Earthquakes, Terrorist, and Technology

This is an early draft of a 250 essay. I’m posting it here so I don’t forget some of the ideas that were cut from the final draft.

Main concern: Are there two types of gray swans? 1) Conceivable, Unpredictable but forecast-able and 2) Conceivable, Unpredictable in the long-run but predictable in the (very) short term. Earthquakes are in the first category. Terrorist attacks are in the second category. 9.0 Earthquakes and 9/11 are both conceivable (and NOT unknown unknowns) but intelligence analysts had enough info to predict 9/11. Earthquakes are inherently unpredictable. 

Terrorist attacks and earthquakes have a lot in common—at least to Aaron Clauset. In The Signal and the Noise, Nate Silver explains that according to Clauset, earthquakes and terrorist attacks both follow power-law distributions. If you don’t have a mathematics degree, that means that small earthquakes (0-4.9) are common, medium-sized earthquakes are less common (5.0-7.9), and large earthquakes (8.0 or greater) strike a few times a century. Terrorist attacks, in terms of total fatalities, behave similarly.

Of course, we can control terrorist attacks, and that’s one reason why they are different than earthquakes. However, I’d rather be a seismologist than an intelligence analyst. While there are only a few different types of earthquakes, there are thousands of ways a terrorist could strike. The challenge for the intelligence analyst is to scrutinize a large number of hypotheses—hijackings, chemical attacks, bombings, shooting sprees.

National security disasters in the United States are often the result not of a dearth of information but imagination. That is, no one considered the correct hypotheses. For instance, at Pearl Harbor analysts never reviewed the possibility of a full blow aerial attack even though evidence suggested that it was possible—even likely. According to the 9/11 Commission, we had enough information to anticipate September 11th, but the C.I.A and F.B.I never seriously examined the idea that terrorists would hijack four planes and crash them into high-profile buildings. As the Nobel-Prize winning economist Thomas Schelling put it, we tend “to confuse the unfamiliar with the improbable.”

What can earthquakes and terrorist attacks teach us about business? More than you think. Technology also follows power-law distributions. In history, a few revolutionary inventions (the wheel, the printing press, the steam engine) are surrounded by thousands of less groundbreaking inventions (thermometers, zippers, CD-Rom), which are surrounded by millions of small inventions (snuggies and post-it notes). Revolutionary inventions disproportionally affect the economy in the same way that large earthquakes and terrorist attacks inflict a disproportionate amount of damage. The wheel was a 9.0 magnitude invention.

Earthquakes are not predictable. Are inventions like the wheel predictable like 9/11 was? Yes and no. We cannot predict inventions (or terrorist attacks) that will occur in the distinct future. But we might be able to predict an invention that will emerge within the next 2-5 years (if there is one). For instance, all of the components of the iPod existed for a few years before Steve Jobs fit them into your pocket. According to Scott E. Page, all of the components of the steam engine existed for two decades before the steam engine. There was a small window in which someone had enough information to predict the iPod and the Steam Engine.

But remember the lesson from Pearl Harbor and 9/11. They were failures of the imagination and not failures of information. “The signals just weren’t consistent with our familiar hypotheses about how terrorists behaved, and they went in one ear and out the other without our really registering them,” says Silver.

A Timeless Analogy About Speaking and Listening

A conversation is like playing catch (and we never learn learn how to listen)

Mortimer Adler & Charles van Duren (How to Read a Book):

The reader or listener is much more like the catcher in a game of baseball. Catching the ball is just as much an activity as pitching or hitting it. The pitcher or batter is the sender in the sense that his activity initiates the motion of the ball. The catcher or fielder is the receiver in the sense that his activity terminates it. Both are active, though the activities are different. If anything is passive, it is the ball. It is the inert thing that is put in motion or stopped, whereas the players are active, moving to pitch, hit, or catch.

Plutarch (Essays):

Instead, just as in a ball game the catcher must move and change position in a rhythm which responds to that of the thrower, so in the case of speeches there is a certain harmonious rhythm on both the speaker’s and the listener’s part, if each of them makes sure that his own conduct is appropriate.

Epictetus (Discourse)

This is what you will see skilful ball players doing also. None of them is concerned about the ball as being something good or bad, but about throwing and catching it. Accordingly, form has to do with that, skill with that, and speed, and grace; where I cannot catch the ball even if I spread out my cloak, the expert catches it if I throw.

