Out of Context Problems and Diversification

Life Jul 4, 2022

How prepared are you for black swan events? These improbabilities can gut your financial plan. So how do we cope with uncertainty?

Savvy active investors may find the idea of black swan events enticing, based on the notion that they have a chance at making a tidy profit. Yet the likelihood is that instead of winning big, such an investor is going to miss the opportunity whilst many people suffer.

Worse still is that there's always that uncertain future where everything breaks down, or at least enough things go awry that a great sea change sweeps society's norms away.

With how quickly things can go wrong, how do we cope with uncertainty?

I say uncertainty is best fought with community, diversification, and solidarity. There's a saying about that: "If you want to go fast, go alone. If you want to go far, go together."

I have lots of thoughts on that, but first, let's address the basics of black swans, diversification, and out of context problems:

What are Black Swan Events and Black Swan Theory?

To give context, the black swan theory was popularised by Nassim Taleb to highlight the flaws he saw within the finance sector. It boils down to how risk is managed: Taleb says that high-impact outlier events are hard to predict, despite hindsight making it seem possible to see them coming.

He criticised heavily the use of normal distributions in statistics. Normal distributions are great for capturing day-to-day routine events, but cannot capture outlier events in their predictions.

This is a problem because outlier events are where there's a lot of "stuff," such as profit to be made or change to be had.

Taleb also proposes that those high-impact outlier events are where a lot of growth occurs. Black swan theory ties into Taleb's notions of "antifragile" robustness: that we should embrace shake-ups as opportunities for growth.

Thus, a black swan event is something that:

Is an outlier, a surprise, and rare
Has an extreme impact, think on a national or global scale
Can only be reasoned about after the fact, with hindsight, and cannot be predicted in advance

Taleb points out several recent events as examples of black swans, notably 9/11, the 2008 financial crisis, and the invention of the personal computer. (But not the Covid-19 pandemic, as that was tragically predictable except for the timing). Natural disasters are often considered black swan events, as are societal and technological breakthroughs.

Point three is particularly important to black swans. With hindsight, people can delude themselves into thinking they understood how and why the black swan happened, and that they could have seen it coming.

Yet in reality, we can't tell when a black swan is coming or what it's going to be.

We simply have to wait for retrospective to let us figure out what was important and what was merely odd.

What is Black Swan Investing?

First, black swan theory is less a strategy to investing and more of a guiding philosophy. That said, there's active and passive approaches to black swan investing:

With the passive approach, you find an investment that is normally near zero gains (keeps pace with inflation) and that occasionally will give large returns that drag the average up much higher.

Such a passive investment vehicle values safety, as avoiding negative returns is important there. You want something stable that might become incredibly profitable under the right circumstances.

With the active approach, you keep your capital in a liquid and value-preserving asset – cash under your mattress is one example. Then you wait until a black swan comes around, and you use your buying power to turn a profit by purchasing deeply discounted assets.

As mentioned above, these points are more philosophical than strategic. Selecting what you want to invest in the majority of the work, and it requires both skill and guesswork.

Which is why, personally, I focus on a passive and diverse portfolio and don't really touch black swan theory for investing.

What is Diversification (and Why Diversify Your Portfolio)?

Diversification is about spreading out your portfolio assets so that any single major loss or win gets averaged out into mediocrity. Thus, on the whole, you do just average and okay.

It's the "spread your eggs in many baskets" approach to finances.

Diversification has two main aspects in my mind:

The first is that you want a diversity of types of investments you make. This can be sectors, asset classes, or whatever else varies and provides some uncorrelated returns.

You don't want to be all-in on tech stocks, for instance, because then you're missing out on industrials, real-estate, power, consumables, healthcare, and so forth.

The second is that you want a diversity of investments within the area you're focusing on. In practise, you want multiple companies or a mutual fund/ETF.

Individual companies come and go, but society's needs remain.

That's why I invest in exchange traded funds. I don't care about the fate of single companies like Proctor & Gamble, but I do care about a fund that includes consumer goods production.

P&G could crumble any day now, but the demand for goods remains. Something else will rise in its place, and I trust that a good ETF for consumer goods will capture that rebalancing and help preserve my capital through the ordeal.

With a diverse portfolio, you're much less likely to see drastic losses due to extreme events like company bankruptcies.

