What Thanksgiving Teaches About Risk (Taleb’s Turkey Chart)

The life of a Thanksgiving turkey can teach us a lot about risk. I believe Nicholas Nassim Taleb’s turkey chart and accompanying quote (from The Black Swan) sums it up best:

Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that is the general rule of life to be fed every day by friendly members of the human race “looking out for its best interests,” as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.

The Black Swan, by Nicholas Nassim Taleb
"A turkey before and after Thanksgiving. The history of a process over a thousand days tells you nothing about what is to happen next. This naive projection of the future from the past can be applied to anything."
Source: The Black Swan, by Nicholas Nassim Taleb; Wikimedia Commons
“A turkey before and after Thanksgiving. The history of a process over a thousand days tells you nothing about what is to happen next. This naive projection of the future from the past can be applied to anything.”
Source: The Black Swan, by Nicholas Nassim Taleb; Wikimedia Commons

The Taleb turkey chart and story is entertaining, but also offers much wisdom about risk-management.

The past does not predict the future

In Taleb’s story, nothing in the turkey’s life had indicated what would occur on Thanksgiving Day. The past had no predictive power in forecasting the future. On Taleb’s turkey chart, the days 1 through 1,000 are completely different than day 1,001 and beyond.

Similarly, we humans often assume the future will be similar to the past.

  • We believe that stability will continue. For instance, who predicted that a suicide in Tunisia would lead to the Arab Spring and the downfall of decades-long dictatorships in Egypt and Libya?
  • We believe that good times will continue. In 2019, who predicted that someone eating a bat or a lab leak would lead to a global pandemic that would reshape our society and economy for years?
  • We believe that bad times will continue. I find this assumption less common (because humans are generally optimistic, I think), but why do we call the modernization of Singapore or Oman a miracle? Perhaps because we believe it is improbable to go from mud and bricks to steel and glass in such a short-time.

In addition to the above, Taleb notes that investors often layer on and are deluded by confirmation bias. Many investors mistake their results for skill rather than luck not realizing that “a high tide lifts all boats.” In bull markets and bubbles, terrible decisions are often rewarded handsomely as hot assets soar in price. Investors double down on bad decisions until something changes, the tide goes out, and (in Buffett’s words) we find out who has been swimming naked. Unfortunately, in every market cycle some investors own assets that look like the Taleb turkey chart.

As Howard Mark’s says,”…trees don’t grow to the sky, and few things go to zero.” Understanding that the today’s conditions are likely to change is the key to not being a turkey. This is why investor protection rules have resulted in this disclaimer on nearly every piece of investment marketing : “Past performance is no guarantee of future results.”

Despite what we believe and despite how strong we believe it, the future is unknown.

Risk is difficult to model

Risks are difficult to model for many reasons, but one reason is that rare events are rare! We do not have sufficient data to estimate their probability or impact. Taleb’s turkey had never experienced what was about to happen.

We cannot predict earthquakes or their magnitudes. Nobody could have predicted what would happen if a strong earthquake occurred in the Pacific Ocean, generated an enormous tsunami, which destroyed a nuclear power plant (as well as its backup safety features), or what impact that would have on energy policy in Europe and geopolitical issues between the EU and Russia. I don’t believe anyone was even aware of these risks before the Fukushima earthquake/tsunami, much less modeled it. The events are rare and the sequential scenarios too numerous and complex to model.

Our record is not much better even when we’re aware of the risk. For instance, there have been many pandemics throughout history, but we were not well prepared for covid. Our leaders did not appreciate the scientific and/or behavioral nuances of pandemic planning. Furthermore, nothing like covid has ever occurred in such a globalized world. Previous plagues spread across cities and continents over months, years, and decades. Covid spread around the globe within weeks. The 2020 pandemic was unlike any past pandemic.

Ignorance is bliss

Since we do not know what risks exist and/or how probable they are, we often ignore the risks. We may think they don’t exist or are too improbable to worry about. That was certainly the case with covid. I recall debating with a family member who said the covid pandemic was abnormally rare even though pandemics occur with some regularity. It is just that there are rarely mulitple pandemics in single generation, so we forget.

