Embracing the Black Swan

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I am in the middle of reading Nassim Nicholas Taleb’s the “The Black Swan – the Impact of the Highly Improbable”.  What is a Black Swan?  Until someone in Tasmania found a black one, everyone till then thought all swans were white.  Taking that analogy, Taleb’s Black Swan is any unanticipated, unforseen event that overturns conventional wisdom, or has an inordinately high impact – either positive or negative.

Examples of Black Swans in history are the invention of the steam engine, the printing press, Genghis Khan, the Black Death, 9/11, the stock market crashes of 1929 and 1987 … and so on.

The book is fascinating, since it explores how we attribute meaning to that which is luck, or lull ourselves into complacency of risks that could be avoided or mitigated, by either assuming that nothing is wrong because the risk is out of scope of prior experience, or by being aware because we rely too much on the heuristics (short-cuts) that our brains use to assess what is going on around us.  (To think through the latter requires concentrated thought and expenditure of energy, which is not the default approach of the brain).  Also, Taleb reminds me of my friend and mentor Omar Sheriffe Vernon el Halawani in his intolerance of superficiality and non-thinking.  I wrote about him (Sheriffe) in one of my first posts here.

How am I embracing the Black Swan?  By going back to being fully invested.   Sound risky?  It is - in the short run. 

Part of Taleb’s discourse is on how, because our brains are wired to summarize and require interpreting information as a causal narrative, we easily see patterns where there aren’t any.  Our minds do not easily accept randomness.  A direct example of this in stock trading is looking at fundamental information and technical charts to infer from past history what might happen in the future.

Over a long enough time frame, this would work in most cases, but the mind more easily digests, and our emotions more easily accommodate, small and steady successes now rather than big payoff in the future, so we look at risk and reward in the short term, whether or not we think of ourselves as “long-term investors”.  We fear our stock going down tomorrow if we buy today (though it might easily double two years down the road), and it is very difficult to resist taking profits if your stock immediately moves up 10%.  Therefore the foundation of the financial industry and its machinery is geared toward trying to predict what is going to happen -typically in the next quarter.

Yet, what can a stock do?  One of only three things:  (1) go up, (2) go down, (3) or stay still.  Over an extended period of time, unless it has its own personal Black Swan – bankruptcy – it will do all three.  (I guess bankruptcy is actually option (4), and a takeover or merger, option (5).  The latter two are special cases.)

What if you could eliminate the requirement for prediction, and simply create a strategy around price movement alone? relying on the three (OK, five) things that stocks can do?

Well that’s my program REAP (Relational Equity Allocation Program), and I’ve already described how it works in three previous posts.  You stay fully invested, you trade the same groups of stocks, and within each group you periodically sell part of the temporary gainers and recycle funds into the temporary laggards based on their relative price movements with respect to each other over a specified period of time.

How is this embracing the Black Swan?  The compounding effect of REAP increases as a function of volatility.  A Black Swan type event in the stock market creates tremendous volatility in around the time of the event, and throughout the ripples thereafter, creating the opportunity to sell high and buy low many times in a compacted time frame within the REAP re-allocation framework.   (Normally it would earnings announcements or unexpected news that makes stocks step or step down significantly – all good for our purposes.)

Since REAP’s focus is to continuously increase the number of shares held; it can do that whether the portfolio is currently high or low in current valuation.  The relative price movement of stocks described above is independent of the value of the aggregate portfolio.  (If you have a simple portfolio of two stocks, the portfolio will be the same value if Stock A goes up 5% and B down 5%, or alternatively if A goes up 50% and B down 50% – and many other combinations.  The second scenario will however create more shares on the rebalancing.)

With the cyclicality of the market, over say, 20 years, it should provide many exit points during up cycles to cash in some or even all of the portfolio growth at favourable prices.

What are my risks to the overall portfolio?  A Black Swan that brings down the whole financial system itself is the biggest.  A terrorist setting off a nuke in Manhattan would have that effect for quite some time (although after 9/11 perhaps the exchanges now have backup capability beyond New York City - though much of your market community and individual financial institutions – and liquidity - would be vapourized.).   Another might be if the power grid goes down irrevocably, for whatever reason. 

These events seem unlikely, but that is the nature of the truly potent Black Swan.  I’m willing to take this risk, because if we got to that point, I would have a whole set of other issues to worry about than a stock portfolio.  Money itself might have no value – after all it’s just blips in computers and a little bit of paper and loose change you have lying around the house.

The next risk is bankruptcy risk.  To mitigate this, the portfolios are compartmentalized, (and the accounts held in one of Canada’s strongest financial institutions), so neither my stockbroker is likely to fail except in the extremest of circumstances, nor all of the portfolio impacted by one or more individual stock bankruptcies.  By compartmentalized, I mean that you don’t transfer funds from one portfolio grouping to another – you let each group grow (or languish) at its own pace.

A stock suddenly dropping and settling into a much lower price range for years might be another risk, but because REAP’s re-allocation is based on relative price movement from a given start and end point in time, even such a stock can contribute in its new trading range, mitigate, and then eventually overcome the initial absolute dollar loss.

“OK genius”, you might then say, “what if your Black Swan halves your portfolio overnight – or worse?”   Well then for a while I will have to seriously doubt my manhood, practice major damage-control with the wife, and perhaps even dabble in Bushido. But, sooner or later, the portfolio will come back, with the tail wind of a lot more shares in hand than before the crash.  And it’s not like I’m plowing all the money into solar stocks and emerging markets. We’re talking a chunk of high-yielding income trusts, a couple of short ETFs for inverse correlation (they go up when the market goes down), and a few blue chips to counterbalance some of the feistier selections.   (I would want to see a nice correction before I make the mix a little more aggressive.)

So since REAP reacts to, and does not require any prediction of, price movement, the whole mechanism can be completely defined, and operated, within the two-dimensional parameters of – up, and down. 

REAP feeds on volatility – it is the source of its compounding effect.  So bring on the Black Swans, I say (but not too black!).

Cheers,
Allocator

Some potential Black Swans to ponder for the near future …

A sudden crash of hte Chinese market that pile-drives other global markets
Another terrorist attack (although everyone expects that, so its not really a Black Swan)
A sudden devaluation of the US dollar – from an avalanche of foreign flight (dumping of US assets)
A sudden surge in the US dollar – from an avalanche of foreign flight (flight to safety)
Runaway inflation
The produce industry collapses because the bees all disappear
Credit crunch drives up the cost of borrowing
A sudden crash of global markets, followed by deflation
We all go to war over the Northwest Passage
Pakistan completely de-stabilizes
Someone sets off a nuke somewhere

OK, some positive ones …

Global warming makes northern Canada and Russia a huge bread-basket for the world
We invent fusion reactors and never have to worry about dirty power again
Aliens make contact (and don’t enslave us)
Osama bin-Laden changes sides

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