Lessons From An Elephant In The Peanut Factory – How To Avoid Financial Regret.

Fans of  The Simpsons may remember the episode in which Bart unexpectedly wins an elephant. In the whimsical style of the Simpsons, the elephant escapes and wreaks havoc through a peanut factory. Confronted with an elephant bearing down on the factory, the foreman’s self-satisfied response to his workers is to remind them that he had been warning of this event but nobody took him seriously.

The episode acts as an amusing metaphor for an important financial planning principle: preparing for low probability but high impact events, often referred to in economic terms as “Black Swan” events. Nassim Nicholas Taleb popularised this term in his influential work on the impact of highly improbable events. They are referred to as Black Swans because until their discovery in 1600 in Australia it was assumed all swans were white. But, an infinite number of white swans does not prove black swans do not exist. And, therefore in financial and economic terms, we can’t rely on history to inform us of the future. We can’t predict the future and a hubristic assumption that history will repeat itself will, as with the peanut factory, end in disaster.

Real-life examples include:

  • the Great Depression;
  • the Chernobyl and Fukushima nuclear disasters;
  • the 9/11 attacks;
  • the Credit Crunch;
  • the COVID-19 pandemic.

However, not all such events are negative; positive Black Swans have also occurred, including:

  • the discovery of penicillin;
  • the birth of the internet;
  • the invention of the iPhone.

Financial Resilience

A Black Swan event has three primary characteristics: it is an outlier, as it lies outside regular expectations; it carries an extreme impact; and, despite its randomness, is often rationalised with the benefit of hindsight. Taleb’s examination emphasizes the need for robustness and the ability to withstand these events, rather than attempting to predict them, which leads to failure due to their inherent unpredictability.

If there had been stronger risk management in Chernobyl, greater scrutiny of the financial markets by the regulators before 2008, and better catastrophe planning by global governments pre-COVID the immediate and long-term effects would have been significantly reduced.

In the context of your finances and planning for retirement this means having sufficient assets, broadly spread to withstand economic shocks but also not missing out on investment opportunities that enable our money to work harder.

The Allure and Risks of Chasing High Returns

During periods like the Great Depression and the Credit Crunch, a significant financial behaviour was the tendency of investors to chase high returns based on past stock performance, often driven by what Robert Shiller describes in “Irrational Exuberance” as a cultural contagion of optimism. Or, to put it more bluntly, greed. This greed creates asset bubbles, pushing investment prices to unsustainable levels based solely on investor enthusiasm rather than underlying economic fundamentals. During the early years of the Internet, investors valued companies highly simply because they were online, not because they were sound businesses.

For instance, before the Credit Crunch, there was a widespread belief that real estate prices would continue to rise indefinitely, which led to excessive borrowing and investing in the housing market without regard to the actual value or risk of these investments. Similarly, before the Great Depression, the roaring 1920s saw a stock market bubble fueled by speculative investments and an abundance of cheap credit. During the nascent years of the internet, companies were highly valued because they were online, not because they were sound businesses.

The danger in these scenarios is that when the bubble bursts, those who have invested heavily or borrowed to invest at high market peaks find themselves in deep financial trouble. Their losses worsen because they put all their eggs in one basket and lack savings to cushion the blow, leading to personal hardships and remorse.

The Importance of an Emergency Fund

The antidote to the potential devastations of Black Swan events lies partially in what author Morgan Housel terms the “Margin of Error.” This concept suggests that having sufficient savings can safeguard against catastrophic failures and provide peace of mind. This is a safeguard against not just the unpredictable Black Swan but also the more predictable risks that necessitate immediate access to capital; the loss of income, the need to provide financial support to children or the cost of private medical bills rather than waiting for NHS treatment.

In practical terms, this translates into maintaining an “emergency fund” or “just in case” money. Such funds are crucial not only to minimize the impact of a catastrophe but also to seize opportunities that may arise unexpectedly.

Practical Steps to Building Your Emergency Fund

As I have written in this article, there is no precise formula to determine how much you should have in savings; it depends on your unique life and financial situation. However, in preparation for the next Black Swan, as long as you have money invested to cover you for the long term, an amount that is bordering on uncomfortable is probably not far off.

Preparing for the unknown isn’t just about avoiding financial ruin; it’s also about positioning yourself to take advantage of unexpected opportunities. By building and maintaining an emergency fund, retirees can ensure they have a margin of error, which allows them to navigate through both the immediate negative impact events and the slow-burn paradigm-shifting opportunities. Taking these opportunities doesn’t mean speculating; it means investing your money in a globally diverse pension and investment portfolio that will provide financial freedom and security for your future selves.

The story of Bart’s elephant may be a light-hearted metaphor, but it introduces a crucial principle: in a world of unpredictables, the best defence is good preparation.