If you're diversifying by holding a broad-market ETF, you're also highly unlikely to be chasing overvalued IPOs or stocks touted to unsustainable hyped prices. The hype cycle of buying into individual stocks is problematic.

It's also standard to diversify outside of stocks, such as by owning real estate or bonds.

The dream in the US is often to own your own stable housing, and gain access to generational wealth by that means. Some people extend that to owning farmable land, to improve their food resilience.

Ultimately diversification is about having enough different ways to provide for your stability, as well as the needs for others around you.

That way if you lose several ways of providing, you can still get by and recover.

Only Invest What You're Willing to Lose

Some "investments" are more gambling than investing. Crypto, meme stocks, and complex active trading strategies are all examples. They have outsized risks that are poorly understood, and unreliable returns.

Hence, gambling. You should only approach such investments with money you can afford to lose, and not leverage yourself into oblivion with debt.

Broad-market index funds are less gambling, but still bear their own risks. You can lose money in many "exciting" ways no matter what you choose to invest in, and especially so if you choose to not invest at all thanks to inflation.

Which really comes down to a fundamental truth of life:

Anything in life can be taken away or lost.

Don't get attached to material wealth. Fortunes may sour through disasters or mistakes. Then there's always the great leveller (death) that will render your wealth useless to you as you cease to participate in life.

For that matter, don't get too attached to people, your own abilities, or anything. Life is constantly changing, and everything in life can be lost.

This view doesn't mean avoid attachments entirely – just engage in moderation and recognise that loss is inevitable. Attachments to people are healthy, and the most worthwhile thing I believe people can engage it!

Yet people drift into and out of your life, and they change all the time. You will grieve for them.

Furthermore, your skills wax and wane. You can be disabled in a variety of ways.

Disability and hardships in life are particularly hard, because most often there was no tangible choice that led to you losing quality of life. It just happens.

Not like in investing, where your actions have clearly connected cause and effect relations amidst the random walking.

Since investing is inherently risky, the standard advice is to let lengthy time in the market grant you regression to the mean – basically if you wait long enough with a "stable" investment, it'll average out and grow a bunch over decades.

Which implies that you should leave your money invested for as long as you can, and that you should avoid investing if you need the cash within a few years time.

Yet you should always remember: nothing is meant to last, and different types of wealth can vanish when systems break down.

Past Performance is Not a Guarantee of Future Returns

There is always an important caveat to consider when thinking about the future:

Nobody knows the future.

We make guesses, we have tools for improving our confidence about the future, but it's eternally uncertain.

For the most part, the future is often a slight variation upon the status quo. When I first learned about forecasting, we were taught, "What's tomorrow's weather? Likely the same as yesterday's!"

This naive forecasting method is surprisingly effective in a lot of contexts. Changes from the status quo are relatively rare in most contexts.

Yet the entire central point of black swan events is that they have widespread impact, that they can change the fundamental shape of the people's lives in the world. The status quo breaks down and great changes happen.

That's why past performance cannot be relied on to guarantee the future. Past performance strongly hints at what the future will likely be. But it's not a guarantee, it's never certain.

This most often comes up in the context of personal finances with index fund investing.

Broad market index funds are talked up as the most reliable choice, the safest way to invest, and that they give the most consistent returns. These points are all mostly accurate, but there is always that aforementioned caveat.

The future is uncertain, and just because index funds have been reliable for decades doesn't mean that they will continue to be so. There is always an element of risk with everything in life.

That said, broad market index funds are relatively tame and safe.

For the average person getting into investing, I strongly recommend them.

What is an Out of Context Problem (aka the Outside Context Problem)?

The outside context problem parallels black swan events in interesting ways. To quote wikipedia about the book that coined the term:

This is a problem that is "outside the context" as it is generally not considered until it occurs, and the capacity to actually conceive of or consider the OCP in the first place may not be possible or very limited (i.e., the majority of the group's population may not have the knowledge or ability to realize that the OCP can arise, or assume it is extremely unlikely).

An example of OCP is an event in which a civilization does not consider the possibility that a much more technologically advanced society can exist, and then encounters one.
– Wikipedia on the book "Excession"

You might say that the out of context problem has two main factors:

It's impossible for the recipients to reason in advance, or impossible to predict
It has a huge impact when it comes up

When laid out like this the parallel to black swan events is clear. Black swan events can only be reasoned about with hindsight, and they shake things up as well.

