If a Hedge Against Unlikely Events Is Cheap, Consider Buying It

Looking at the events of these past few years after the pandemic, I can personally say that my confidence in predicting the future has gone down. Generally, many of us have this belief that things will turn out the way they normally do. That's because, as mathematicians and statisticians like Nassim Nicholas Taleb (of The Black Swan fame) put it, most of us view the world in Gaussian or bell curve terms. Gaussian or bell-curve thinking is when we tend to predict events in the future based on how they turned out in the recent past.

What exactly is a bell curve (or a Gaussian curve)? An easy way to explain it is if we pour a bucket of sand on the floor, and our hands are steady, the sand turns to form a mound. Most of the sand is in the center of the mound and so that is the peak or highest point. The rest trickle off into the sides, and we get less and less sand as we move away from the center of the mound. That mound looks like a bell, hence many call it a bell curve.

Now think of this mound as an indication of probability. We can say that the peak of the mound (or bell) is the center, and that is, what we call in math, the mean of the bell curve. If we measure the point from the mean (or center) as it curves down and out toward the center, that's called the variance, and the square of that is the standard deviation, which represents a normal variation from the mean. Never mind if you're a bit confused now. The point is that this curve indicates probability.

One can say that in times where we normally have predictable outcomes, the mean up to the standard deviation is where most of the sand or where most of our expected events or outcomes occur. For example, if our flight from San Francisco to New York is supposed to arrive at 6 p.m., maybe one flight will arrive at 6:02 p.m., but another flight may arrive at 5:58 p.m. If it arrives at 6 p.m. the next day (24 hours later), then that is not a regular outcome, and we could consider that as being in the tail of the pile of sand, maybe an event that has happened but is far away from the usual events.

Another is when we assume that just because an allocation of 60% stocks and 40% bonds in our portfolio worked well in the recent past, it will carry on as a rule into the future. That may not hold true anymore. Just as a theoretical example (this is not financial advice), what if an allocation of 40% stocks, 40% bonds, 10% gold, and 10% Bitcoin works better for you now? Again, I'm just giving that as an example. That's not necessarily the right allocation for you. But the point here is, the "rule" that used to work well in the past may have already changed. The bell curve rule may no longer be true.

As Taleb points out in several of his books, as many of the events of the past few years point out, it is not the Gaussian or bell curve events that wipe us out. Often it is the sand that has trickled a few feet away from the mound that we call "outliers" or "Black Swan" events. Taleb coined the term Black Swan because he said that just because we haven't seen one doesn't mean it doesn't exist. We only believe that there is a black swan if we actually see one. But most of the time we see swans, they are mostly white. Hence, we incorrectly think that all swans are white.

Similarly in 2018, we never believed that a plague or pandemic would happen, but it did just two years later. We never thought that airplanes would hit the World Trade Center and the Pentagon in 2001, but they did. There are a lot of catastrophic events in our lives that have happened that were outside the range of possibilities we thought could happen but still did. As some would say, sometimes it is the thing that you least expect that kills or wipes you out.

So do we obsess over every remote possibility in our lives? Of course not, else we wouldn't get out of bed in the morning. But there are things we can do that can somehow mitigate random and low-probability disasters.

One of those is to hedge for the unforeseen and what we think are low-probability events, if the hedge is cheap.

For example, if insurance is cheap, consider buying it. Even if you think you are invincible and will live forever. If a hedge is cheap, such as gold and silver just in case stocks and bonds fail, consider putting those in your corporate treasury. It is said, for example, that Coca-Cola executives who know their cola formula are not allowed to travel together at the same time, but maybe that is just an urban legend.

Simply thinking that tomorrow may not turn out like today and yesterday is already a first step in ensuring we have the right mindset for almost everything life throws at us. The surprises of the last few years should remind us of that.

The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.