strongly than ever that a low-cost market matching strategy is better than trying to beat the market. The latest Wall Street crisis highlights the difficulty in separating the winners from the losers in advance. Until an improved method comes along, I think a globally diversified portfolio is the best way to manage risk and achieve long-term goals.
Greenspan’s book is significant because it adds another layer of knowledge of economic and political history. Greenspan chronicles not just the triumphs but also the missteps, and shows us that we can learn from past mistakes. When a black swan appears, by definition, it won’t happen again, but knowledge gained can prevent future problems. For example, the Great Depression led to a stronger commercial banking system. I’m hopeful that the current Wall Street meltdown will lead to transformation of the investment banking system.
Reading about history and philosophy can only take you so far, though. Some things you have to experience first hand. My thirty years of professional life (which began before Greenspan took the reigns of the Fed and continues beyond his retirement) has done more to shape my judgment than any reading or research. Black swans like the tech bubble and the credit calamity have a way of leaving an indelible mark on your psyche. Each passing year adds another layer of bricks to the foundation and new tools for the tool box. To rephrase a famous quote, “We can learn from experience, but we can’t teach it”.
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