Tuesday, January 26, 2010

The Hype Surrounding Black Swans

No, we are not talking about the beer. Investors who read a lot would have come across the quite audacious yet thought provoking book by Nassim Nicholas Taleb. You can summarise the book with the line: The Impact of The Highly Improbable.

The Nobel Laureate Daniel Kahneman proposed the inclusion of Taleb's name among the world's top intellectuals, citing "Taleb has changed the way many people think about uncertainty, particularly in the financial markets. His book, The Black Swan, is an original and audacious analysis of the ways in which humans try to make sense of unexpected events."

Before the discovery of Australia, poeple in the Old world were convinced that all swans were white, an unassailable belief as it seem completely confirmed by empirical evidence. The sighting of the first black swan might have been an interesting surprise for a few ornithologists (and others extremely concerned with the coloring of birds), but that is not where the significance of the story lies. It illustrates a severe limitation to our learning from observations or experience and the fragility of our knowledge. One single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans. All you need is one single black bird.

Consider these factors: rarity, extreme impact, and retrospective (though not prospective) predictability. A small number of Black Swans explain almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives. We amble through life, in our careers, personal life, investing, etc... and these are punctuated by "black swans" - the humdrum would not kill you or make you rich and wealthy, its the black swans that turns everything around, be it in relationships or investing.

The central idea of this book concerns our blindness with respect to randomness, particularly the large deviations. In other words, we do not see the big picture but base our decision making process on what has happened in the past.

For those of you who attended my talk, I have spoken on how most of us make decisions: anchor & adjust. That in effect is one way to make sure we will never see or predict black swans in our analysis. When you anchor & adjust, you fixate on what happened recently and make your guesstimates from that point of reference. When Malaysia's GDP growth last year, say was 3%, to predict GDP growth the following year, we would anchor at 3% and make adjustments according to how we view FDI, unemployment, currency, interest rate differentials, blah-blah... Hence 99% of the predictions would be plus or minus 100-200 basis points from 3%. A black swan effect would be tantamount to something like two major banks collapsing in Malaysia overnight, and the resulting GDP growth was a contraction of 8% - now, that's a black swan effect - most did not see it coming because they never figured in our calculations.

Its not just in investing, you can be dating a girl for 5 years and planned to marry next year, and wham, she turned into a lesbian - turning your world upside down, what a black swan.

It is easy to see that life is the cumulative effect of a handful of significant shocks. It is not so hard to identify the role of Black Swans. Consider the significant events, the technological changes, and the inventions that have taken place in our environment since you were born and compare them to what was expected before their advent. Look into your own personal life, to your choice of profession, say, or meeting your mate, your sudden enrichment or impoverishment. How often did these things occur according to plan?

Taleb appeared to be vindicated against statisticians in 2008, as he reportedly made a multi-million dollar fortune during the financial crisis of 2007–2008, a crisis which he attributed to the failure of statistical methods in finance. Universa, where Taleb is adviser, made returns of 65% to 115% in October 2008 in its approximately $2 billion “Black Swan Protection Protocol.”

While most human thought has focused us on how to turn knowledge into decisions, ... if you follow Taleb's reasoning, we should be more interested in how to turn lack of information, lack of understanding, and lack of “knowledge” into decisions. That is because the world is always a place where information and understanding are lacking in most areas. Knowing that we will never be able to grasp all critical issues is important. The question of "what if" carries with it graver consequences when we know how to ask "what if" properly.

The LTCM collapse, with two finance gurus in the company (Nobel prize winners no less), was very Black Swannish. Using standard deviations and pricing models, they try to extract price differentials when certain factors move in a certain way. They looked at correlation between various asset classes and instruments. Well, the best minds could not explain when things that are supposed to correlate, starts diverging in a big way.

Our system of rewards is not adapted to black swans. We can set up rewards for activity that reduces the risk of certain measurable events, like cancer rates. But it is more difficult to reward the prevention (or even reduction) of a chain of bad events (war, for instance, the recent subprime crisis is a major example).

When our system of risk-reward is not geared towards detecting, spotting or preventing black swans - that put everything at risk. We can get into a very theoretical debate on black swans, but for us who are in investments, how does Black Swans apply to our senses?

The impact of black swans has been enhanced many times over due to the globalisation of markets, as well as financial firms getting a lot bigger and international (and fewer of them as a result). You can be owning very safe stocks with splendid dividend yields in Timbuktu, but due to over speculation in certain asset classes in Eastern Europe, or a maniacal over leverage by some Icelandic banks, you could have a cascading effect which hits at banks, markets, confidence ... leading to a de-rating of emerging markets, smaller currencies ... i.e. risk aversion, nobody wanting to own stocks. Hence your so called blue chips could be halved in value, to no one's fault.

The Black Swan thing should alert us to reflect that we really CANNOT adopt a buy and hold forever type of investing mentality. The markets are so different now, many things are the same, but there are critical nuanced differences now. Black Swans in investing will usually be found in over-leveraged situations, bubble type situations in certain asset classes, sovereign debt defaults, the collapse of a major financial firm, ... You may be just investing in stocks, but now you have to read and follow closer on what's happening or bubbling in other areas as well. Their bubbles will affect you in the end.

There are things we cannot control, that is external to us. We need to stay tuned to potential black swans, even though we may be laughed at initially. Take any industry or markets, think of a few really "upsetting things" can whack them out of the water - these are your potential black swans, then you start ticking things off in your research and analysis to see of any of these potential black swans are about to morph into something sinister.

Do not take things at face value, learn to ask better "what if" questions even when they appear to be silly sounding. Beware of leverage, beware of things like "value at risk" because nobody really knows VAR in reality.

p/s photos: Gu Chen

1 comment:

tohff7 said...

It's a great book. Highly recommended.

I particularly like the idea of fractal geometry by Benoit Mandelbrot