There is also the issue of human memory and recency bias. There have not been any major airborne pandemics in the US within a generation or two and so we took the risk less seriously. We believe that we are smarter, more advanced, with better healthcare than past generations. Yet, we were still caught flat-footed during covid.

Information asymmetry

As Taleb notes in his book, the turkey’s surprise is not a surprise to the butcher. This is because the turkey does not have all of the information. If the turkey had a copy of Taleb’s chart for other turkeys, it might have known.

Unfortunately, we humans do not have complete information either and we rarely acknowledge it. In his famous book “Thinking, Fast and Slow,” Daniel Kahneman discusses his abbreviation WYSIATI or “what you see is all there is.” The concept of WYSIATI describes our tendency to create narratives based on the information that we have rather than admitting that there is a lot of information that we do not have.

What we see is not all that there is and our observations lead us to mistake the odds.

Note: Narratives can lead us astray in many areas of our life, even our giving! Here’s an example from the holiday season: Is Operation Christmas Child good or bad?

We think we know black swans to expect, but we miss the real ones

The bottom line is that we consider, anticipate, and worry about risks that we can imagine. Yet we often miss the risks that end up occurring. As Josh Wolfe says, “Failure comes from an a failure to imagine failure.” We cannot always imagine black swans, but we should try to avoid the common mistakes that Taleb’s turkey made.

Alpha and Beta for investors

Alpha and beta are two of the most common words used in investing conversations. Interestingly, each has a technical finance definition as well as a more common meaning. However, it can be difficult to distinguish between alpha and beta in real life. Furthermore, several famous investors believe that a framework that relies of things like alpha and beta are flawed at best and dangerous at worst.

The definition of beta (β)

At it’s simplest, beta can be defined as the volatility of an asset relative to a benchmark. The benchmark could be an of index an entire asset class, a specific sector, or something else entirely. For example, a US large-cap stock that is 20% more volatile than the S&P 500 index has a beta of 1.2. Or if the volatility is 20% less than the index, it’s beta is .8. Beta is a measure of relative volatility.

The common meaning of beta

When used colloquially, the word beta usually has a different meaning than it’s technical definition. Beta often refers to the risk and return characteristics of a benchmark. Some examples:

  • US large-cap beta may refer to the Dow Jones Industrial Average or the S&P 500.
  • Investment grade bond beta is often synonymous with the Bloomberg Barclays Aggregate Index.
  • Tech beta may simply refer to a tech-sector ETF.
  • International beta could be the MSCI EAFE Index or MSCI ACWI ex-USA Index.

I often refer to index ETFs as cheap, liquid beta. Some may compare large-cap beta to small-cap beta or consumer staple beta to consumer discretionary beta, when discussing risk and returns. Below are some examples of how someone might refer to beta:

  • Utility sector beta is sensitive to interest rates.
  • An index fund may be called beta exposure.
  • An investor holds investment grade bonds and reports a -1% return while the Bloomberg Barclays Agg return is -3%. Some might say that the beta return was -3% (and alpha was positive 2%).
  • The Russell 1000 index is large-cap beta, while the Russell 2000 index is small-cap beta, and the Russell 3000 is total market beta (read our explainer on the differences between the Russell 1000, 2000, and 3000).

The definition of alpha (α)

Within the Capital Asset Pricing Model (CAPM), beta (as technically defined) is used to forecast returns. Under CAPM, higher beta leads to higher returns and lower beta results in lower returns. In other words, an asset with more volatility should have higher returns and an asset with lower volatility should have lower returns. Reality rarely unfolds as modeled, so another CAPM equation was created to account for the difference between reality and modeled outcomes. It adds a variable called alpha to account for the difference between an asset’s actual return and it’s expected return (which CAPM predicts to be the benchmark return, adjusted for volatility). Below are a couple of examples on calculating alpha:

  • An investor invests in large-cap domestic stocks and reports a 10% return, while the Russell 1000 returns 7%. The investor has produced 3% alpha.
  • An investor invests in global equities and reports a 9% return, while the MSCI All Country World Index returns 13%. The investor has (negative) alpha of -4%.

