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Black Swan Investing

Carl from Behavior Gap recently posed an important question over at Morningstar’s blog. He asks whether laziness is a significant motivator in investment advisors’ tendency to steadfastly recommend a buy and hold strategy. Carl writes,

“I have found that there is a subculture in the advice industry that dismisses any inquiry about the economy, the markets, or anything other than buying and holding, as speculation.”

He then continues,

“I have recently asked questions about:

  1. The fact that total debt to GDP is over 350% and that is 2x higher than it was in the 1920’s (see chart).
  2. Nassim Taleb’s great books: The Black Swan and Fooled By Randomness.
  3. The work of Benoit Mandlebrot on risk (see this book and this Morningstar Conversation).

…People dismiss the questions as foolishness without even considering them.”

I absolutely agree that it’s worth thinking critically about investment strategies. Whatever strategy you choose to follow, you must have a deep understanding of why you’re following it, otherwise you’ll be unable to stick with it.

Placing Bets

On the other hand, I have my doubts as to the value of attempting to work economic indicators into one’s investment strategy. Take, for example, the above-mentioned 350% debt to GDP ratio. What do you do with that piece of information? In order to make use of it, you need to actually change your strategy in some way.

You have to make a bet. Overweight or underweight something relative to a simple market-cap-weighted portfolio. Or, rather than buying and holding, attempt to use that information to predict where a particular asset class is heading next.

Instead, I choose to bet against anybody’s predictive abilities (including my own).

Planning for the Unpredictable

Incidentally, a large part of my reasoning is exactly what Carl referenced in his post: the concept of the “unknown unknown” or, to use the current catch phrase, the black swan.

Say you know Fact A, and you believe that A will cause Event X to occur. In a vacuum, you may be completely correct. But in the real world, there are also Facts B, C, D, and an infinite number of other facts that you’re entirely unaware of. And any one of those could potentially cause Event X not to occur.

And judging from history, what tends to happen is that while we’re debating whether Events X, Y, or Z will occur, Event Q sneaks up out of nowhere and screws up our plans beyond recognition.

My understanding is that the entire point of the black swan concept is that, rather than looking at some fact (350% debt to GDP ratio) and predicting a particular result, we should accept the fact that we’re not good at predicting major events. We should attempt to build a portfolio (and investment strategy) that recognizes that reality and deals with it appropriately.

My method of planning for the unpredictable is to:

Do I think that’s the only way to respond to an unpredictable investment environment? No. Not at all. But I have yet to encounter any strategy that I’d say is better than this one.

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  1. Good luck with this comment thread Mike. 😉

    To play devil’s advocate, I’m not convinced your investment strategy as outlined is looking ahead to all possible events. It’s really betting that the world’s economy will grow in the future, that such growth will be captured by the markets, and that you’ll be given your fair share.

    Black Swan thinking would point out that Russian or German investors back in the early 20th Century didn’t do too well from such faith, nor have Japanese investors from the 1980s (2o years since the peak must be getting into any definition of long-term!)

    You may say any move that saw the world’s markets go into decline would be ruinous for any other strategy, but I’m not so sure.

    For instance if we saw a return to semi-forced nationalization then government bonds and physical gold might still do well while the market tanked.

    Or what if Governments decided free markets were best but that they wanted more of the gains? They might jack up income and capital gains taxes accordingly — they’re pretty low by historical standards in much of the world.

    Perhaps if you owned real estate and never sold you’d still be safe, as more voters own their own homes than have made their own substantial savings egg.

    You can go into various diversification strategies until the cow comes home, and personally I think stocks will outperform; but you do have a post on going 100% on stocks, and I *am* playing devil’s advocate… 😉

  2. Good luck with this comment thread Mike.
    Thanks. Should be interesting. 🙂

    Russian or German investors back in the early 20th Century didn’t do too well from such faith, nor have Japanese investors from the 1980s.
    If they had had market-cap weighted portfolios (which is what mine is), would their experience really have been so bad? (Admittedly, given that index funds weren’t around, such a thing would not have been impossible for them. But it isn’t impossible now.)

