Musings Report #22 6-1-13 The Unknown Unknowns and Survivorship Bias
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The Unknown Unknowns and Survivorship Bias
Former Secretary of Defense Donald Rumsfeld is famous for uttering a near-koan description of the epistomological ambiguity of human experience:
There are known knowns; there are things we know that we know.
There are known unknowns; that is to say, there are things that we now know we don't know.
But there are also unknown unknowns – there are things we do not know we don’t know.
I recently read two fascinating accounts of why we have such a difficult time knowing what we don't know: it's called survivorship bias, and what that means is we only get information from the survivors, not those who perished and vanished from sight and from the records.
Here's how this works: big-bucks Author Z says, here are the 10 steps you need to take to become as successful as me. The list always mentions perseverence, being nice to your readers, writing 1,000 words a day and so on.
The 99.9% of writers/authors who make less than $10,000 a year from their writing (and the 99% who make less than $1,000) take this list as a script or program that if followed, will yield great success. But when the 99% follow the script and methodically do all 10 things, they discover they are still unknown and not making any money.
The point is that nobody asks the 99% who fail to make it big what they did, or try to analyze what they did that inhibited or prevented their success.
The numbers of people who become successful in these sorts of high-competition careers is vanishingly small--hedge fund managers are an example, along with musical acts, artists and writers. A handful at the top make most of the money, a relative few make some money (let's say a middle-class income) and then 99% make near-zero.
Longtime correspondent B.C. just sent me an analysis of mutual fund managers and how many outperformed a low-cost index fund. He found that 66 managers out of 26,507 outperformed the SPX over 5 years. That mirrors hedge fund managers, a few of whom net $500 million each while the rest underperform a plain old index fund.
The conclusion is that luck is the ultimate factor in these signal-noise levels of success, and being in the right place at the right time with the right product/idea can't be replicated by following a "script for success" prepared by the wildly successful.
The next essay is longer and well worth a read: Survivorship Bias: The Misconception: You should study the successful if you wish to become successful.
The basic idea here is that studying the bomber aircraft that make it back to base riddled with holes from missions over hostile territory leads us astray when we try to analyze the damage inflicted on the surviving planes: what would really help us is studying the planes that were shot down, but they are not available for study. Their absence opens a huge hole in what we can know, and what we need to know to improve the odds of success.
The same principle applies to restaurants: the few that become roaring successes are endlessly studied and hyped, but the more useful causes of success and failure are buried in the stories of all those that failed and close their doors without leaving any record for us to study. Nobody collects that data, for a number of reasons, including the study of failure isn't sexy and won't sell business magazines. Covers of Larry Page and Sergei Brin (co-founders of Google) sell content, not studies of unknowns who fell by the wayside.
We know that we learn from mistakes and failures, yet the study of failure is never recorded or saved unless the company or individual "came back from the dead," for example, Apple after Steve Jobs returned to lead the company from the abyss in 1996. (A big chunk of cash from Bill Gates and Microsoft helped immensely.) Very little is known about the hundreds of tech companies that arose and then faded into obscurity.
Survivorship bias offers a profound insight into how we confuse the known knowns, the known unknowns and the unknown unknowns.
Market Musings
Everyone know global markets are in bubble territory, with many instances of bear flags (fast-rising channels) being broken decisively, and all sorts of high-flyers breaking down: Brazil's market, Aussie dollar, Japanese stocks, to name a few.
So what happens next, now that the S&P 500 (SPX) has broken below critical support at 1,630? We can see three basic possibilities by looking at the May-June Swoon in the previous three years.
In May 2010, the market fell precipitously, losing about 20% in two months. The decline was swift and then the SPX spent the summer carving out an inverse head-and-shoulders pattern before shooting up on the announcement of QE2.
In 2011, the markets spent 6 months tracing out a major 3-peak head-and-shoulders pattern before collapsing in August and hitting bottom in October.
In 2012, a smaller topping pattern occurred in May and June, and the market declined sharply in July but recovered quickly.
The backdrop is now quite different. In 2010, Europe's debt crisis was bursting through the dam of denial, and the Fed's response was unknown. QE2 unleashed a massive rally.
In 2011, the end of QE2 and the re-emergence of the Euroland debt crisis sent markets lower, until more central bank easing saved the day again.
In 2012, the same script was repeated, with European Central Bank honcho Mario Draghi reversing global markets' decline by declaring the euro and the EU banking sector would be saved by "whatever it takes."
Now that unlimited QE is the official policy of all major central banks, there is nothing that can possibly be announced to "save the day" when markets swoon in summer. That is a new and potentially unsettling situation for global markets.
The latest runup of over 300 SPX points mirrors the extended uptrends of 2009, 2010-11 and 2012. Measured by length of the uptrend without a 3-day retrace, the 2013 rally is the longest since 1987.
So do we noodle around for several months in a topping formation, or do we get a sharp cascade down followed by a meandering bottom or an equally sharp renewal of the Bull?
Given that the central banks are all-in, there cannot be any more "surprise saves" of the next decline. The steepness and bubble-like characteristics of this runup suggest a violent decline is more likely than a meandering top, but we have to be open to the possibility that the SPX wanders directionlessly through June and July.
Technically, every previous summer swoon touched the lower Bollinger band on the weekly chart, which is around 1,480, which also happens to be close to the 50-week moving average. The only question is how long it takes for the SPX to get there.
Many good technicians expect the SPX to reverse at 1,620, or perhaps 1,580, and then spike back up to a new high or a right shoulder (i.e. not quite a new high) before reversing for the usual summer swoon.
I don't see any strong evidence yet for or against this forecast. The SPX might meander in June as many expect, but it could also waterfall back to 1,500 in short order, for we already know the Fed and ECB have nothing else they can announce to "save the day" here.
All sorts of strange dislocations are occurring in the global bond markets, and since they're larger than equity markets, that should give equity investors who are confident the Fed will never let stocks decline pause.
The "smart money" has been selling and the "dumb money" has been buying equities. Combine that with the bubble-like ascent of financials, Japanese stocks, etc. and you get the setup for an equity crash.
The best thing that happened to me this week
My Klout score clicked up to 57. (Only joking; all these metrics of influence are meaningless, only three things matter: Page Rank, page views and the net income your site generates monthly) Best thing that happened was getting through the difficult rewrite of chapter 1 of my next book.
From Left Field
On $100K you can just get by: Getting a job in San Francisco (via Maoxian) S.F. now more expensive than Manhattan, according to this fellow. Want work? Become a software engineer who codes for fun.
new film alert: THE EAST: Official Trailer (via B.C.) Eco-terrorists are the good guys, FBI the bad guys protecting despoil-the-Earth corporate leeches
Mountain of trash: Maxed Out on Everest--too many climbers leaving too much junk, all desiring to join an exclusive club, regardless of the costs
On narrative: Finding The Story (via G.F.B.) "There is a point to be made here about pointing: It’s harder than it looks."
“We are what we pretend to be, so we must be careful about what we pretend to be.” – Kurt Vonnegut
Thanks for reading--
charles