Distinguishing alpha from beta-rotation

One of the challenges for alpha is that it is difficult to prove. in fact, most alpha can be explained away. Consider the following three scenarios:

  • If an investor beats the market with a portfolio of anything besides an index, observers argue that the investor took more risk or different risks. They will explain that higher returns are not from alpha, but from different factors, higher beta, or what I call beta combinations.
  • If an investor beats the market by rotating sectors or adjusting duration, people will say, “That not alpha, that’s just beta rotation.”
  • If an investor buys assets at the lows or sells at the highs, academics will explain that the resulting outperformance is due to timing the market and exposure to systematic risk.

Generating alpha through any of the above activities can be explained away generally as beta rotation, but that does not negate the skill required and/or benefits gained. The much more important question is whether the actions and benefits can be consistently repeated to generate a material risk-adjusted return (net of expenses and taxes). Thus, finding that marginal return is much more difficult than labeling it as alpha or beta.

A side note that this is partially why hedge fund hurdle rates exist, to compensate managers for alpha above some defined level.

“Beware of geeks bearing gifts”

"Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas." -Warren Buffett

As usual, Buffett says it best. In his 2008 shareholder letter in the midst of the Global Financial Crisis, he wrote:

“Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.”

Warren Buffett, 2008 Berkshire Hathaway shareholder letter

A few years later, he expanded on the idea and closed with joking nod to antiquity.

“…they had advanced degrees, and they look very alert, and they came with these — they came with these things that said gamma and alpha and sigma and all that. And all I can say is beware of geeks, you know, bearing formulas.”

Warren Buffett, CNBC interview

Summary of alpha & beta in investing

  • Beta is an asset’s volatility, relative to another asset or benchmark.
  • Alpha is an asset’s return above or below it’s benchmark, after controlling for differences in volatility.
  • Technical definitions notwithstanding, the term beta is often shorthand for a benchmark or may refer to the benchmark’s risk and return characteristics. 
  • It is often difficult to distinguish between alpha and beta-rotation or beta-combinations.
  • Investors should be knowledgeable about beta and alpha, but I do not believe they should become too reliant on these measures. To learn more about the the challenges of risk measurement, investors should read Taleb’s story about the Thanksgiving turkey.

Are Markets Efficient?

Are markets efficient?

The question of whether markets are efficient has been debated for decades and there is no consensus. However, I think the debate and conclusion is best summed up by a famous story.

A finance professor and his student were walking across campus when they spotted a $20 bill on the ground. The professor advised, “Don’t bother picking that up. If it was real, someone would’ve picked it up already.” The student picks it up anyways and buys herself a beer.

There are not a lot of $20 bills laying on the ground, but they are found from time to time. That’s the short answer. The longer answer is below.

What does market efficiency mean?

The term efficiency is used to connote several different ideas, but the most common one is a concept formalized into the Efficient Markets Hypothesis (EMH) by Eugene Fama, who won a Nobel prize for his work on the subject. The theory basically says that markets allocate capital best and thus value assets best (or “efficiently”). There are 3 forms of the theory:

  • Weak Form: all historical information is priced into an asset’s price.
  • Semi-Strong Form: all historical and public information is incorporated into an asset’s price.
  • Strong Form: all historical, public, and non-public information is Incorporated into an asset’s price.

Below are some examples of situations where each form does not hold up.

Strong Form

Strong Form claim: all historical, public, and non-public information is Incorporated into an asset’s price.

Strong Form problems:

  • Prices often have material and sustained moves when private information is publicized.
  • Prices often move on earnings announcements or press releases.
  • The uncovering of scandals or fraud impacts prices.
  • I do not know anyone that subscribes to the strong form of the EMH.

