"A single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans.  All you need is a single black [one].”

 

From “The Black Swan”

By Nassim Taleb (2007)

 

Previously, I posed an observation that the current “mortgage crisis” is a “Black Swan”.  If that is so, if one knew in advance that a “Black Swan” was present, what actions could reasonably be taken?

Knowledge of a "Black Swan" would, by definition come from a source with unique perspective, at least unique from established, credible financial sources.

Further, such knowledge would have to be categorized as rumor or “one man’s opinion”; not validated elsewhere in the public media.  As such, investment decisions made from such information would be inherently risky and form an unsound foundation for managing portfolios.

Imagine a conversation casual conversation with someone from an accounting firm, law enforcement pursuing an investigation in a representative local market, or regulatory agency outlining one significant element of the current crisis, be it lax appraisals, unverified household income, or fraudulent mortgage applications (aided and abetted by real estate agents or builders or mortgage brokers).

Based on recent Wall Street Journal article (“Fraud Seen as a Driver In Wave of Foreclosures”, December 21, 2007) describing recent cases that have worked through the courts in a ”garden variety scam” to “steal a fortune from lenders in recent years”, there was clearly verifiable indication of this problem as early as 2004-2005. Therefore, imagine responding to knowledge of this “Black Swan” before it hatched.

What to do!

Reactions from experts fall into four generalizations:

 

If you (meaning me, one investment professional) know such information, so must it be known elsewhere in the “market”; and, because it is not reflected in stock prices, one must realistically assume it either not true or extremely limited.

To believe this true, one has to assume executives of the American banking industry to be either dishonest or incompetent, an assumption you (meaning me, one investment professional) is not qualified to make.

If such a problem exists on that scale, it would involve trillions of dollars and could not possibly slip by regulators of banks, securities and money laundering.

To act on this by avoiding investments in the banking and mortgage sectors, overall risk to clients is increased and returns possibly decreased as this sector is a major component all the major indexes.

These were all valid, rational responses.  Investment returns from financial industry stocks surpassed performance of other most other sectors between 2005 and mid-2007.  Avoiding financial industry stocks likely would have resulted in below average returns to investors during that time period, and could possibly have resulted in clients changing strategy sometime in between, thus missing the opportunity of financial stocks from 2005 to mid-2007 AND feeling the full impact of the recent losses.  Hypothetical better returns experienced in late 2007 through NOT being invested in financial stocks are little noticed by clients in the turmoil of the generally declining markets of the last few months.  

However, the “Black Swan” did appear suddenly and unexpectedly, is causing great turmoil in the financial markets, and yet, seems perfectly explainable after the fact.

Perhaps this leads us to expect future “Black Swans”.

Thus, the conclusions of my last post seem applicable:

  • “Barbell” investment strategies that include some riskier investments in a conservative portfolio;

    or, insure investments in a more aggressive portfolio against losses in excess of some level.
     

  •  Turn “black swans” into grey swans, by replacing usual normal (mean and standard deviation statistics) decision making with “black swan” distributions that recognize outsize positive or negative return possibilities.
  • Ask yourself “what impact do extreme return outliers (positive or negative) have on total returns.”

In everyday language, this means owning a variety of investments and investment approaches, keeping focus on performance of the overall portfolio (not on each single investment), and trying to change our hard wired tendency to focus on what we know while ignoring what we do not know.

Jack Carney

Copyright © 2008 MWBoone and Associates All Rights Reserved. MWBoone and Associates is a Registered Investment Advisor Investment Management services are not available through this blog site but are described at www.mwboone.com. Securities offered through Linsco/Private Ledger Member NASD/SIPC.