By: Michele Wood, Director of Research, Valbridge Property Advisors | Houston
January 21, 2021
Recently, I saw a headline reporting a 136% rise in people seeking readings from online psychics, no doubt caused by the acute uncertainty that we all find ourselves in over the past 10 months. Uncertainty leads to anxiety, and in times of anxiety, we seek comfort and assurance. Over that time we have seen in commercial real estate a corresponding spike in demand for forecasting, predictions and value projections. It’s only natural. But it’s likely not all that useful.
So, what might be useful to not only self-soothe our personal and professional selves in times of turbulence and uncertainty, but to help us position for the future? Often, the best insight comes from unexpected places and visionaries emerge from unlikely origins.
Winter, with its uninviting temperatures and shortened days, is the perfect time to give the blog posts and business newsletter articles a rest and pick up a book. Below are three recommendations that will help us navigate the current economic environment and will almost certainly feel like a beacon of light in some of the dark days we have been experiencing.
The (Mis)Behavior of Markets: A Fractal View of Financial Turbulence. Benoit Mandelbrot. Basic Books 2004 (update reprinted post-financial crisis)
I found this book by going down a research wormhole last summer. What caught my eye was first the use of the word “fractal” associated with words like “financial” and “markets.” A fractal, for those of you who didn’t have as many nerd friends in high school like I did, is a “curve or geometric figure, each part of which has the same statistical character as the whole.” Visually, think of a tree, which has branches that grow out from the trunk in a visual way similar to the way smaller branches grow from the large branch, down to the smallest ends of branches. Take a minute to look them up—they are quite beautiful. Here are some in different contexts:
Mandelbrot’s ideas are counter to the predominant “Efficient Market Hypothesis,” or “EMH” theories of the 20th century, as well as the “random walk” school of economists. While many now use his theories and models in their risk management modeling, many still miss his central idea, which is that volatility can be seen to cluster in market events, and “black swan” events, or “fat tail” events, though increasingly factored into models, often fail to consider what happens when more than one extreme event happen back-to-back, as they sometimes do.
There was a passage in the first chapter of the book that made me get up and get a pencil. “On October 19, 1987, the worst day of trading in at least a century, the index fell 29.2 percent. The probability of that happening, based on the standard reckoning of financial theorists, was less than one in 10 to the 50th power—odds so small they have no meaning. It is a number outside the scale of nature. You could span the powers of ten from the smallest subatomic particle to the breadth of the measurable universe—and still never meet such a number.” (my italics) How do you model for THAT? Well, you can’t. But, you can look at the patterns in the market and make intelligent conclusions from those about your risk exposure. Annie Duke’s ideas of assessing your level of certainty (as expressed in your “bet”) would fit right into Mandelbrot’s claims that markets follow fractal patterns.
For example, he writes of the Efficient Market Hypothesis, “Theory suggests that over that time, there should be fifty-eight days when the Dow moved more than 3.4 percent; in fact, there were 1,001. Theory predicts six days of index swings beyond 4.5 percent; in fact, there were 366. And index swings of more than 7 percent should come every 300,000 years; in fact, the twentieth century saw forty-eight such days.” When a professor emeritus of Mathematical Sciences at Yale says the models are wrong, it behooves us in the financial world, and especially in the world of financial modeling, to pay attention.
Multi-fractal analysis employs some modern-day tools such as computer computation to do extreme level Monte Carlo simulations. We cannot predict with certainty, but we can see differing scenarios and how our investments and portfolios fare under different stressors with these tools. “A financial transaction is like a small explosion,” Mandelbrot writes near the end of the book. You cannot predict where all the particles and debris will go—there are too many trajectories at play. But like good demolition experts, we can shore up nearby areas and make choices that ensure the blast zone is contained and we are not in the path of danger ourselves.
One line that struck me as relating particularly to valuation: “The prime mover in a financial market is not value or price, but price differences; not averaging, but arbitraging.” This seems especially pertinent in the past 12 months when so much “value” has moved, but there is much opportunity in arbitraging certain assets and positions. I can’t pretend that I understood everything in the book—I have no head for statistics or probabilities equations. But the book is written for anyone, polymath or not, who is curious about markets and open to more modern ways of looking at them.
Thinking in Bets: Making Smarter Decisions When You Don’t Have All the Facts. Annie Duke. Penguin Random House 2018.
A trusted friend and colleague recommended this book to me during the spring pandemic lockdown. Having time to indulge in reading, I picked it up and was instantly struck with how relevant the content was to the current economic and cultural climate. One of the passages in the first chapter “Life is Poker, Not Chess” reads, “Game theory is the modern basis for the study of the bulk of our decision-making addressing the challenges of changing conditions, hidden information, chance, and multiple people involved in the decisions.” I read that in May 2020, having seen headlines that same week reporting changing conditions, hidden information, and chance in the economic climate. Fast forward to the beginning of 2021, and we are still surrounded by changing conditions and vulnerable to hidden information.