Semi-Strong Form

Semi-Strong Form claim: all historical and public information is incorporated into an asset’s price.

Semi-Strong Form problems:

  • Arbitrage opportunities exist fairly frequently. Although not all are actionable due to constraints and costs, enough are.
  • Closed-end funds can trade at extreme premiums and discounts to their underlying NAV.
  • We have seen public companies trading for less than the value of their stakes in other public companies.

Weak Form

Weak Form claim: all historical information is priced into an asset’s price.

Weak Form problems:

  • Momentum as a risk factor has been shown to offer a return premium.
  • Flash crashes and flash rallies have extreme mean reverting tendencies.

There are many more examples of market inefficiency, but few would have been robust enough to categorically prove markets are inefficient (and stand up to every possible logical critique).

So, are markets efficient?

Beyond poking holes in the idea of market efficiency, the above examples represent opportunities for active managers to outperform. Yet, there is plenty of data that indicates markets are difficult to beat on a consistent basis. This implies (but does not prove) that markets are at least somewhat “efficient.” If markets were generally inefficient, it would seem that investors would beat the markets more easily, frequently, and consistently.

So what can we conclude? That markets are not always efficient, but are probably efficient at least some of the time. This is a very unsatisfying answer, but that is okay because it is unclear whether market efficiency even matters to investors. I’ll explain why in an upcoming post.

Additional thoughts on market efficiency

Even if markets are generally efficient, efficiency seems non-existent during certain times (ie. when rationality gets thrown out the window during bubbles and panics) and in specific asset classes (where there are constraints to arbitrage, complexity, due diligence costs, transaction costs, or anything else that makes it difficult to invest easily). So my usual answer to the original question is that markets are generally efficient, but there are episodes and pockets of inefficiency.

Peter Thiel on Competition

It is wise to remember Thiel’s quote about avoiding competition. Just as businesses do best in the absence of competitors, investors perform best when they do not have to compete for opportunities.

“Competition means no profits for anybody, no meaningful differentiation, and a struggle for survival. So why do people believe that competition is healthy? The answer is that competition is not just an economic concept or a simple inconvenience that individuals and companies must deal with in the marketplace. More than anything else, competition is an ideology—the ideology—that pervades our society and distorts our thinking. We preach competition, internalize its necessity, and enact its commandments; and as a result, we trap ourselves within it—even though the more we compete, the less we gain… If you can recognize competition as a destructive force instead of a sign of value, you’re already more sane than most.

Peter Thiel, Zero to One

Additionality

Solar panels can drive additionality in a similar way to carbon offsets.

Additionality has been on my mind lately. Although the term is most commonly applied in the context of carbon emissions and offsets, I believe the concept is helpful in many domains.

Let’s start with the definition of additionality. Additionality occurs when a particular action will provide a benefit in “addition” to a “baseline” alternative of taking no action.

For example, let’s say that I invest in a solar energy project. I’ll pat myself on the back because I’m generating a financial return AND a positive environmental impact. However, if there were other investors competing to allocate to the project, then:

  • The project would’ve been built anyways, regardless of whether I invested.
  • If I didn’t invest in the project, another investor would have.
  • Taking action (investing in the solar project) would not have generated any more environmental impact than the baseline of not taking action (not investing in the solar project).
  • In this example, there would have been no additionality from my investment. However, the investment may still be aligned with my values (even if it did not result in additionality).

The above is a textbook example, but we find similar situations in both investing and philanthropy.

  • Within impact investing, the above example is a common situation that occurs when an impact strategy is capacity constrained or a fund is oversubscribed.
  • For portfolios of public companies/stocks, I believe the concept of additionality implies that ESG integration is more about alignment of values than effecting change. In aggregate, ESG investors may lower a responsible company’s cost of capital or vote proxies in a unique way, but even the largest investors are typically very small minority shareholders in most public companies. Thus, within public equities, the additionality of individual investor decisions is either theoretical or infinitesimally small.
  • Investors invest to generate financial returns (and some may consider additionality). Philanthropists donate to generate additionality. This creates a powerful incentive for non-profit organizations to promote the appearance of additionality even if it does not exist. Some organizations generate tons of additionality and some probably generate negative additionality, so caveat dator (Latin for “let the donor beware”).