    It’s really betting that the world’s economy will grow in the future, that such growth will be captured by the markets, and that you’ll be given your fair share.
    Guilty as charged.

  3. Rob Bennett says

    This is a fantastic post, Mike. You possess an ability to combine intelligence and a sensitivity to opposing arguments that I don’t see often in personal finance blogs. That’s why I haunt you! (that’s a joke, kinda, sorta).

    As regular readers know, I am the world’s most severe critic of Passive Investing (while also being one of the world’s strongest proponents of much of the Passive Investing Package — I love indexing, I love focusing on the long term, etc.). I am always on the look-out for strong defenses of the Passive Investing concept. Mike is essentially defending Passive Investing in the words above (in my assessment!). I am not convinced by the argument. But I do see merit in the argument. This is probably the best defense I have read in seven years of exploring this stuff in depth.

    The problem that we all have as investors is that we must make important decisions while lacking total knowledge. Not one of us is entirely secure in our choices (this certainly includes me). But we must do something. There are so many options that we cannot possibly entertain them all. We must apply filters to keep out distractions.

    Carl from Behavior Gap (a wonderful blog) is making a great observation. He is saying (in my interpretation of his point) that investors are defensive. That’s obviously a bad thing. But Mike is making a good case as to why some types of “defensiveness” are called for in the investing realm. If we don’t apply strong filters to block out information weakening our resolve in following our chosen investment strategies, we would forever be jumping from one thing to another and never making steady progress. At some point, we must decide. And once we decide we must try to stick with our decisions. That means tuning out information bits that weaken our resolve by pointing out weaknesses in our approach.

    This is what the “Buy and Hold” concept is all about. Buy-and-Hold is either the best choice of all or the worst choice of all. It is the best if the thing we are holding to is right and it is the worst if the thing we are holding to is wrong. But we never know for certain which it is when making the choice to hold no matter what. The Buy-and-Hold concept is one of huge potential but also one of huge danger.

    I am going to link to this blog entry as the “Today’s Passion” feature at my site today. I am also planning a podcast in which I will explore what is being said both by Carl and by Mike in some depth. The implications of what is being said in this blog entry are far-reaching, in my assessment. This blog entry helped a puzzle piece click into place for me.


  4. Gregg Severson says

    This is a great post on a truly important issue. As Monevator notes, pursuing your investment strategy does require you assume the world’s economy will grow.

    The fundamental point of Taleb is that we are bad at predictions and are bad at dealing with uncertainty. So, we shouldn’t bank very much on our ability to predict things properly and we should take advantage of the fact that other people think they can.

    My understanding of Taleb’s points as applied to investing suggest that most investments should be very conservative (i.e. government bonds that will pay out a certain rate unless very very bad things are happening) and the rest of the portfolio should be designed to expose yourself to positive Black Swans (i.e. unpredictable, large scale events resulting in a benefit – an example of this is a drug company finding a new blockbuster drug accidentally).

  5. Questioning the relevance of events and economic or market measures is, by definition, speculation. To then place bets, based on that speculation is speculative investing. I’m not sure what a logical argument to contrary would even sound like.

    I’m a fan of buy-and-hold indexing, and have yet to find a better way as well. There are two general obstacles that must be overcome when it comes to trading strategies for me. The first, assuming a legitimate inefficiency is identified, how long would I be able to exploit it before I become one of the exploited? And the second obstacle is the zero-sum math involved, which raises the question, is it even worth (risk vs. reward) trying?

  6. Mike,

    A great argument for the buy and hold- I agree that the economy is complex enough that no one really knows how all of the factors will ultimately affect things. I’ve seen statistics on economic predictions – the accuracy was just terrible!

    Even worse, it may be theoretically impossible to make an accurate prediction. I have to believe that the economy is a chaotic system- which means that the final state can change radically due to small changes in the inputs. If the input parameters can’t be measured accurately enough then the output can’t be predicted- even with a perfect mathematical model of the system!

