Bill Gates, Nassim Taleb and your money

In June this year, Bill Gates tweeted, "I'm always amazed by the disconnect between what we see in the news and the reality of the world around us. ...we must fight the fear instinct that distorts our perspective." Included in the tweet was a chart of the distribution of the actual causes of death that Americans die of, and for comparison, the same topics in Google searches and in media coverage. Predictably, factors like heart disease, cancer and accidents dominate the actual causes of death. Yet, Google searches were dominated by cancer, accidents and some other diseases while media coverage was dominated by terrorism, murder and suicide.

This adds up to a nice view of risk as it really exists, as it is perceived by people themselves, and as the media tries to portray it. Or does it? As per Gates, if people did not have this distorted perspective on the risks they faced, then Google searches and media coverage would have, for example, a lot on heart disease and very little on terrorism or crime. On Twitter, people pointed out many flaws in Gates' assumptions. One obvious one was that heart disease was mostly an affliction of age and Google's overwhelmingly youthful audience does not really worry too much about it, nor does it need to.

However, the most cogent and interesting objection to Gates' tweet came from Nassim Nicholas Taleb, the great philosopher of risk, investing and probability. Taleb said that the pattern of people's worries was actually the correct one. As per Taleb, a simplistic view of the statistics does not reflect the actual risks. He tweeted, "Never compare risks with fat tails to regular ones. The law of large numbers works differently. We survived hundreds of millions of risks thanks to paranoia. We don't need to be lectured by pseudostatisticians."

What is this 'fat tail' that Taleb talks about? There's a technical definition of 'tail risk' that you can Google but in a general sense, 'tail risk' is the chance of a loss occurring due to a rare event and a fat tail is the phenomena of extreme events, that would normally be expected to be rare, actually having a far higher chance of happening. Taleb's point here is that while one can calculate the probability of 'thin-tailed' events based on their past rate, one should not compare this to fat-tailed events. Last year, X number of people died of heart attacks or road accidents or slipping in bathrooms around the world. This X is not going to become 10X or even 5X next year. However, in the case of terrorism, the number of victims could be 10X or 0.1X for that matter. The two kinds of 'tails' cannot be compared.

Is there a parallel of this in investing? Obviously, there is. In fact, Taleb originally articulated all these ideas in the context of investing in his first book, Fooled by Randomness. In fact, the problem is not just of the probability of an event, but also of the impact it will have. A 50 percent chance of losing Rs 10 lakh and a 10 percent chance of losing Rs 50 lakh are not equivalent if the latter would ruin you. For the statistician (naive empiricists, as Taleb derisively says), an event may have a low probability over a population but for the individual who is subject to the adverse event (be it in investing or any other aspect of life), it could be life-changing or even life-destroying. Therefore, human beings act with extreme caution and alarm with respect to events that appear to be uncontrollable and which may have a catastrophic outcome, no matter how unlikely that outcome may appear statistically. The first requirement of success is to survive.

We investment advisors often forget this and are guilty of relying too much on averages and trends and not enough on the extremes. Some investors and businesses do that too. The problem is that when the going is good, extremes look very unlikely. Standard ways of doing the numbers always make them look unlikely. Understand that that's an illusion, and always focus on controlling risk first. The rest is easy.