We live in two very different worlds.
One is the bounded physical world which is predictable, where averages have meaning, and there is strength in large numbers. It obeys the laws of physics and never shocks us even if it occasionally gives us ’normal’ surprises.
The other world is full of extremes, with high levels of unpredictability and randomness. In this world, averages have no meaning and there is a "winner takes all" phenomenon.
In his book "The Black Swan", Taleb refers to the first world as Mediocristan and the second as Extremistan.
Ain't so tall, after all
Let's randomly select 1,000 adults and measure their heights. Now, let's add one more individual to this sample. What would be the impact on the previously calculated average?
Now, let's assume that this individual is the tallest person ever recorded, standing at a height of 8'11". What would the impact now be?
As you'd rightly expect, even this individual would barely impact the average height of the 1,001 people as a whole. This world where 'heights of people’ belongs to is Mediocristan, which has a number of other inhabitants including weight of individuals, age of tortoises, manufacturing defect rates in an automotive plant, etc.
Artefacts in Mediocristan typically follow the bell curve or the normal distribution (to a large extent). Here are some examples of the distribution of heights of people, or exam scores. You see the beautiful normal curves, well, almost!
Buffett walks into a bar
Now consider a similar example with a parameter such as wealth. We have a 1,000 people sitting in a bar (okay, a large Oktoberfest sized tent for the logic Nazis who can't imagine a bar which can accommodate the 1,000 people), enjoying their beers and watching their football match, and we shamelessly survey their wealth - let's say, for the sake of simplicity, that number is USD 100,000.
Now let's add one more person to this sample - and he is Warren Buffett. What happens to the sample then? On average, everyone is now a centimillionaire (100 Mn USD)! It is possible for a single sample to be so large that it can exceed the value of 1,000 samples combined by a thousand times. This is an example of Extremistan, with others including income, book sales, website traffic, and stock returns.
The extremistan residents follow a distribution called as a power-law. It is also called as the long tailed distribution and is characterized by outliers which have tiny probabilities, but are exceptionally huge in magnitude, and the rest of the world, which barely has an impact in comparison the these outliers. To visualize this, think about movie stars, or your favorite Instagram influencers. There are some - such as Brad Pitt or Dwayne Johnson in case of movies who make the highest amount of money while there is a long tail of struggling actors barely making anything, or Kylie Jenner with a few million Instagram followers while most wannabe influencers with barely a few thousand followers. Extremistan is a world where the winner takes all. It is a world where it is difficult to predict what would happen next. It is a world where a turkey which is fed well for 200 days thinks the 201st day will be the same as the the other 200, without realizing it is Thanksgiving.
Extremistan is a place which is very unfair, strange and significantly impacted by randomness. It is a place where there is a mirage of stability, and in an instant everything gets disrupted. A company like Apple which is reigning supreme since a decade, give or take, will be considered to continue to outperform in the foreseeable future, however, will eventually get disrupted by some unknown startup (like it's predecessors - IBM, Nokia, Kodak et al). It is a place where the COVID virus lives, and a place where 9/11 or the Mumbai terror attack happens.
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The Great Indian Middle-Class - An example of Extremistan
We (especially in India) often hear about the power of the middle class, how the incomes of this Middle-Class is rising, and how that is going to turn the fortunes of a number of consumer focused companies. We intuitively visualize that the middle class would cover the bulk of the country’s population, and would be spread across most cities and towns. But how middle is the middle-class though?
To answer this question, let’s first get a good definition of that middle-class means. The National Council for Applied Economic Research (NCAER) in India has defined the middle class as the following:
Lower Middle Class: Monthly household income between ₹20,000 and ₹50,000
Middle Middle Class: Monthly household income between ₹50,000 and ₹200,000
Upper Middle Class: Monthly household income between ₹200,000 and ₹1,000,000
Now this is a very broad range, but lets consider the first two (arguably) as the Indian Middle Class -and we are essentially talking about the top 11% of households in India with incomes above the ₹20,000 per month. At the top end of the Middle Middle Class - we are basically talking about the 99th percentile of the population. Not so middle, ain’t it?
However, the top 11% contributes to ~60% of the total household income earned in the country, making it’s impact extremely significant. Income levels are Extremistan artefacts, and understanding such ‘themes’ is essential to invest sensibly.
The monkey visits Extremistan
Throughout our evolutionary history, until the last few centuries, we have dealt largely with events and objects from Mediocristan. We intuitively understand them better and have a more suitable response to such events. We are all like the turkeys, who intuitively extrapolate events based on what we have seen in the past. Snakes bite us, and their venom may kill us, if we see a snake we must run. But such extrapolation for Extremistan residents is dangerous. Nay, it is suicidal. And here is where all of the modern world resides - economics, stock markets, internet traffic, social media and more.
And while it is impossible to predict the future in extremistan, we can at least prepare ourselves, and set ourselves up to take advantage of the disproportionate outcomes of extremistan, while protecting us from the extreme downsides. Here are some thoughts on how we could go about this:
First, understand Extremistan Exists
The biggest blunder one can make is to mistake and assume a resident of Extremistan to follow to the rules of Mediocristan. We live in an increasingly complex world, and most of the non-physical phenomena we deal with belong to Extremistan. Understand that most of them are highly variable, difficult to predict, follow power laws and exceptions are the norm. As an example, AI is emerging as a theme today, and a number of companies will participate in it. However, only a handful will succeed, and it will be extremely difficult to predict who the winners will be. Just being cognizant of this will help us prepare and respond better. If only the quants in investment banks in the early 2000s followed this advice!
Risk taking and risk mitigation are equally important
If you don't take risk in Extremistan, you are sure to lose out. Upon relying only on a fixed deposit (term deposit) for instance, you will not lose money for sure, but you will also not beat inflation let alone grow real wealth. In extremistan, you need to be prepared to get lucky. At the same time, leveraging to the hilt and investing in SPACs or tulips or <insert the flavor of the season here (AI?)> is not going to help either. Measured risk taking is the mantra - and how to go about this? Well, that's a topic for another day!
Increase the time horizon to validate success
Given extremistan is infused with uncertainty and randomness, it is difficult to determine sustainable success in the short run. The signal is fraught with the noise of randomness, and it is difficult to distinguish between luck and skill. Measuring success over a longer time horizon helps average out the randomness, and skill plays a much larger role. Van Gogh, within two years of not achieving success in painting, had concluded he had made a mistake. It took them years for his work to get recognized, unfortunately for him, just before his death at the young age of 37!
The world of extremistan makes the modern world both, dangerous and exciting. It gives us an opportunity to become a runaway success which would otherwise be impossible in Mediocristan. It is up to us to understand this and position ourselves to seize the opportunities it offers, while protecting ourselves from catastrophies.
As I complete this article on the last day of 2023, after a long hiatus, I sincerely hope you like it, and that it adds some food for thought in your journey towards rationality!
Wish you a very happy new year!
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