The Black Swan
Nov 14, 2008
Posted by Jody Eisenman | Filed under Uncategorized
Nicholas Taleb, whom I spoke about in previous articles, has coined a term known as a “black swan”. Simply put, a black swan is a completely unforseen event that throws all previous trading strategies out of whack. In the book, “Mobs, Messiahs and Markets” by Bonner and Rajiva, they discuss the following scenario:
Most people are not prepared to take huge risks in order to get huge potential profits. However, they are willing to take the risk of losing a huge portion of their portfolio if they think there is a good chance of constant small returns. In other words, many investors are prepared to grind out small but steady returns consistently. Unfortunately, what that unforseen event occurs (the black swan), they get crushed. This is exactly what has happened to most investors this year.
Take a fictitious investor called Jen. Upon advice of her respected financial consultant, Jen takes her portfolio of $1,000,000 and diversifies into a mix of corporate/municipal bonds, mutual funds and equities. Over the past several years, Jen has gotten average returns of around 7%/year, rarely showing a loss. She’s not looking for “home runs”. She’s very content to get a single digit return on her money because she believes she has a very low risk of any significant loss. Until this year, she was right. Unfortunately, when she looks at her statement , she is down almost 40%. She has completely wiped out all her gains over the last several years. She is stunned. Her financial advisor has no idea what to tell her. He is as shocked as she is. The net result is, she never realized the potential risk in a severe recession. Those were things that only happened in the 1930’s. Surely, the government had taken steps to avoid this. Unfortunately, what happened to Jen has happened to most investors this year. The moral of this story is to take steps to protect your portfolio.
The market finally staged a big rally for the first time this month, with the averages closing up about 6.5%. That’s the good news. The bad news is, there have no sustained rallies since August. Therefore, I have no real confidence that this rally will continue for any length of time. The only I do have confidence in is that the extreme volatility will probably continue through at least the end of 2008.
