Predicting The Next Black Swan (Again)

That title is still a joke as by definition a black swan is not reasonably predictable. The Wall Street Journal had sort of a long article on the subject called How To Profit From The Next Black Swan. For most individuals and professionals this has bad idea written all over it.

What the conversation is really about is profiting from the next big market decline. There are a couple of big points here. The first, and bigger, point is that the market does not have huge declines very often and the second is we've just had two in the last ten years. This is not to say the market can't go down a lot very soon but based on probabilities and the freshness of a lousy decade the chances are less.

Much of the concept is attributed to Nassim Taleb, rightfully so IMO, who has talked many times about 85-90% in t-bills and being very aggressive with the rest. This thought has evolved into 85-90% in t-bills with the rest betting on very extreme outcomes via the options market. Anyone interested in Taleb no doubt is aware of his affiliation with Universa which is a fund that that does just that; bets on extreme outcomes mostly with options.

The WSJ article notes several other funds and products that have popped up that do some similar things or seek similar outcomes. The article does cover the extent to which this can be problematic. If you accept that panicked extremes don't show up in asset prices every month or every quarter but there is an ongoing purchase program of out of the money puts, then what results is a (hopefully only) slow drawdown of the asset base. Out of the money puts cost money, even if not a lot, and when the expire worthless there is of course a small loss. After a few months or quarters of no calamities and little losses from puts that go out worthless when a calamity does eventually hit the homerun that might ensue might not cover the losses.

The article quotes William Bernstein as saying "whenever an investment company tells you that they've come up with a product that can protect you from black swans, you should hold onto your wallet." Wall street has long created products based on investor demand which is often triggered very late in the cycle. The supply of product created is often inefficient and leads to investors feeling regret; the best example I can think of is the massive issuance of internet stocks and the frenzy and subsequent bust that ensued.

One hedge fund manager pursuing this strategy is quoted in the article as saying "for what we expect to lose on the premium we're spending, we expect to get a big payoff in a tail-risk event." Assuming he truly understands what a black swan is, he believes he knows how to make you money off of that which cannot be reasonably predicted. Between both of Taleb's books (I only know of two) I'm sure there are a couple of fallacies and biases that address this quote.

For most people, myself included, the best path is not to try to profit from a panic but to avoid getting hurt in one. This brings up an important point. Real market panics are very short lived and often (mostly) retrace very quickly as well.

If you went on a two week vacation where you were not able to connect and found out that while you were gone there was some panic that sent the market down 17% in three days but then rallied 19% over the next four days leaving the market down 1% (that is the math involved) from where it started and your portfolio through all of that netted out to be down 1.1% what would you do? If you had been home or otherwise connected throughout what would you have done?

Real problems for the market do not come from fast panics like 1997 or 1998 or even 1987 but from slow rollovers that don't scare anyone, more correctly don't scare enough people. Relative to the 50% decline from early in the last decade investors had months to get out with very small losses. This was also the case from the peak in October 2007 and these are the market events to be very concerned about, more so than a devaluation of a small emerging market currency. If the current goings on in Vietnam cause a panicked reaction it is a good bet that it would retrace very quickly.

Some investors obviously can game very fast panics but most of us would end up spending far too much for something that might never come. I'll close with one question do you think the people opening up hedge funds for this are trying to capitalize on peoples' fear?