Black Swan Investing: How Not to Die

Posted on September 27, 2012 at 12:11 PM PST by

Which would you prefer, hurricanes or earthquakes? We’ll get to black swan investing shortly, but consider that question first.

People who’ve lived through Florida’s storm season over the past few years would probably say a little shaky ground sounds like a relief compared to days of high winds and surging tides, followed by weeks without power and streets that are a mess of tangled power lines and downed trees. People caught unaware can die.

Of course, our friends in California would counter that small earthquakes are a nuisance, but the big ones are catastrophes. Houses split, roads crack, cliffs fall. And, sometimes, people die.

If you had to choose — and living in any part of the world is often a choice, after all — take the hurricanes, hands down.

Why? Simple. You can see a hurricane coming. Forecasters can’t tell the ferocity of the eye-wall winds to come or the point of landfall, but they can tell you, days in advance, whether to evacuate. Dying in a hurricane is a highly avoidable outcome.

Meanwhile, earthquakes, as the Japanese have concluded after wasting billions on research, are fundamentally unpredictable. You can mandate stronger buildings, but that’s all.

black swan investing

All this weather talk is a good way to think about what market experts call a “black swan” event. Coined by the writer Nassim Taleb, black swan investing means being ready for a high-impact event that is so unexpected that people don’t believe it until they see it with their own eyes. The Sept. 11 attacks, for instance, or the leveling effects of the global Internet.

Later, of course, we make up reasons that create the impression that black swan investing events can be predicted. But that’s just a defense mechanism for our own egos. (And, yes, black swans exist.)

Stanley Crouch, chief investment officer at Aegis Capital, told CNBC recently that he sees the convergence of a number of events — slowing global economies, the U.S. election, Fed monetary easing, problems in the eurozone — combining to create a “freckled swan,” a white swan so pockmarked with bad news that it ends up being black after all.

He’s essentially calling for a black swan investing strategy, warning of a potential 25% decline for stocks. Here he is on CNBC:

Crouch argued that stocks have rallied largely based on bond-buying expectations from the Federal Reserve, rather than healthy factors underpinning the global economy. The Fed’s unfurling of more quantitative easing was mostly a non-event that had already been factored into stock prices. “We paid in advance for this classic ‘buy the rumor, sell the news’ event,” Crouch said.

We certainly respect anyone who has garnered the reputation necessary to manage billions in assets, as has Crouch. However, think about what he’s saying here: He’s arguing that black swan investing is predictable, an event one could forecast. Essentially, not a black swan at all.

It’s inside-out logic, not to mention unfalsifiable. Stocks could decline dramatically over the next few months. Certainly, the amazing equity rally we’ve seen alongside a bull market in bonds reflects the very unusual effects of Federal Reserve policy.

Back to the weather analogy: If Crouch is right, he’s acting the part of the hurricane forecaster. He sees a dangerous weather pattern forming. The conditions are ripe for a disastrous turn. He’s suggesting, obliquely, that you should begin to prepare. Yet he cannot pinpoint the landfall or come anywhere close to the expected wind speed at your specific address.

The problem, of course, is that markets act much more like earthquakes. Tremendous forces, unseen and poorly understood even by experts, push and pull at each other nonstop. Cave-ins and ruptures can and will occur. You won’t have much time to plan, or maybe even to react. That’s life.

Black swan investing for passive investors

If you have to live in an earthquake zone, and millions do, experience shows that the only effective response is to improve building standards. Tsunamis aside, better buildings have kept fatality rates low in places such as Chile, Japan and San Francisco. Even small earthquakes kill thousands in poor countries.

In terms of your portfolio, the equivalent of a strong building is a strong asset allocation. Building an allocation that properly balances the risks of stocks, bonds, cash, and hard assets allows an investor to withstand the sudden cave-ins that result from a true black swan investing event. They can and will happen. That’s about as close to a forecast as you’ll ever get: “Things happen.”

In fact, black swan investing can be seen as an opportunity. As “haven” assets such as bonds or commodities rise in response to bad news, rebalancing leads to selling those gains. That frees up cash to buy risk assets on the cheap. That’s how pension funds and college endowments do it, and you can do it, too.