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Betting on another Black Swan — Pop Economics

Betting on another Black Swan

by Pop on August 21, 2010

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Why it’s so hard to make money from the unpredictable

Today, the Wall Street Journal carried a story about how mom and pop investors can profit from “black swans”—those seemingly impossible events that, when they arrive, completely disrupt the investment landscape.

The term was made popular by Nassim Nicholas Taleb in The Black Swan a few years ago. Then, the financial crisis happened, and now, Taleb is one of those rare authors who would actually prefer to do fewer interviews and book promos than he does now.

Black swans are supposed to be inherently unpredictable. They’re the “unknown unknowns” of the investment world—extremely rare events that most consider impossible if not inconceivable. We all worry about tax reform, and then, boom, a few planes hit major American landmarks. (Which happened.) We all worry about Iran getting nuclear weapons, and then, boom, a nuclear power plant goes Chernobyl in Pennsylvania. (Seems improbable, but that’s the point.)

Once a black swan event happens, all of that other little stuff you normally care about as an investor—whether it be valuations, interest rates, or profit margins—ceases to matter, or at least matters much less. And as we discovered during the financial crisis, hitting a high-impact, improbable event results in almost all traditional asset classes losing value.

But in 2008, a hedge fund managed by one of Taleb’s collaborators didn’t lose money—in fact, it more than doubled. Today, mutual fund companies are opening their own funds, for investors who can’t afford a hedge fund, dedicated to protecting against or profiting from black swans. That’s not surprising. Mutual fund companies always come up with products after they would have been most useful. But now that these guys are around, do they ever make sense to invest in?

Predicting a black swan.

“Predicting” a black swan is an oxymoron. So how can investment strategies be tailored to do it? In his book, Taleb advocates putting the overwhelming majority of your assets in something extremely safe, such as Treasury bonds, and then taking a flier with the last 10%.

For example, after putting 90% of my portfolio into Treasuries, I might put the last 10% in a few biotech stocks. If one of them finds a cure to cancer—thereby hitting a positive black swan—I get rich, even though I had relatively little money invested in it. If they don’t, the worst I can lose is 10% of my portfolio.

More complicated strategies, used by some of the hedge funds that espouse Taleb’s strategies, involve buying out of the money put options.

Without getting into the strategy itself, basically the funds only make money if there are extreme market losses on whatever asset they buy the option on. Because the market thinks those events are unlikely, the options are very cheap. But over time, if the event never happens, a fund can slowly bleed to death as it waits in vain for luck to strike.

Practically, for a mutual fund like the Pimco Global Multi-Asset fund, which the WSJ article cites as a black swan fund, you get a fund that charges a 1.41% expense ratio with a strategy that you’re not going to really understand. The managers say that their hedging strategies will limit your downside risk in any one year to 15%, but isn’t the whole point of a black swan event that you don’t know in what magnitude and in what way the swan will strike?

Lessons from the last black swan.

Which brings us to the event that rocketed thinkers like Taleb to prominence—the collapse of Lehman Bros. and the financial crisis. Between Lehman’s collapse and the March 9, 2009 market trough, the S&P 500 lost 46%. That’s pretty bad and really devastating to someone who needed that money soon and had most of their money in equities.

But your average retiree didn’t (or at least shouldn’t) have most of his money in stocks. Using the oft-used rule of thumb to put your age in bonds, a 65-year old would only have 35% of his money in stocks. Which means, his portfolio right now might be down 15% to 20% from that peak. Not good, but not devastating either.

Sure, another crisis is still possible, but it seems that crises of the most recent variety, which wipe out a large, but manageable, amount of wealth, are best dealt with after the fact rather than beforehand. If you happen to be the unlikely victim of a huge, unpredictable event, it’s much easier to reduce your spending, delay retirement, or take a part-time job than it is to try to run an investment strategy that will eliminate the bad event’s effect.

Take Peter Schiff, for example. His prediction of the 2008 financial crisis was dead on, but his clients lost 40% to 70% of their money.

Why? Schiff was right about the crisis, but wrong about its effect. He thought the dollar would lose its value and foreign stocks would stomp stocks here. Instead, the dollar soared, as investors poured into what they thought was the last safe investment out there, and his clients lost a ton of money. Of course, we’re not out of the woods yet, but Schiff’s mistake shows how hard it is to get bets on unlikely events correct.

So in my view, black swans are just something we have to live with. It would be nice to “beat them” by anticipating and profiting from them, but that’s probably impossible. It would also be nice to limit the downside risk of a black swan event, but there are so many ways in which such an event could affect you that limiting your downside is also probably impossible.

You can invest wholly in Treasury bonds, but what if the “black swan” is the dissolution of the American government? You could invest in gold. But what if the black swan is the discovery of a way to turn lead into gold?

As long as black swans—and their effects—can’t be anticipated, the best strategy is to remain flexible and quick to adapt when it occurs, not to try to predict the unpredictable.

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{ 4 comments… read them below or add one }

eclecticvalue August 22, 2010 at 2:25 pm

Hey great article Pop, Does Taleb conclude in his book that black swans can’t be anticipated? Do you think the recent oil spill was a black swan because I think Taleb said it wasn’t a Black swan event during his interviews? BTW, I think you should make a Black Swan Pop art piece

Pop August 22, 2010 at 3:43 pm

Hey, thanks. Yeah, pretty much the entire crux of the book is that we can’t anticipate black swans, by definition. Instead, with hindsight we try to identify signs that could have helped us foresee the event, according to Taleb, when actually there was really no way we could have seen it coming.

I’m not sure if the oil spill measures up…in the end, while it was devastating to BP and might have a longterm impact on the Gulf, it doesn’t seem to have had the same level of impact as the market crash in 1929, Sept. 11, or the financial crisis.

Also, good idea for the pop art. I need to get some new images going. Thanks for writing!

Rob Bennett August 23, 2010 at 11:48 am

So in my view, black swans are just something we have to live with. It would be nice to “beat them” by anticipating and profiting from them, but that’s probably impossible.

We disagree, Pop. But I am happy to see you writing about this topic. Anything written about it gets people thinking about it and that always advances the ball a bit.

Your note about Schiff is wonderful. I believe that the reality is that some things can be predicted easily and some things can be predicted not at all One of the first things that we should do in learning about investing is dividing different things into the two different categories. Schiff got the easy thing right but then got too proud and attempted a prediction of something that cannot be predicted and thereby ruined things for his clients. Oops!

I do not understand why there is anybody who found it even a tiny bit difficult to predict the economic crisis. The market was overvalued in 2000 by $12 trillion. Even the most ardent Buy-and-Holder alive (John Bogle) acknowledges that Reversion to the Mean is an “Iron Law” of stock investing. So everyone who was paying even a tiny bit of attention knew that we would be losing that amount of wealth over the next 10 years or so. And there are people who express surprise that we are living through an economic crisis today?

The problem with predicting stock returns is not an intellectual one. It is an emotional one. Lots of people want to pretend that it is difficult to predict long-term stock returns because that lets them continue to live in the illusion that going with a high stock allocation at a time of insanely dangerous prices is a rational strategy. We need to start talking more sensibly about this stuff.

Rob

jim August 23, 2010 at 6:52 pm

Great article.

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