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What I’ve Learned So Far- Chapter 4
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Beware the Black Swan
By Ted Schwartz, CFP®
Well, after 25 years in the investment biz, I thought I would try to distill some of what I have learned so far (for myself and for you). Some has been learned the hard way through trial and error and some has been learned from the help of others without too much pain and suffering on my part. At any rate, I would like to offer some of what I now believe in a series of blogs that will hopefully be of some value
to you.
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The idea of black swan events was popularized by Nassim Taleb in his book of the same name. The essence of his idea is that we experience events that are rare, hard to predict, and have a significant impact. They are the type of events that some pundits, only with 20-20 hindsight, say were bound to happen. Events like 9/11 or the Financial Crisis could be
examples of this type of phenomenon. Before they happened, one might assume we have safeguards and systems in place to prevent such tragedies.
Because we are so accustomed to these types of events not happening (e.g. before 9/11 we assumed that an attack on the US mainland would not be attempted by anyone), we tend to make no accommodations for them.
Over the course of my career, I have probably heard people say of bear markets that “the market always comes back” thousands of times. They are right…..at least so far. While the market has always come back, there is not a rule of nature that assures this will always be true in the future. Hopefully, the market will continue to “always come back” for the rest
of our lives. If it doesn’t, it would sure be a game changer for everyone. A black swan.
A useful example (problematic but short of a real black swan) is having your flight cancelled. When you go to the airport, you assume your flight may be a few minutes early or possibly a bit late. In either case, your plans probably accommodate for this range of outcomes. But, do you really have a plan for what happens if your flight is cancelled and you
cannot get where you intend to be that day? Usually, we don’t really have a plan for this and have to improvise and make a new plan. Think phone calls, reservation changes, gnashing your teeth, and maybe a bit of cussing. Part of this event that we must consider here is that the negative outcome is so much bigger and more damaging than the positive one. I would guess that there are no flights that land more than an hour earlier than scheduled. On the negative side, your flight could be delayed
for more than a day. So, there is a potentially far larger negative outcome than positive one.
In investing, I think we tend to be a bit spoiled by the good long term outcomes we have so often enjoyed and often do not see the possibility of black swans out there waiting for us. We assume most people are on the up and up and we assume the regulators will weed out the bad folks. A Black Swan like Bernie Madoff comes along and can both take advantage
of us (including many very smart investors) and leave us in shock when we uncover their fraudulent behavior.
I am not advocating that we live in fear or panic of the next unexpected event. I just think we should do our best to realize that extreme results are part of the potential outcomes. Riskalyze (the software program we use to measure your preferences and portfolio risk) shows how your portfolio might perform over time. It provides an average annual return as
well as, from best case to worst case, how your portfolio might perform 95% of the time over a six month period. The other 5% of the time are the outliers that can happen. Your planning should be about the outcomes that happen 95% of the time but…we must not fail to recognize that 5% of the time your portfolio can do better than our “best case” expectation for a 6 month time period or worse than our “worst case” outcome. This would not be due to the faulty design of your portfolio but due to the
events that transpired that were outside of expectations.
MoneyGuide Pro, the financial planning software we use, is designed to show how likely you are to fund your life goals without running out of money during your lifetime. It displays up to a 99% certainty of plan success, but…always stops short of 100%. Why? Easy, because of Black Swan Events that the program cannot factor into its calculations as they are rare
or have never happened before.
I think it is a waste of time to plan and stress out about Black Swan Events-I am not a bomb shelter guy. However, reasonable precautions and awareness are of value. Diversification, not having all your eggs in one basket, etc. is one of the primary things that help you survive the unexpected and rare challenges that can arise in life.
It helps you be a SWAN (Sleep Well At Night) investor.
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