    -Rick Francis

  7. “But I have yet to encounter any strategy that I’d say is better than this one.”

    How do you judge whether it’s better?
    What would you say if a significant number of people you resepct said something different was ‘better’ – but you did not think it was better?

    Does past performance matter? If yes, how much data would you need?
    Do you base the decision on whether it ‘feels’ better to you?
    Do you base your judgment on whether it fits the Prudent Man rule?

  8. Gregg, if I remember correctly that is indeed what Taleb’s personal investing strategy is, last I heard (which I thin was probably late 2007/early 2008?)

    If I recall correctly he owned lots of Treasuries and maybe 5-10% crazy small caps and out-of-the-money options and so forth.

  9. Regarding Taleb’s own investment strategy (as explained in Black Swan and Fooled by Randomness), I’d imagine that he too would acknowledge that

    1. There are multiple ways to deal with uncertainty, and
    2. That his own method also makes a huge assumption (namely, that U.S. gov’t debt is safe).

    Not that I’m arguing with that assumption, just pointing out that it is one.

  10. Mike – some very good points in your post and I am glad I just found your blog (via tip’d btw).
    However I would tend to agree with Gregg’s point of view and tend to understand that alpha would come from buying far out-of-the-money options to supplement safest investments such as Government bonds (are these really safe though?). Out-of-the-money options are priced according to “predicted” possible outcomes and most of them would expire worthless but the one time where an unpredictable event occurs and creates a massive price shock (i.e. Black Swan event) the option payoff would generate a big enough return to compensate all the losses so far.

    Another strategy which is based on the fact that markets have fat-tails and that you can not predict them (i.e. ) is Trend Following: just notice when a trend starts going up or down, and ride it until it finishes. The majority of the trades will cancel each other out (ie randomness of markets) but the big over-shooting ones (i.e. resulting from Black Swan events) will generate a positive return for the strategy.
    You can see on my last blog post for example (quite timely: ) a collection of trend following wizards that have consistently outperformed the market – without doing any prediction at all… Just riding the trend!


  11. To Mark:

    Great question regarding what makes an investment strategy “better.” My first answer would be “higher expected risk-adjusted returns.” But the more I think about it, the more I realize that’s not a complete answer. I’d also include simplicity. If an investor cannot fully understand a strategy, or finds it to be difficult to implement, he or she is unlikely to execute it properly over an extended period.

    As to how much value I place on what other people say: If William Bernstein, for instance, were to write something explaining why he’d given up on buy & hold indexing, it would certainly get my attention, and I’d certainly take a look at his new proposed strategy. But if I wasn’t fully convinced, I’d stick with what I believed in. (I imagine this is analogous to your own situation.)

    Regarding the Prudent Man Rule: Maybe there’s something to it that I’m missing, but I’ve never found it to be very useful. It seems to me that everybody will interpret it differently. As I read it, it’s practically a mandate for buy & hold indexing. I’m sure you read it quite differently.

  12. Mike-

    Very well written post. This is what we need more of, people with different views discussing them without going after each other.

    A few points:

    [1] This conversation reminds me of the story of the university finance professor walking across campus with a student. They came upon a $20 bill on the ground, as the student went to pick it up, the professor said “don’t bother, if it was a real $20 bill someone else would have picked it up long ago”.

    I think that it is time that we at least lean down to see if it is real….

    [2] Did you actually read Taleb’s book or just what other said about it? Did you watch the Mandlebrot interviews?

    [3] If you don’t know about Louis Bachelier’s contribution to MPT you need to. This is really the guy that first has the idea that returns and risk could be modeled in a bell-shape based on his observations or how heat traveled through metal and how molecules move (brownian motion). So the entire foundation is built on what Louis started…it might be worth understanding…

    [4] A lot if us hang on to MPT, Buy & Hold, based on the argument that there is nothing better. I am just suggesting that we forget about the solution for a moment and judge the current model on its own merits. Just because you may not have a better model DOES not make the current one correct.

