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Black Swans Now a Regular Part of Market Landscape

Wednesday, 16 Mar 2011 | 12:58 PM ET
AP

For global financial markets, once-in-a-lifetime events are happening with such regularity that black swans may as well be white swans.

Such supposedly rare occurrences, brought into the national consciousness largely through Nassim Taleb’s 2007 book, “The Black Swan,” have dominated the markets for more than a decade.

They include the Internet explosion in the late 1990s, the ensuing dotcom bubble burst and stock market selloff a few years later, the 2001 terrorist attacks, the collapse of the real estate market that began five years ago, and now, the events in the Middle East and Japan.

The “highly improbable consequential” event is how Taleb frames the Black Swan phenomenon, and each time they arise, the markets react violently.

In his widely acclaimed book, he says traditional models and probability scales, in particular the bell curve, fail investors miserably, causing them to get on the wrong side of the trade primarily from taking on too much risk in their portfolios.

Indeed, the normal course of events—those happening within the belly of the bell curve—have little impact on stocks and other investments. It is only in times of great enthusiasm or great distress that truly impactful moves occur.

“You have to understand that whatever you want to call it—a hundred-year flood, Black Swan, sixth standard deviation—they happen a lot more often than the probability models will tell you,” says Gary Flam, portfolio manager at Los Angeles-based Bel Air Investment Advisors, which oversees about $6 billion for high-net-worth clients.

The Black Swan by Nassim Taleb
The Black Swan by Nassim Taleb

“The market decline in 2000, the mortgage bust, the stock market decline in ’08 and ’09 are supposed to be one-in-a hundred-year events and they’re occurring a lot more regularly. So I think we have to figure out how to rephrase it.”

Whatever you want to call it—a Gray Goose, like the vodka?—the perils for unprepared investors are severe.

The problem is, when these events happen, investors often can’t get out of their own way, zigging when they should zag and zagging when they should zig.

“It comes down to two things: Monitoring your risk-reward and also understanding the behavioral aspects of investing,” Flam says. “Your own psychology is going to be your own worst enemy. You’re going to want to invest when you’re most comfortable with what’s going on around you, and then the stocks have priced that in. You’re not going to want to in invest in times of uncertainty, and that’s usually the best time to be investing.”

From Taleb’s view, the best investment strategy is to construct a portfolio filled with mostly safe investments such as government bonds and the like, with a much smaller portion dedicated to risk in options.

“You always have to be focused on not just the upside but the downside as well when investing,” Flam says. “‘Margin of safety’ is what the value investors call it.’”

Protests and government overthrows in the Middle East first upset the market’s rally off the March 2009 lows back in February, and the earthquake and tsunami in Japan—both “highly improbable events”—have caused havoc with investor psychology in recent days.

Reaction, though, has been predictable. Investors have shed risk assets like stocks and have flocked toward the safety of US Treasurys.

That could be a precisely the wrong reaction.

“It’s a buying opportunity here, actually,” says Michael Cohn, chief investment strategist at Global Arena Investment Management in New York. “This is an opportunity to kind of shuffle things around and buy things that are going down."

Not exactly the Taleb strategy, but there is a protection element to it.

Cohn relies on 13 years in derivative trading to use covered calls to limit downside, not a foolproof strategy, to be sure, but one that at least braces for the probability of the improbable.

Strategists at Bank of America Merrill Lynch also are counseling clients to avoid panic selling, saying the strategy of dumping stocks in turbulence and then buying back 20 days later has only worked once—during the 1987 Black Monday crash, which was, yes, another Black Swan.

“Although this strategy helps to avoid many of the market’s worst performance periods, it usually significantly underperforms a simpler strategy of just staying invested,” chief US equity strategist David Bianco said in a research note for clients. “This is because it also misses the best days, which tend to closely follow the worst days.”

After all, nobody said a Black Swan had to be a bad thing.

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