Risk management & probability

how a pilot analyzes the worst case

A short note for context

(1) I am a licensed Commercial Pilot
(2) I was a flight instructor from 2010 until 2021
(3) I was the CEO of a flight school from 2019 until 2021

The death of a family
Mr. Shannon is a busy man. He is a lawyer, has a successful career and owns a Multi Engine (2 engines) airplane. For weeks Mr. Smith wanted to take a deserved vacation. Him and his family planned to fly to Key West for a long weekend, celebrate Christmas, hoping to enjoy some quality family time together. The wonderful family vacation was to begin with an early morning flight to Key West on December 24th.

As is typical for Florida during the winter, the morning was foggy. As the night cools down the ground, warmer ocean air flows inland, cools down and settles as a beautiful mist across the entire state. Sometimes the rising sun can clear the mist in a few hours, sometimes it manages to do so by mid-day.

Mr. Shannon, his two daughters, one husband and a family friend departed at around seven in the morning. They never reached Key West as their plane crashed shortly after takeoff, killing everyone on board.

A wedding and a choice
My college friend was getting married in the middle of February in sunny Florida. The wedding was on a Saturday about a five-hour drive away from my house. Naturally I wanted to fly there instead of drive. As is typical for the Florida winter, warmer air flows in from the ocean and creates fog as it cools.

Two days before the wedding I began looking closely at the likely temperatures for the day before the wedding. It became clear that the probability of there being fog during the time of my departure was relatively high. The forecast showed it and the last two days were foggy in the morning. I really did not feel like driving for five + hours, but mentally prepared myself for the possibility.

On the morning of my planned departure, I woke up at five in the morning to see what is truly taking place. My expectations of the future were confirmed: it was very foggy. I decided in that moment that I will begin getting the car ready. I returned on Sunday evening after having spent a great time with my old friend.

Human Misjudgment
An accident in aviation never has just one cause. There are multiple factors affecting the flight at any given time. Most of them are not foreseeable. If they were foreseeable, there would be a lot less accidents. The major difference between a private pilot with a life outside of aviation and a professional pilot, who flies a lot, is the experience in having seen the unforeseeable affecting his flights in the past.

I will never know Mr. Shannon’s exact thoughts and emotions that he experienced that morning. But I am highly confident that I know what went through his mind and heart. Christmas is not a date that is moveable. It will happen regardless of the circumstances. A planned family vacation is something wonderful, which creates a powerful emotion. In pilot lingo we call it “Get-There-Itis” (p. 5-6). It simply means that your emotions to reach our destination overpower our ability to think rationally about the present environment we’re in, causing us to make foolish decisions. Sound familiar? Mr. Shannon was unaware of his own inexperience, not in flying and skills, but in decision making. He did not conduct a thorough worst-case scenario analysis and figured that while the fog is present, he can just takeoff, fly above it and it'll be fine.

Mr. Shannon became the victim of his own emotions; his desire to reach his goal overpowered his ability to put present data into the proper context. He experienced overconfidence tendency in his own abilities, he experienced the fear of missing out and he showed a lack in probabilistic thinking. If you do those things in investing you lose money, if you do them in aviation you die.

Risk analysis & probability
In the early February morning I made the decision not to fly. Why did I say no?

The airplane doesn’t know it’s flying in fog. It will takeoff just the same, the engines will run just the same and the aerodynamics will work just the same. Past data of all general aviation flights suggest that flying is so safe, that the probability of having an accident is quite low. Quite simply things rarely go wrong. So why not just take off and get above the fog? After all it will take only a few minutes before we reach the wonderful early morning sunset (quite beautiful). What could possibly go wrong?

I said no because I was not concerned with the probability of something going wrong. That rarely enters into my thinking before a flight. I was solely focused on the probability of success should something go wrong. And within this framework I was evaluating several possibilities of what could go wrong. My thoughts went something like this:

(1) If I experience an engine failure (truly worst case), what is my probability of a successful return to the airport if I cannot see the airport at all? LOW

(2) If I experience an electric failure, what is my probability of a successful return to the airport if I cannot see the airport at all? LOW

(3) If I experience anything that makes me feel like I should return to the airport, what is my probability of success if I cannot see the airport at all? LOW

(4) Are there any other airports close by that have better visibility? NO

In other words, probability across all flights (all past data) was heavily in favor of success, but the probability of success in case I encounter a Black Swan (worst case data) was heavily in favor of failure (if you’re not familiar with this concept, stop everything you’re doing, buy all books by the author linked and stop reading this post). The parallels to investing are so striking it is almost weird right?

Focus on the probability of success if you encounter a black swan
In investing we tend to make the exact same mistakes. The difference is that we do not risk our lives (well, depends on the leverage I suppose), just our money. Here are the striking similarities:

(1) We place too much value on large, past data sets

(2) Due to long periods of success in the past we become overconfident in our skills / we correlate our success to our skill

(3) We tend to be fooled into thinking that past investment success correlates to future investment success

(4) We tend to overweigh past data, because there’s so much, instead of focusing on the present data, staring us directly in the face

(5) We tend to focus on the desired outcome of our investment instead of the worst case

(6) We assign probabilities on possible future events, instead of assigning probabilities to our success if the black swan appears

A lot I am about to write comes from the ideas and books of Mr. Nassim Nicholas Taleb whose Black Swan you’ve met above

(1)
If the past data set is large enough, we can encounter two major problems. First if the data is large enough, I can go backwards in time and I promise you I will find an investment that perfectly correlates with the temperature in a country on the other side of the planet. Second, if the past data set is large enough, ie. Thousands of investors and managers are in the game, there will be success just by chance.

(2)
If we’re making money for two years, three years or ten years running we’re so vulnerable to feel confident in our ability to invest that we begin to forget to prepare for the worst-case scenario, making ever optimistic assumptions about the future.

(3)
In aviation each flight is a new mission. No flight, by logic, correlates to an old one, because we landed and shut the engine off. It is the exact same in investing. A past successful investment has nothing to do with a new investment. There is a 0% correlation (there may be some, but it is low and much safer to assume it is 0%). The reason is the same as in flying, the environment we operate in has changed. Even a flight an hour after the first flight (common schedule for flight instructors) has a completely new set of variables affecting it. The same is true for an investment.

(4)
Howard Marks evaluates the risk of the future by looking at the present data available to him. Why? Because the vast amount of past data doesn’t hold much value precisely because it is so large. This can be illustrated by the famous coin flip analogies made by Buffett and others, which I am sure you’re all familiar with.

(5)
If I focus on the desired outcome of my investment, I will continuously find information confirming that I will soon be rich. Li Lu said that all one should be concerned about is the worst-case future of the investment five or ten years from today, because the positive outcomes take care of themselves. In aviation the positive outcome is literally irrelevant, all that matters is your ability to succeed when dancing with a black swan.

(6)
The pilot approach to probability assignment is the way to think about investments. What is the worst possible scenario that I can imagine (within realistic bounds of course)? If this scenario occurs when I least expect it, what is my probability of success? What is the probability that I will lose all my money, or will I have a high probability of a safe return to the airport?

Thank you for reading, I hope you’re gaining some value out of these posts.