Black swan events come as surprises for people, just the same as out of context problems.

There's a lot of literary examples of outside context problems on TV Tropes:

A lot of the examples boil down to an unknown party coming in to upset the status quo, such as aliens, time travellers, or empowered individuals.

In real life, we've got "exciting" problems like side channel attacks in cryptography. Rather than trying to break the mathematics of security, people find inventive ways of reading leaked information. For instance, how long it takes to run an algorithm (if it fails early) might tell you whether an attempt is more correct or less correct than another.

We also can look at the Covid-19 pandemic as an out of context problem for most small and medium businesses. Just like any disaster, most smaller businesses don't have sufficient disaster preparedness. Being prepared takes time, planning effort, and assets in reserve (like a war chest).

Whilst the pandemic is not really a black swan event because it was entirely predictable – just a matter of when according to the CDC prior to the pandemic – it is still an out of context problem for the majority of people.

Talking about the highly improbable, unpredictable, and events with widespread impact leads towards a thought: societal collapse.

What About a Collapsing Society?

"May you live in interesting times" was my mother's favourite blessing and curse.

With so much information available about what's going on in society, it's hard to not feel as though everything is going poorly. It definitely feels like interesting times.

We might hope for the best, prepare for the worst, and expect something in between.

Yet expectations are worthless, if you refer to aforementioned points about the future being uncertain and past performance not guaranteeing future results.

One worst case is the collapse of society. It can be an outside context problem if you don't dedicate planning to it.

My question for you is thus:
If the stock market and economy becomes superfluous overnight, will you be able to thrive anyway? If the government becomes redundant, do you have the skills and resources necessary to keep making the world better?

This isn't a nudge to go overboard on prepping, by the way. It's to point out the risk inherent to living at all – anything can be taken away when you least expect it.

I highly recommend this article from BGR:

The article is a breath of sanity amidst the fantastical culture of prepping. It's a pragmatic list for getting by most of the time. It helps lower the barrier to entry to being more resilient through the uncertainties of life.

Whilst we're presently living in interesting times, there's still stuff we can do to help alleviate some of the uncertainty.

How do We Cope With Uncertainty?

We cope with solidarity, love, and community.

Nobody can realistically thrive on their own. There's simply too much work to do for a single person or family to take on in our modern society.

To be self-sufficient requires more labour and knowledge than is feasible to sustain for life.

Building your own house is nice, especially with locally sourced materials. Yet, are you treating your own water, or simply relying on the lack of contaminants in your groundwater? Do you mine and recycle all your metals by yourself? What do you do when something breaks?

I think true self-sufficiency is a conceit, though moving closer to that ideal is a worthwhile endeavour for resilience reasons.

Community has always been a powerful force through human history. People can become specialised in their areas, which is why our contemporary times have such high standards of living for typical people compared to those throughout history.

These days, we've engineered such an abundant wealth of resources and knowledge. It's a matter of sharing that wealth with everyone we can.

People need help the most when times are uncertain. It's worthwhile to turn towards each other, help when we can, and accept help when we need it.

Society functions smoothly on a generous helping of trust. Trust that others are acting in good faith, that people will honour their agreements, and that there is enough stuff to go around for everyone. Scarcity can foment distrust!

If we all agree – collectively throughout society – to look after one another and work towards solutions for crises we face, then we will be well off.

In my eyes, the answer to uncertain times is not to hoard wealth, or to distrust and fear neighbours, or to seek to profit off their misfortunes.

Instead, the answer is to help one another, build friends and community, to stand in solidarity with people who are trying to make the world better than it is.

Focus on what tangible changes you can bring about, both small and large ways of improving people's lives.

Closing Thoughts

One of my partners had an observation I found amusing:
Her favourite form of aid involves a bunch of queers passing around the same twenty dollar bill.

I think that highlights several things, such as how few resources float amongst marginalised peoples – they desperately need material support. It also alludes to the kindness that leads to many people giving what they can, when they can.

It is easy to give when you have abundance; it is harder to give when you have little, but shows all the difference in priorities.

We all face hardships in life. It's best to prepare ourselves for their eventuality, and be graceful and supportive when those around us face their own hardships.

I have more thoughts on hardship and partnerships that I shall call to your attention: