I heart Black Swans

Two days ago I might have experienced a Black Swan event.

To qualify what I’m about to share, let’s review the definition of Black Swan. The theory was developed by Nassim Nicholas Taleb to explain: (wikipedia)

  1. The disproportionate role of high-impact, hard to predict, and rare events that are beyond the realm of normal expectations in history, science, finance and technology
  2. The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities)
  3. The psychological biases that make people individually and collectively blind to uncertainty and unaware of the massive role of the rare event in historical affairs

It’s basically a statistical anomaly, known as a fat-tail event. Some could debate elements of the definition like the shape of the Bell Curve or other minutiae of Taleb’s work, but, in general, this is how the definition is being applied in the vernacular of today’s investing world: a rare occurrence not considered by most.

A Butterfly Flaps Its Wings

Two days ago somebody searched for Black Swan 60/40 Portfolio & found my site, iheartWallStreet.com

I assume they were looking for a 60/40 portfolio designed to weather a Black Swan. It doesn’t say ‘profit with Black Swan 60/40 portfolio’ or ‘make fat stacks’. In my mind, anyone seeking a profit would have surely typed in something to that affect.

Now, when I think of portfolios designed to survive a Black Swan, I think about properly allocating your risk in the face of some massive unknowable event. With risk, I like to keep it simple. And why not? At it’s core, risk is a binary function. You either have risk or you don’t.

Simply put in investing terms: Cash is today. Investing is tomorrow. Tomorrow is risk. The risk of holding cash is tomorrow. The risk of investing is tomorrow’s today. {sit with that for a few spins}

Long story short, don’t invest what you don’t want to lose. Now how on earth could I have possibly seen ‘Black Swan 60/40 portfolio’ becoming relevant to someone? I couldn’t. I didn’t. It was basically an unknowable event… So that’s a Black Swan, right?

Black Swan Losses

Now, if you really want to play out a true Black Swan in the market, a definitional fat-tail event, it is 5 standard deviations (or more). From my years in the industry, I can tell you that most financial advisors only forecasted about 2 deviations when they showed you your portfolio proposal, covering you about 95% of the time. Seems reasonable, I suppose. But if they forecast 3 standard deviations it would cover you 99.7% of of the time. But most don’t. Why? It makes their risk/reward numbers look much more palatable. If you used three deviations, you’d probably have much, much less in stocks, which coincidentally pay more to the advisor vs. the fees a more heavily weighted bond portfolio might generate.

Here’s the real mind bender though — Most of what you just witnessed in the markets in 2008 was a perfectly normal 3 standard deviations.

To play out the Black Swan scenario, look at wherever your portfolio was at the worst of it on March 9, 2009. Yeh, that was only 3/5th’s of a Black Swan’s potential.

Here’s the another mind twister. Black Swans reside in both realms: Today & Tomorrow. There’s no avoiding it, frankly. So at some point, don’t we just surrender to the notion that life is short. It’s a balance between how much you want to live today vs. tomorrow. And at some point, there is no amount of cash that is going to save you. That’s never going to change.

In investing, you should always be considering the Black Swan of course. If you’re not considering something could happen that you’ve never considered, you haven’t thought enough about your risk. But you have to accept the limitations of the exercise. Life is messy. So, let’s be reasonable.

Now here’s the laughable part. It’s the new hot money. Hedge funds are lining up to invest in Black Swans with uber leveraged & complicated ways for you to make money off of stuff nobody can actually consider. Want to bet on a huge palladium spike because of some mutant ravenous palladium-eating termite outbreak? I’m starting a new fund…

And right now, if you search for “Black Swan Markets” … there are 15,000,000+ results. “Black Swan Hedge Fund”: 291,000. Geez, how often do these Black Swans happen?

Doug Kass lays out some points about the frequency of events we hadn’t considered & how we are likely to see more. I can’t say I disagree.

Black Swan events over the past decade:

• Sept. 11, 2001, attacks on the World Trade Center and Pentagon;
• 78% decline in the Nasdaq;
• 2003 European heat wave (40,000 deaths);
• 2004 Tsunami in Sumatra, Indonesia (230,000 deaths);
• 2005 Kashmir, Pakistan, earthquake (80,000 deaths)
• 2008 Myanmar cyclone (140,000 deaths);
• 2008 Sichuan, China, earthquake ( 68,000 deaths);
• Derivatives roil the world’s banking system and financial markets;
• Failure of Lehman Brothers and the sale/liquidation of Bear Stearns;
• 30% drop in U.S. home prices;
•  2010 Port-Au-Prince, Haiti, earthquake (315,000 deaths);
• 2010 Russian heat wave (56,000 deaths);
• 2010 BP’s Gulf of Mexico oil spill;
• 2010 market flash crash (a 1,000-point drop in the DJIA);
• Surge of unrest in the Middle East; and
• The earthquake & tsunami in Japan — followed by the nuclear crisis.

Kass warns of contagion because the network has become so interconnected. And uber blogger (and one of my heroes), Barry Ritholtz drives home the notion that “The time to do drills is before the blitz, not after.”

But ultimately, I don’t really think we can keep calling these things Black Swans just because we hadn’t considered it. A fat tail event is a statistical measurement. A rare occurrence. Technically speaking, the datasets for our markets & their reactions are absolutely infantile. Anything remotely reliable, as far as datapoints are concerned, only go back to the early 1900s. That’s not really enough data to derive such statistical hyperbole.

So, maybe we should all stop pointing our fingers at things we hadn’t considered & continue to call them Black Swans. Or maybe not…

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Related:

VH-1 Presents: Where Are they Now? The New Normal – I heart Wall Street

The Black Swans of The Internet – Howard Lindzon

Black Swans, 100 Year Floods – Barry Ritholtz: The Big Picture.

A Contagion Of Black Swans – Doug Kass: The Street.com

Killing a Black Swan – World Beta

Where the Black Swans Hide – World Beta

A VC – Fred Wilson

The “Black Swan” Hedge Fund Returns Aren’t So Hot – Joe Weisenthal: Business Insider

Resolving Timeframe Conflict – Derek Hernquist

Fat-Tail – Wikipedia

Common Errors in the Interpretation of the Ideas of The Black Swan and Associated Papers – Nassim Taleb (ht:MF)

How do Markets Prepare For Disaster? – NPR