Festival of Black Swans
Last week, Bloomberg LP convened its first Money Managers Conference in Boston to explore the topic: Preparing for the Next Black Swans. The conference brought together 25 professional money managers before an audience of investment professionals and journalists (and a live stream to 300,000 terminals) to consider “strategies should the unthinkable happen.” Last week I wrote about my own panel topic, “The Safest Investment.” What Black Swans did the other panelists envision?
What are these birds?
First of all, what exactly is a black swan? Nassim Taleb, in The Black Swan, published in 2007, defined three key characteristics of black swan events:
- They are exceptionally rare and unpredictable events
- They have extreme impact
- They are explainable only after the fact, if at all
Taleb lists 9/11, World War I, and the rise of the internet and the personal computer as black swans. Consequences can be negative or positive, although the term is almost always assumed to be negative.
Next black swans? (6 bad, 1 good)
Over the course of nine Bloomberg panel discussions covering equities, real estate, gold, energy, Treasuries – in other words, just about everything big and investable – panelists identified seven potential events that could jar the markets.
- World deflation – Japanese deflation spreads worldwide as economies falter; double dip sends interest rates plunging
- Massive gold liquidation – huge sell orders lead to plunging prices for this $2.3T investment winner over the last 10 years
- Systemic risk due to crowding – flash crash redux – program trading quirks, ineffective regulation, and unintended consequences lead to a 1987-style stock price crash
- Failed US Treasury auction – not enough buyers of US debt show up after the end of QE2
- Cascade of residential foreclosures in US – domestic real estate prices go from bad to worse to awful as owners can no longer service the debts, banks need money, and the Fed can’t help
- China’s hard economic landing; 30 years of 9% annual growth collapses under the weight of bad loans, kleptocracy, and no more money to buy Chinese goods
- US equity melt-up (my “white crow” contribution to the list) multiple year double digit equity returns in the US driven by cheap valuations and soaring profits leaves some investors fearfully watching from the sidelines
Of course, since black swans are by definition unpredictable we were all stretching the concept, but in a useful way, I thought. Although some panelists were emphatic in their convictions, no one was making specific predictions. It was an interesting exercise, knowing that anything can happen. After all, August 2nd (our first annual Government Default Day) is only six weeks away!
In my view, the next black swans are unlikely to come from the list above. The next big unpredictable events will be just that.
Prediction is overrated
The value of prediction is overrated, in my opinion, for one simple reason: unintended consequences. Take oil, for example. Anyone who knew for certain that oil would rise a dozen-fold from its low of $8 per barrel in the ‘90s to $96/barrel today would likely have also predicted that the worldwide economy would buckle under the high costs, and that the Middle East would end up with all the money and power. As we now know, we are uncomfortable, but functional with $96 oil. And Middle Eastern countries, hobbled by dictators and revolts, are no more dominant today than 20 years ago. Why? Oil consumers adapted through conservation and efficiency to costly oil and gas.
Likewise, the population explosion we all feared in the early 1970s arrived on schedule. The global population has doubled since then, but the mass starvation and wars over food that many predicted never materialized. The world just got better at growing and distributing food.
For more on the subject of prediction, see the wise and entertaining Future Babble: Why Expert Predictions Fail, and Why We Believe Them Anyway by Dan Gardner.
What black swans teach us
We don’t know what the future will bring, or what will happen when it arrives. So how can we plan for the next black swans? Well, we can’t plan for specific outlier events that can’t be predicted. But what we can do is make sure our portfolios are diverse enough that any single bad event is unlikely to cripple all holdings at once. By diversifying across stocks and bonds, domestic and international, large and small, high and low tech, financial and industrial, we can’t eliminate the danger of black swans, but may soften the blow.
Patience is another tool for black swan readiness. 2008-2009 was awful, but investors who were willing to just grimace and bear it have recovered much of what seemed like was lost forever.
Accepting the limits of our predictive capabilities is humbling, but humility can be a powerful force in investing. The Bloomberg Conference was great in that respect, since it required me, for example, to listen and talk with people as they advocated their ideas, many of them very different from mine. It reinforced how little we know about the future.