One of the best ideas presented in the book, particularly for those of us in commercial real estate investment, valuation or development, is the idea of a “premortem” exercise for complex decisions. As relates to CRE decisions, the task is basically to do “negative visualization” on the project wherein you analyze as many things as possible that can go wrong. Doing so not only triggers you away from confirmation bias (i.e. “this is a good investment because…”) but allows one to address weaknesses in a deal or a property’s characteristics and build in protections or remedies.
There are many, many passages I underlined in the book that made me connect her ideas and experience to issues in real estate and other areas of finance, but even if that doesn’t interest you, her ideas are much more broadly applicable and her writing style is easy and fun. “Thinking in bets starts with recognizing that there are exactly two things that determine how our lives turn out: the quality of our decisions and luck. Learning to recognize the difference between the two is what thinking in bets is all about.”
There’s a reason why the book was a bestseller, and you may even pick up some fun tips for your weekend poker game along the way.
Antifragile: Things that Gain from Disorder. Nassim Nicholas Taleb. Random House 2012.
Taleb’s name is likely known to you, and you have certainly seen his most famous concept, that of the “Black Swan,” invoked countless times this past year. Antifragile is one of the books, in addition to The Black Swan that make up Incerto, the collection of Taleb’s works investigating concepts like uncertainty, probability, risk, etc. in a cohesive collection.
I read The Black Swan when it came out in 2007 and it is one of the few books in my life that defined a “before” and an “after.” I literally never looked at things the same way after reading it. When Antifragile came out years ago, I bought it, but it sat on the shelf unread until the title captured my attention in the thick of the COVID months—things that GAIN from disorder? Disorder was all around and very few people were focusing on what was gaining, and what was gaining seemed uncertain to last (residential real estate sale trajectory, demand for distribution space, etc). What could he mean?
This book took me longer than the others to finish because I kept having to pause to let my mind really soak in the concepts. Like Black Swan, the ideas seemed to touch all aspects of life: healthcare, diet and exercise, financial decisions, politics and business. Completely by coincidence, I recently learned that The Black Swan was dedicated to Benoit Mandelbrot, and Taleb mentions his ideas on fractal analysis frequently in the text of Antifragile.
The basic idea of something that is antifragile occurred to me years ago. I toured the site of “Biosphere 2” in Arizona, an artificial environment fully enclosed and designed to mimic ecological systems on earth for study as potential use in alternative environments like space. In the “ocean” room were fully grown trees, but they were all deformed and irregular looking. The guide explained that one of the lessons they learned from that room was that trees need wind blowing, and blowing fairly hard, regularly, for their trunks to strengthen and grow properly. That is a perfect example of antifragility: the stressor, as long as it is not tornado-strength, benefits the tree, and the tree suffers in its absence. Our bones and muscles are like that too—they atrophy in the absence of stress.
Taleb spends 425 pages outlining evidence for this idea, examples from all aspects of nature and human enterprise, and does so with breathtaking scholarship and background. Not only that, but his writing style is brisk, cheeky and just the right amount of catty. I never thought I could put down a book on financial markets and miss the author’s voice, but that is what happens when you read Taleb. He takes aim at economists, business writers, colleges and college professors, doctors and more. It’s great fun.
There are too many underlines in my book to try and give a decent summary of all it contains. Here are a few of my favorite quotations:
“Just as a little bit of fire here and there gets rid of the flammable material in a forest, a little bit of harm here and there in an economy weeds out the vulnerable firms early enough to allow them to ‘fail early’ (so they can start again) and minimize the long-term damage to the system.” In the past year we have seen many businesses fail and close, but there has also been an explosion of innovation and entrepreneur energy. Nature, and humans in the economy, abhor a vacuum.
“Not seeing a tsunami or an economic event coming is excusable; building something fragile to them is not.” This seems especially pertinent in a post-pandemic world. The game is not to imagine all the specific black swan events and prevent them, but to build in anticipation of them. This goes not only for actual structures (the San Francisco earthquake in 1989, a 7.1 on the Richter scale, killed 62 people. Conversely, a 1988 6.7 Richter scale quake in Argentina killed 25,000 people. This was due to San Francisco’s building codes ensuring that structures were better prepared to withstand the stresses of earthquakes.) Preparation and strength to withstand, and even benefit from volatility and stress can be built into financial transactions and investments as well as structures. Events that affect value do not happen in linear fashions, as so many models falsely imply.
The implications for some of the ideas explored in these texts, as well as the countless works that were cited and influenced these authors are boundless. Volatile times are anxious times. But they are the opportunities to clear the forest of the endangering underbrush, to create fertile soil for the new to germinate.