Although this post is thematic and the examples are more illustrative than practical, I hope to write more detailed posts about how investors and donors can actually evaluate the balance of need, capital, and capacity in order to get a better sense of additionality.

The Story of the Mexican Fisherman

The story of the Mexican Fisherman is at least fifty years old, but it is a timeless tale that is both revealing and enlightening. Below is one version of the story of the Mexican fisherman:

An American investment banker was taking a much-needed vacation in a small coastal Mexican village when a small boat with just one fisherman docked. The boat had several large, fresh fish in it.

The investment banker was impressed by the quality of the fish and asked the Mexican how long it took to catch them. The Mexican replied, “Only a little while.” The banker then asked why he didn’t stay out longer and catch more fish?

The Mexican fisherman replied he had enough to support his family’s immediate needs.

The American then asked “But what do you do with the rest of your time?”

The Mexican fisherman replied, “I sleep late, fish a little, play with my children, take siesta with my wife, stroll into the village each evening where I sip wine and play guitar with my amigos: I have a full and busy life, señor.”

The investment banker scoffed, “I am an Ivy League MBA, and I could help you. You could spend more time fishing and with the proceeds buy a bigger boat, and with the proceeds from the bigger boat you could buy several boats until eventually you would have a whole fleet of fishing boats. Instead of selling your catch to the middleman you could sell directly to the processor, eventually opening your own cannery. You could control the product, processing and distribution.”

Then he added, “Of course, you would need to leave this small coastal fishing village and move to Mexico City where you would run your growing enterprise.”

The Mexican fisherman asked, “But señor, how long will this all take?”

To which the American replied, “15–20 years.”

“But what then?” asked the Mexican.

The American laughed and said, “That’s the best part. When the time is right you would announce an IPO and sell your company stock to the public and become very rich. You could make millions.”

“Millions, señor? Then what?”

To which the investment banker replied, “Then you would retire. You could move to a small coastal fishing village where you would sleep late, fish a little, play with your kids, take siesta with your wife, stroll to the village in the evenings where you could sip wine and play your guitar with your amigos.”

(This story of the Mexican fisherman was originally written by Heinrich Böll, although Tim Ferriss published the above adapted version which can be found across the internet.)

Financial Advice for New Parents

“Do you have any financial advice for new parents?”

A handful of friends have asked this question in the past week. The question often relates to childcare expenses or college savings plans, but I usually advise new parents to prioritize the below items before anything else:

  • Buy enough term life insurance to provide for your family if you and/or your spouse die prematurely. There’s no “right” amount, so ask yourself what you would want covered if you passed. Your salary of x years? Your spouse’s salary so he/she wouldn’t have to work for y years? Childcare expenses for z years? Payoff a mortgage? College tuition? Other expenses? Add those numbers up and go get some quotes.
  • Establish an estate plan, including a revocable living trust and will. The will should appoint a guardian for your children if you pass away while they’re still minors, although the courts do have the final say. The will also directs what to do with assets that were excluded from the trust (or forgotten to be put in the trust, which I see very often!). The trust should help avoid probate for assets placed within it and provide for supervision of the assets for the benefit of the children.

Buying insurance and establishing an estate plan are simple steps, but each does require some time and money. Fortunately, each item can be a one-time decision, which may be a relief for new parents who are completely overwhelmed!

In my experience though, insurance agents are hungry for business and often provide speedy and over-the-top service. And unless there is some complexity, my observation is that most attorneys can draft an estate plan within a couple days of an initial meeting.

These two steps might not optimize your financial life, but they may protect your kids against the worst outcomes.

Frequently Asked Questions (FAQs)

Many of my friends are having kids these days, which means I’m being asked about 529s more than anything else. Below are just a few of the common questions:

  • Should I open a 529?
  • Which company should I use?
  • How much should I contribute?

