January 11, 2008

The black swan – unpredictability, futility of forecasting etc

I have just finished this book. I wrote about this book earlier here. I have also read N N Taleb’s earlier book – fooled by randomness and liked it a lot.

I will not be doing a detailed review of the book as that can be found on amazon and a lot of other website. I will however highlight some of the points, which struck me as important and how they impact me as an investor.

One of the key points, which the author makes, is about the complexity of the real world and lack of predictability. For ex: No one predicted the rise and the importance of the internet. The Internet has become one of the major forces shaping our world. It can be termed as a positive black swan. As a result all complex systems such as the economy, financial markets, which get impacted by such black swans, cannot be predicted. But that does not stop analysts and all the talking heads on TV from making predictions (predictions for 2008 etc etc)

Now one can argue that some prediction do come through. Well, you don’t have to be a guru for that. Just take some events, toss a coin and make a prediction based on the toss. You will be right 50% of the time. Analysts and TV gurus are worse than that in terms of their success rate. There are numerous studies supporting it, so you don’t have to take my word for it. Try this on your own – write down some predictions you hear this year and check back a year later.

Why are we suckers for this? because we want to resolve uncertainity and anyone who can or claims to provide visibility to the future is sought out (we do have astrologers !) . The author terms this as the narrative fallacy.

Personally, I stopped looking at predictions, analyst estimates, top picks/ hot picks etc etc long time back. If I want to be entertained I would rather watch a movie or a cricket match!

A logical question is how to invest if you do not predict. Does developing a DCF not amount to forecasting a company’s cash flow? Well it does. The difference is between a macro and a micro forecast. Forecasting a company’s cash flow is much easier than forecasting the direction of the stock market. If you know the company well, it is in your circle of competence, and you can figure out the few key variables driving the cash flow of the company then it is possible to arrive at a reasonable estimate. Will it be accurate? I don’t think so. However if you are conservative in your assumptions (don’t assume 50% growth rates) then the impact of the negative surprises would be minimal. I would not worry about positive errors (cash flow more than forecast) as I will gain from it. In addition, if you buy at a discount to the estimate of the intrinsic value (margin of safety concept), then you are protected further from errors in the forecast.

Compare this approach with macro, top down forecast. If some one says – infrastructure stocks will do well because infrastructure spending is to increase by 50%. In addition to all the stock specific factors, you thesis is also dependent on the increase in the spending which in turn depends on multiple factors. The more variables in the investment idea, the more there is a chance of something going wrong. In addition, you will also pay more for such an optimistic scenario. So if the macro forecast or something else with the company goes wrong, the losses can be severe.


Ranjit kumar said...

Hi Rohit,

Please can you elaborate on the following "No one predicted the rise and the importance of the internet". I think almost everybody predicted the importance of internet which is why we had 2000 bubble. Please can you let me know your thoughts.

Ranjit kumar

Rohit Chauhan said...

Hi ranjit
the invention of the internet was sometime in the 70s or 80s. It was initially used by the US military and the some universities.
i think it started coming into the mainstream around the mid 90s. none of the US agencies, or the japanese MIT (a think tank) or any major forecasters had predicted in early 90s that the internet would have a huge impact.
the bubble was after everyone realised that the internet could have a major impact. even then it seems people got it wrong and ended up bidding up the wrong companies. for ex: i would say the indian offshore companies have benefited a lot from the internet, which was not realised in the early stages.
i think even now we do not know in what ways the internet would impact us in the long term.
in addition the author refers in the book to a bias called as the narrative fallacy where we think that history is more predictable after the event has happened. that may well be in the case of the internet where a lot of people think the potential of the internet was always evident.
for other examples like this the author has given the example of the laser.

VISHNU said...

Hi Rohit,

My Poicly is try to reserve capital for any Negative Black Swans which may / may not occur in your portfolio ..(Less Probable and High Impact events that are negative in nature)

Ex: Buffet's cash reserve against their Super Cat Insurance

2nd policy is to avoid investing in Positive Black Swans as well..(Less probable and High Impact events that are positive in nature)

For example: Buffet avoided all internet stocks..he doest invest in Private Equity which is the best example of positive Balck Swans

The best policy I feel is to invest in High Probable and moderate impact events..(becasue as Taleb puts in its very difficult for the human being to predict the black swans)

Rohit Chauhan said...

Hi vishnu
what you describe is the typical value investing approach ..investing based on certainity and avoiding risk via diversification. i try the same thing for positive black swans as i do not have the skills to identify them. not sure of the negative ones though ..i think i am protected ..but then you never know. but atleast it is good to be aware of the ignorance

sujith said...

Hello Rohit ,

Is it possible to bring out a topic or blog post in ur blog as "How to calculate Discounted Cash Flow Methology using the "the financial sheet" fo any one of the listed Indian comapanies in NSE or BSE using step by step instruction. Though it is used differently by every investor , i need to know the basics of using DCF

Rohit Chauhan said...

hi sujith
i plan to do that in course of time