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Fat tails and the precautionary principle: How Isaac Newton lost his shirt in the stock market

Alan MacDonald

Sir Isaac Newton was a mathematician, physicist and philosopher who was considered by many to be the father of the scientific revolution, and one of the greatest thinkers of the seventeenth century.

He was also a wealthy man, who inherited a small fortune from his stepfather and used his international renown to acquire several high-paying positions in the British government.

But in spite of his prodigious genius, Sir Isaac lost almost his entire fortune speculating in the stock market – all because he made the same two mistakes that millions of investors continue to make today.

So what were Newton’s two big mistakes, and what can we learn from them to keep us from losing our own shirts in the markets?

Mistake #1: Underestimating the impact of fat tail events

The first mistake Newton made was not being conscious enough of the potential outsized risks of what economists like to call fat tail events.

In finance, a fat tail event is something that’s relatively unlikely to occur, but which can have a very big impact if or when it does. Things like stock prices or rates of return, for instance, typically have a fairly predictable distribution of probability for how often they will move up or down, by how much, and how frequently certain events will happen within a given span of time.

If you think of it like a graph, the range of probability for the price of a given stock would look pretty much like a standard bell curve. The events that are most likely to happen (and therefore those that occur most often) would fit into the larger middle span of the curve. This includes things like relatively minor movements up or down in value over a certain period.

The events that tend to happen only rarely, on the other hand – things like huge, sudden gains, unexpected bankruptcies or history-making market losses – would be relegated to the long, thin and less likely “tails” of the curve that stretch out to either side. This doesn’t mean that the events in the middle of the curve are always going to happen. It just means they’re more likely to occur than events on the tails of the curve.

Because of this fact, many investors tend to ignore even the possibility that those tail events might come to pass. But the problem is, while they might not happen very often, when rare events do occur, those normally thin tails of probability can suddenly balloon out instead of vanishing away. Unfortunately, the consequences of not taking the risk of those potential fat tail events into account can be devastating.

Sir Isaac and the South Sea Company

Take Sir Isaac as an example. For most of his life, Newton was a cautious investor, who usually put most of his money in Government bonds. But in early 1720, he also held several shares in a British joint-stock venture named the South Sea Company.

The South Sea Company was one of the original bumper stocks, a market titan whose shares had risen eight-fold since the beginning of the year. Sensing an easy fortune to be made, Newton decided to sell his bonds and go allin on what he was sure was a once-in-a-lifetime opportunity.

Unfortunately, within three weeks of making his decision, the unlikely event Newton hadn’t bothered to consider happened. The markets turned on a dime, and by Christmas of that same year, the South Sea Company had vanished – taking most of Newton’s wealth with it.

Because he had placed all his money on that one bet, Newton turned what would have otherwise been a normal setback into a fat tail event, and transformed what couldve been a simple bump in the road into a life-changing financial disaster.

From Newton to the Lehman Brothers

Even today, investors like Newton who put all their wealth in a single stock are especially vulnerable to the risks of a fat tail event.

The usual justifications are something along the lines of this stock has been incredibly consistent or “but it’s such a well-managed company.All of which may be true, which is why it’s highly unlikely that one stock will go bust. But if it does – and if you’ve invested all or a significant portion of your money in it – then that one unlikely event might just undo everything you’ve spent your whole lifetime building.

During the 2008 financial crisis, for example, many investors experienced the results of a fat tail event first-hand when Lehman Brothers went bankrupt. Once considered to be too big to fail, the company had been selling obscure derivatives against securities they saw as having almost no chance of going under, so their risk managers felt that the risks were acceptable.

What they didn’t consider was what the consequences would be if the extremely unlikely event they were ignoring actually occurred. When those seemingly unsinkable underlying securities plummeted in value during the subprime mortgage crisis, both the company and many of its investors were wiped out. Once the dust cleared, it turned out that the downside to Lehman Brothers’ risk blind spot was about 40,000 times the upside – a classic fat tail situation.

Mistake #2: Forgetting the precautionary principle

Which brings us to the second mistake that both Newton and many modern-day investors are guilty of ignoring: forgetting to practice the precautionary principle.

The precautionary principle is an investment approach which says that if you don’t understand something, even if everyone else seems excited about it, it’s better to either do something else, or do nothing until more evidence shows up.

While this seems like obvious advice in the calm light of day, ever since the very first stock was traded, countless investors have allowed themselves to get caught up in the feeding frenzy that can surround the latest hot stock-of-the-day and poured their life savings into investments they barely understand, but which they see as “winners” (where winning is defined as whichever equity has gone up the most).

But as Sir Isaac’s experience with South Sea shows us, buying stocks that have already skyrocketed often means investing in securities that have been massively over-inflated by speculation, and which are therefore vulnerable to the worst kinds of setback.

Nortel. Enron. The dot com bust. The list goes on and on. But what each of these former market darlings have in common, is a seemingly unassailable investment that ends up tanking only after scores of fortune-seeking investors have piled in.

Isaac Newton vs the Oracle of Omaha

So if we can’t use escalating stock prices as our guiding light for where to put our money, what criteria can we apply to help us avoid the kind of disaster that robbed Newton of his entire life savings?

I’d say we could do worse than listen to the advice of Warren Buffett, perhaps the single most successful investor of the last 100 years, and a disciplined financial manager whose reliance on the precautionary principle has long been the foundation of his investment approach.

In the year 2000, when all the dot com companies went bust, Buffett’s portfolio barely felt it because he had almost no exposure to any of those formerly high-flying tech stocks. Why? Because he simply didn’t understand these companies or what they were selling. And as Buffett famously said over and over again in the runup to the collapse, he never invested in anything he didn’t understand.

At the time, Buffett was criticized for being old school and not understanding technology. But of course he did understand technology. What he didn’t understand were the insane valuations many of those companies had been given, or the business models that didn’t seem to rely on anything but hopes and dreams.

Buffett could’ve ended up being wrong, of course. And if he had, he might’ve missed out on some hefty profits. But because he chose to exercise the precautionary principle instead of mindlessly jumping on the dot-com bandwagon, he was able to minimize his exposure to the fat tail event that followed. In the process, he saved both himself and his investors billions of dollars.

Whose footsteps would you rather follow?

There’s no question that Isaac Newton was a scientific genius. But when it comes to finances, if you’d rather follow in Warren Buffetts footsteps, it might be worth taking a look at your own portfolio to see if you’re exposed to any potential fat tail events, regardless of how unlikely they might seem to be.

Is an outsized portion of your portfolio invested in a single stock, geographic area or sector? Do you own any equities that you bought just because their names have been splashed all over the weeknight news? Or if the unlikely event of a market crash or a stock going bankrupt were to happen, would it have an impact on your investments from which it would be hard, or even impossible, for you to recover?

If the answer to any of these questions is yes, it might be worth applying the precautionary principle to your own investments to keep any future tail events from becoming any fatter than they have to be, and to help make sure a single unexpected reversal won’t take all your hard-earned savings with it.


This article is supplied by Alan MacDonald, an investment advisor with RBC Dominion Securities Inc. Member–Canadian Investor Protection Fund.

This article is for information purposes only. It is not intended to be financial advice, and the opinions expressed are the opinions of the author only. Past performance is not a guarantee of future results. All assumptions, opinions and estimates made by the author are subject to change without notice.

Before acting on any recommendations, consider whether they are suitable for your individual circumstances, and seek out professional advice.