My answer to all of the above is:

  • Are you properly insured?
  • Is your estate plan in order?

If not, my advice is generally “Go get properly insured and engage an estate planning attorney. Before investing money for an uncertain future, invest to protect your family should anything unexpected happen.”

The above is educational and is NOT legal or financial advice. Every situation is different and I’m not an insurance agent or an attorney.

Why This Site Exists

The reason I created this site is because I believe sharing my knowledge and experience can generate a positive impact.

People have questions

This site was inspired by the friends and family who are always hitting me up with financial questions. The constant questions are a reminder that it’s difficult to find quality and trustworthy financial information. I started posting answers to the most common questions in attempt to share my knowledge with a much larger audience… and to reduce the amount of time I had to cut and paste the same email or text 🙂 Now I can just reply: “Read this post and then let’s talk!”

My reach is limited

Most of my time is spent helping people via my investment advisory firm and I find that work incredibly satisfying. However, my firm can only serve so many clients. Writing and sharing my knowledge is one way for me to broaden my impact.

People are underserved by financial advisors

Most of the American population does not have access to high-quality advice. I won’t get into all the reasons for it here, but many people are unable to work with a fee-based financial advisor. There are others who may qualify to work with an advisor, but don’t due to trust issues with the industry, cultural norms, or they just prefer to do things themselves. I believe many of these people can still benefit from some generalized information, even if it’s not personalized to their situations.

There is a lot of bad information out there

There is a lot of great information on the web. Unfortunately, there is also a lot of bad information too. I see so many things that are just plain false, missing context, or heavily biased. Obviously, I cannot stop bad content from being published, but I can write reliable information.

My hope is that this site will be a trustworthy source for financial information and answers.

No Specific Investment Recommendations

This site will never recommend specific investments or investment managers. There are a few reasons for this:

I Don’t Know You

I don’t know you. I don’t know what your ability or willingness to take risk is. I don’t know your liquidity needs or investment time horizon. Unless I know you and understand your situation well, it’s impossible to make a recommendation.

To illustrate the above, consider that I will often make different recommendations to the exact same client! Suppose a client has four accounts, but wants to invest all of them identically. I may recommend a specific index fund for one account, a different share class of the same fund for the second account, a different fund targeting the same index for a third account because it is taxed differently than the first two, and a separately managed account targeting the same index for the fourth account due to tax considerations. The client may be purchasing the same underlying holdings in all four accounts, but there are four different recommendations.

Things Change

Things change. An investment may look attractive in one environment, but not in another. A manager’s strategy may “drift” over time, turning a low-risk portfolio into a high-risk one. Time stamping recommendations could help, but not to the level that I’d be comfortable with.

Clients Come First

Sourcing and conducting due diligence on investment opportunities is what I do in my day job for clients and many of the funds that we invest in have capacity constraints. My goal is to help the investor community as much as possible, but not at the expense of my clients.

The Bottom Line

Investment advice is personal and recommendations should be made within the context of an investor’s situation. To make a good recommendation, I’d need to know someone’s ability to take risk, willingness to take risk, time horizon, liquidity needs, tax situation, net worth, account details, and a lot more. If I were to make a recommendation on this blog, I’d have to list out all of the nuances, caveats, exceptions, and so on, which I do not believe is feasible.

Its not clear to me how anyone can make a recommendation to strangers, so I will leave the specific recommendations to the talking heads on CNBC and the writers who contribute to Seeking Alpha. Publishing specific recommendations for the general public is not something I want to do, nor do I believe it is especially helpful to individual investors. My goal is to be helpful to investors.

New Blog, One Goal

Hi, I’m Matt. Most of my time is spent managing an investment advisory firm.

Helping people reach their goals through investing is incredibly satisfying. Yet my firm can only serve so many clients, many investors do not have enough assets to work with an investment advisor, and I recognize that some people prefer to manage their own investments even if they can work with an advisor.

My goal is to provide readers with the resources that they need to reach their own goals.