    [5] I want to be clear: I am not saying that buy & hold, indexing, or MPT are wrong or dead. I am just suggesting that we look at alternatives, understand the math, and judge them against reality, and maybe at least bend down and look at the $20 bill FOR OURSELVES.

    Just a few things I have been thinking about

  13. Carl:

    1) One reason I’ve never particularly liked that analogy: Leaning down to check out a bill on the ground hardly incurs any risk. Changing your investment strategy does (or could). That said, be my guest and lean down to check it out if you’d like. As I mentioned, there are several other ways a person could invest that I’d find reasonable. I’m simply not convinced that any of them are better.

    2) My copies of Taleb’s books and my notes on Fooled by Randomness. (I couldn’t readily find my notes on Black Swan. I wasn’t as impressed with it as by Fooled, so I don’t reference them very often.) Yes, I watched the Mandelbrot interviews.

    3) All I know about it is what Mandelbrot briefly mentioned in said interviews. Do you have any other suggested references?

    4) I’m not arguing in favor of market efficiency or any other model of how the markets work. I’m arguing in favor of a strategy. I don’t see buy & hold indexing’s success as being dependent upon market efficiency or MPT.

    5) I’m all for looking at alternatives.

    Edited to fix the link tag and to clean up my own grammatical sloppiness. 🙂

  14. Mike-

    I realize now that my comments were directed at you but I meant them of course as a general question for all of us trying to make sense of this very important question…I know that you are very thoughtful about this stuff.

    A few more comments:

    [3] I would highly recommend actually reading Mandelbrot’s “The Misbehavior of Markets”. Very, very insightful.

    [4] The core reason that most people view Indexing or passive investing as a good “strategy” is because of MPT and The Efficient Market Hypothesis.

    Thanks again for the civil discussion…like a great dinner party.

  15. Carl:

    Thanks for the reading suggestion. I’ll add it to my list. 🙂

    My own preference of buy & hold indexing is based on:

    1. the evidence that there’s a lack of investment professionals who consistently beat the market, and
    2. the fact that I have far less resources at my disposal than the pros do.

    For me, those are the only two pieces of information I truly need.

    Admittedly, I’m fascinated by discussions of the reason for point #1. But regardless of the reason for the phenomenon, the phenomenon is still there, and I’m comfortable investing accordingly. (Or rather, I’m more comfortable investing accordingly than I’d be investing in any way that presupposes a contradictory phenomenon.)

    …what dinner parties do you attend? If I used the words “Modern Portfolio Theory” at any of the ones I go to, I don’t think I’d have many people to chat with! 😀

  16. I second the idea of reading Mandelbrot misbehaviour of markets. One of my best read in recent years. I initially preferred Foold by Randomness compared to Black Swan and I think it is because the first part is more laboured and makes it hard to get into the book. I find the second part (We just can’t predict) much better! try re-reading only this part – I am sure you’ll enjoy it much more…

    Regarding Buy and Hold vs. other strategy: something that ties in with trend following (which is my favourite non-predictive investment philosophy) and Buy and Hold is the Buy and Hold Asset Allocation “Timing” by Mebane Faber. It is really worth looking into it as an alternative investment method available for all kinds of traders. It basically identifies when the trend is up in a specific asset class and buys and holds it (the timing is done on a monthly basis and only generates very few trades – hence the resemblance to Buy and Hold – but it gets you out as the trend reverses and could crash).

    He has a paper out on his website (a quick google of “Mebane Faber + asset allocation” should do it) and I would recommend you take a look at it.


  17. Jez: Not a bad idea (rereading the second half of Black Swan).

    I just read that paper from Faber a couple weeks ago. You can see my thoughts on it in my reply to Retirement Savior’s bringing it up here.

  18. Mike-

    I think your link is bad….

  19. Sorry about that. I copied the url for editing the comment rather than the url for the comment itself. Here’s the proper link:

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