Yet if we catch or throw the ball in a flurry or in fear, what fun is there left, and how can a man be steady, or see what comes next in the game? But one player will say “Throw!” another, “Don’t throw I ” and yet another, “Don’t throw it up!” That, indeed, would be a strife and not a game. In that sense, then, Socrates knew how to play ball. How so? He knew how to play in the lawcourt. “Tell me,” says he, ” Anytus, what do you mean when you say that I do not believe in God. In your opinion who are the daemones? Are they not either the offspring of the gods or a hybrid race, the offspring of men and gods?” And when Anytus had agreed to that statement Socrates went on, “Who, then, do you think, can believe that mules exist, but not asses?” In so speaking he was like a man playing ball. And at that place and time what was the ball that he was playing with? Imprisonment, exile, drinking poison, being deprived of wife, leaving children orphan.These were the things with which he was playing, but none the less he played and handled the ball in good form. So ought we also to act, exhibiting the ball-player’s carefulness about the game, but the same indifference about the object played with, as being a mere ball.For a man ought by all means to strive to show his skill in regard to some of the external materials, yet without making the material a part of himself, but merely lavishing his skill in regard to it, whatever it may be. So also the weaver does not make wool, but he lavishes his skill on whatever wool he receives. Another gives you sustenance and property and can likewise take them away, yes, and your paltry body itself. Do you accordingly accept the material and work it up. Then if you come forth without having suffered any harm, the others who meet you will congratulate you on your escape, but the man who knows how to observe such matters, if he sees that you have exhibited good form in this affair, will praise you and rejoice with you; but if he sees that you owe your escape to some dishonourable action, he will do the opposite. For where a man may rejoice with good reason, there others may rejoice with him.

Prospect Theory Through the Ages

“Riches do not exhilarate us so much with their possession as they torment us with their loss.” – Epicurus

“Men feel the good less intensely than the bad.” – Livy

“For most people, the fear of losing $100 is more intense than the hope of gaining $150. We conclude from many such observations that losses loom larger than gains and that people are loss averse.” – Daniel Kahneman

Irrational Overconfidence

In September, 2008, Dick Fuld, the Chairman and CEO of Lehman Brothers, traveled from his office on the thirty-first floor to Lehman’s trading floor to make an announcement. “I know some of you are unhappy with the performance of the stock,” Jared Dillian, a former Lehman employee reports in his memoir Street Freak. “And so am I. As you know, I own a lot of stock. And this has been just as painful for me as it has been for you. But we’re going to… get the stock back up to eighty-five bucks.” Fuld concluded on a reassuring note. “And don’t think I forgot about that one-fifty!” alluding to his long-term goal. Lehman filed for Chapter 11 bankruptcy protection on September 15th.

In September, 1998, precisely ten years before the collapse of Lehman Brothers, John Meriwether, the founder of Long-Term Capital Management, wrote a letter to investors announcing that “we see great opportunities in a number of our best strategies.” Long-Term’s equity plummeted from $2.3 billion to just a few hundred million dollars by the end of the month. The fund was liquidated two years later. According to Roger Lowenstein, author of When Genius Failed, “[Merriwether’s] analysis was devoid of any suggestion that anyone at Long-Term had made a mistake.”

Why does overconfidence sometimes flourish as our odds diminish? In nearly every corner of human life involving prediction—from poker tables in Las Vegas to corporate board rooms in Manhattan—we’d be better off if we were more realistic about our chances. But no. We double down. And we usually pay the price.

How You Make Money Will Influence How You Understand Luck

Imagine a genie visits two people. He gives the first, Brett, $100 million. The second, Mike, also receives $100 million. But the genie places Mike under a spell. Whereas Brett is aware that he received his fortune from the genie, Mike believes that he has spent the last twenty years of his life investing in the stock market. Through hard work, he has netted $100 million so far.

To an accountant Brett and Mike are the same. But Brett and Mike inhabit much different mental lives. Brett continues his life as normal, minus a few indulgences. He remains parsimonious, knowing that his fortune might vanish just as fast as it appeared. Mike continues to invest confidently. One weekend, however, an oil crisis in the Middle East erupts and a bubble in the tech industry bursts. Mike loses all of his money. Devastated, he commits suicide and destroys the lives of those who loved him.

On the path to $100 million, we should never judge the quality of a decision based on its outcome. If a hypochondriac buys 10,000 bottles of Advil and the world’s supply of ibuprofen suddenly runs out, we would never praise him for his foresight. Luck can play a large role in success, especially with respect to investing. There’s nothing inherently wrong with that, of course, except when we attribute a lucky result to our skill and intellect. Once that occurs, overconfidence and risky decisions flourish, and the chances of blowing up increases.

In his splendid book The Most Important Things: Uncommon Sense for the Thoughtful Investor Howard Marks offers similar advice. “We all know that when things go right, luck looks like skill. Coincidence looks like causality. A ‘lucky idiot’ looks like a skilled investor. Of course, knowing that randomness can have this effect doesn’t make it easy to distinguish between lucky investors and skillful investors. But we must keep trying.”