The Black Swan
Have you ever seen a Black Swan? Most likely the answer is no, but there’s a good chance that you’ve been affected by one.
For some 1500 years, western civilization believed that all swans were white. In fact, the idea of a black swan was a popular metaphor inEurope, which symbolized something that could not exist. That all changed in 1697 when a Dutch explorer sailed into New Holland and made the first recorded European sighting of this elusive bird.
What was once thought to be non-existent – a black swan – turned out to be not only existent, but rather common in a certain part of the world. This is a lesson that we should all take to heart as it relates to investing.
Many models used by sophisticated investors are predicated on the idea that by using statistics, we can come up with the odds of certain events occurring. Using a made up example, looking at historical stock market performance, a model might suggest that the odds of the Dow Jones Industrial Average dropping by 10% in one day, is 1 in 6,000. With that data, a sophisticated investor might create a complicated transaction that tries to eke out a predictable return using a lot of leverage. What we’re finding is that in reality, the models some investors use may actually misprice the risk of certain events happening.
Nassim Taleb, in his 2007 bestselling book titled, The Black Swan: The Impact of the Highly Improbable, lucidly pointed out that on Wall Street, black swan events seem to occur more frequently than most investors expect. As a result, investors may be unprepared for negative events that were once thought to be highly improbable, but actually turn out to happen every few years.
In the past 25 years, Taleb pointed out a few “black swans” including the 1982 Latin American debt crisis, the October 1987 stock market crash, and the collapse of hedge fund firm Long-Term Capital Management in 1988. Perhaps the turmoil in the auction-rate securities market qualifies as another example.
The emotional nature of human beings makes us unpredictable. Taleb’s insights help us understand that while “black swan” events may be infrequent, they do happen and we would be wise to incorporate their possibility into our investment planning through proper risk control.
For some 1500 years, western civilization believed that all swans were white. In fact, the idea of a black swan was a popular metaphor inEurope, which symbolized something that could not exist. That all changed in 1697 when a Dutch explorer sailed into New Holland and made the first recorded European sighting of this elusive bird.
What was once thought to be non-existent – a black swan – turned out to be not only existent, but rather common in a certain part of the world. This is a lesson that we should all take to heart as it relates to investing.
Many models used by sophisticated investors are predicated on the idea that by using statistics, we can come up with the odds of certain events occurring. Using a made up example, looking at historical stock market performance, a model might suggest that the odds of the Dow Jones Industrial Average dropping by 10% in one day, is 1 in 6,000. With that data, a sophisticated investor might create a complicated transaction that tries to eke out a predictable return using a lot of leverage. What we’re finding is that in reality, the models some investors use may actually misprice the risk of certain events happening.
Nassim Taleb, in his 2007 bestselling book titled, The Black Swan: The Impact of the Highly Improbable, lucidly pointed out that on Wall Street, black swan events seem to occur more frequently than most investors expect. As a result, investors may be unprepared for negative events that were once thought to be highly improbable, but actually turn out to happen every few years.
In the past 25 years, Taleb pointed out a few “black swans” including the 1982 Latin American debt crisis, the October 1987 stock market crash, and the collapse of hedge fund firm Long-Term Capital Management in 1988. Perhaps the turmoil in the auction-rate securities market qualifies as another example.
The emotional nature of human beings makes us unpredictable. Taleb’s insights help us understand that while “black swan” events may be infrequent, they do happen and we would be wise to incorporate their possibility into our investment planning through proper risk control.
posted by Triton Wealth Management at
1:11 PM
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