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Saturday, 11 April 2009

Black Swans, Tsunamis and Cardiac Arrests

Low Probability, High Consequence

On 26th December 2004 an earthquake off Sumatra caused a tsunami that sped across the Indian Ocean and led to the death of nearly 230,000 people. It was one of the deadliest natural disasters in recorded history. Despite the possibility of such an event being long acknowledged and the relatively low cost of putting early warning systems in place no such protection was available.

In the jargon it was a low probability, high consequence event and the failure to plan for it is a consequence of the human psychological focus on the predictable and short term to the exclusion of the unpredictable and long term. More colloquially the world had witnessed a Black Swan.

Taleb's Black Swans

The “Black Swan” is Nassim Nicolas Taleb’s metaphor for such events as the tsunami. Taleb’s contention is that massive and devastating events happen far more often than you’d expect and that when they do we are almost always unprepared for them. A further consequence of such events, combined with modern media, is that we then overestimate the likelihood of a further similar event and modify our behaviour accordingly.

A grim example of this is the behaviour of Americans in the wake of the 9/11 Twin Towers terrorist attack. Even though the actual risk of a reoccurrence was very small and even though if terrorists had started to hijack and crash a plan a week flying would still have been the safest mode of travel – by a huge magnitude, people stopped flying. I don’t blame them, it scared the living daylights out of me.

Instead they started driving, which is statistically much more dangerous than flying. Predictably the result was that far more people started dying on the roads, as much victims of the events of September 11th 2001 as those who died on the day. The psychological triggers that cause us to overrate the stuff we can see and ignore the stuff we can’t are hardwired into our neural systems and can only be overcome with huge efforts of will.

Surprising Stockmarkets, Unsurprising Commentators

Stockmarkets are classical territory for Black Swans and are where Taleb’s ideas originated. Although returns oscillate about a stable midpoint over many years out at the extremes we see many more surprises than you’d predict. Yet despite the relative regularity of these Black Swan events – think 1907, 1929, 1931, 1936, 1973, 1987, 1989, 1997, 2000, 2008 – most commentators and fund managers simply ignore them in any analysis of stockmarket returns.

There’s a good reason for this – anyone sticking their neck out is more than likely to be wrong, since although Black Swans are more common than we might expect they’re still much rarer than normal market behaviour. So any commentator predicting a market crash is very likely to end up looking very silly indeed. As are fund managers.

The classic example of this was the late Tony Dye of the British fund manager Phillips & Drew who remained bearish all the way through the dotcom boom at the end of the 1990’s, remaining invested in value stocks throughout. Stuck to the bottom of the performance charts his management finally lost patience just as the UK stockmarket peaked. With a certain natural irony markets then crashed before his replacements could modify his selections and Phillips & Drew soared to the top of the performance charts.

For fund managers and expert commentators is usually better to run with the herd. If everyone’s wrong there’s safety in numbers, but if you’re on your own you’d better be right.

Real World Black Swans

Richard Poser (see the Becker-Posner Blog) is one of the leading protagonists of managing natural Black Swans. He argues that spending relatively small amounts of money to provide early warning systems for tsunamis or asteroid strikes is a sensible use of resources. The fact that these events are rare doesn’t mean we shouldn’t plan against them because they’re so devastating and, relatively, cheap to guard against. As Posner points out, planning for such events is rarely in the interests of any politician because the chance of such a disaster happening during their term of office is very low and there is little kudos to be won by spending money on such schemes.

Human myopia in these circumstances is widespread. In 1999 there was widespread media hype about the coming crisis that the “Millennium Bug” would cause. This was, supposedly, the problem that many old computer systems would fail when the clocks ticked around to 2000. Billions were spent by organisations resolving the problem, which helped to push up the earnings of technology stocks with non-repeatable revenue and contributed to the technology stock crash that followed.

Once the potential crisis had passed the general view of the media was that the whole problem had been a non-issue – a position “proven” by the lack of any problem. Which, of course, ignored the huge quantities of money poured into ensuring that the problem didn’t occur. Saving the world from itself is not a story.

Investing with Black Swans

As individual investors we need to factor these rare but catastrophic events into our investment rationale despite the fact that no one is going to tell us to do so. One of these events at exactly the wrong time – on the eve of retirement, for example, can destroy us. So we need to continually bear in mind the possibility of such an event and plan against it.

What does this mean in investment terms? Well, it means taking a long term view – markets can easily take up to twenty years to recover fully from a major catastrophe. It means taking a view on risk which should mean spreading our investments across various asset classes and geographies. It means being careful to not over commit resources to one specific trend or investment. Possibly it means insuring ourselves against nasty events by using properly backed derivatives, especially as we move towards that time of life when we can’t recover our losses through work related earnings.

However, we need to retain some balance. Back in 2003 Dorothy Fletcher suffered a massive and life-threatening cardiac arrest, during which her heart stopped, on a transatlantic flight from Manchester to Florida. Only the prompt and immediate intervention of an cardiologist could have saved her. So it was her good fortune was that when a stewardess made an appeal for help no less than fifteen of the world’s leading heart experts, on their way to a conference in Orlando, came rushing to her rescue. Black Swans are not always bad.

Just don’t expect the financial wizards of the world to tell you when the next one will arrive. They have no incentive to predict one and no ability to do so. Random stuff is simply random, I’m afraid.


Related Posts: Contrarianism, Darwin's Stockmarkets

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