I have a fear.
It is more frightening than not having enough money.
Yet it is unknown and undeterminable. I do not know if it is lurking and waiting somewhere in the future and eventually haunt me one day.
I have a fear – the possibiliy of having a black swan that kills me in the end.
More about the black swan later.
Why is this fear frightening? Simply because it gives you the false illusion that you are right for a very long time, say 20 years, and then one day, something opposite happens and take away whatever you have. And you did not know the existence of this thing.
Lehman Brothers existed for 158 years, crashed and burnt in one mortgage crisis.
Long Term Capital Management armed with 2 Nobel prize winners collapsed in 4 years.
Victor Niederhoffer, a successful trader for 17 years, averaging 35% annual returns in 1996, went bankrupt in 1997.
The illusion of winning is scary. A string of successful winnings feedback to you that you are “right”, and naturally, you do what you always do to continually reap the benefits. I do not want to be the turkey. I do not want to be misled that my farmer will feed me forever, only to find out that I am killed before christmas. I fear having a successful investment journey for 20 years and getting my capital wiped out in one single event. It is not that I am negative or fearful of the future. The point is that I know about the existence of this problem and I am trying to protect myself against it, so that I do not suffer like the turkey. In other words, I am trying to find the vulnerabilities of my investment strategy.
Black swan is what Nassim Taleb termed as an improbable event that happens, and has huge impacts. The term was adapted from the way our society deduces. After seeing millions of white swans, human concluded that all swans are white. It just took one black swan that was found in Australia to debunk the entire human belief. The scary part is not only about swans, but we use the same method to run our government, banks and other functional parts of the society. The idea of established companies are “too big to fail” is a myth. Lehman Brothers is one good example. It failed, but it took 158 years to get there. With 157 years of sound operations, people and investors feel safe. Even the bankers feel safe, that was why they packaged Lehman bonds into structured products (remember the mini-bonds?) and sell them to you. The collapse of Lehman Brothers is improbable but it happened, and it has worldwide impacts, even in our little red dot Singapore. This is the characteristic of black swans. They hide in large cloaks in dark corners such that they look so improbable to attack. Because you are not prepared against them, the black swans strike with ease and have high success rate.
I need to find the black swan in my investment strategy, if not I will be killed one day. Likewise for you. One thing to note is that a black swan for me may not be a black swan for you. The black swan is valid for the turkey but not for the farmer. The turkey did not know he is going to die but the farmer knows. The recent sub-prime crisis is a black swan for most people, but there are people who benefited from it.
The bell curve and statistics that we learned in school are vulnerable to black swans and these are what our economists and bankers use as a concept for their analysis. What kills them (and us) is that the tails of the bell curve are fatter than they suggest. They happen more often than statistics show. In our modern society, economists assure us the economy is under control as they know what is going on and will introduce sound policies to steer away from crisis. The truth is that market crashes more frequently than everyone would like to. Bell curve works in non-complex conditions, like our classroom. In the real world, complexities are beyond human’s understanding. It has butterfly effects – a butterfly that flaps it’s wings in Brazil can create a tornado in Texas. This means that a simple condition that changed will have amplified ripple effects downstream. The bell curves that we use do not take these changes into considerations, and hence, making ourselves vulnerable to black swans with falsified predictions.
The conclusion is find out the unknown unknowns, that may destroy you, no matter how improbable. Unknown unknowns = you do not know what you do not know. Turn them into known unknowns = you know that there are unknowns that can happen but you are prepared for them. And no one can help you. The economist can’t. The financial analyst can’t.
Share
{ 1 trackback }
{ 8 comments… read them below or add one }
“I need to find the black swan in my investment strategy, if not I will be killed one day. Likewise for you. ”
I don’t think you can find the black swan at all. It’s always the unexpected that hits you and ’tis the definition of black swans. I suppose what we can all do is to prepare ourselves for the worst. If you always trade with money that you can lose and do it without excessive leverage, wiping your entire capital will not kill you.
I like the part about the turkey. Never thought of that before :) I’ve written extensively about black swans – if you like, you can search about it in my blog. Just type “black swans” :)
Have a great day!
Thanks La papillion. So you are a black swan fan? I am not trying to find the black swan, but like what you said, is to uncover the vulnerabilities and protect myself.
Will definitely take a look at what you have wrote!
Haha, how does one become a black swan fan? I only want the good ones, not the bad ones, of course :P
Invest in preparedness, that’s the bottom line after reading it. I like his books, very insightful. I make it a point to re-read every year. I find his skepticism quite refreshing, haha
We can resolve the black swan problem by using a discipline risk management. For myself I will only risk 2% of my capital for each trade. So if there is a evil black swan eating my trade, its just 2%.
I don’t know about traders. For investors, there are simple strategies one can use to ensure that one does not lose it all.
And personally, my No. 1 question I ask myself before I invest, make sure I don’t lose all, my no. 1 question is: “If I’m wrong, will I be financially ok?”
I managed to avoid most of the stock market crash and managed to increase my wealth further through the financial Crisis from year 2007 to year 2009….
Cheers!
Dennis Ng
Forex Educator – I agree with you. Position sizing and cutting loss are important protective measures against black swans.
Dennis – I agree with your question no.2. As long as we make sure we can afford to lose, we will not be financially jeopardised.
A bit of lesson can be learned from the discovery of Black Swan. It was discovered at the Swan River, Perth, Australia. Geographically , it’s not located near the central rim. Also the area has not much of significance during the discovery. Same as risk I suppose. It has its origins at the periphery but found its life when it shifts to the central rim ie the radar or line of vision. The recent blow out with sovereigns has its origins at the periphery, and Dubai was a spark, and yet the market judiciously ignored it and stock markets went up. Risk then shifted to the central eurozone, and suddenly it was in the line of vision. Suddenly, from isolated obscurity risk under constant microscope, begins to morph. My point I guess, in handling risk , just like fishes, we need to train ourselves to have peripheral vision.
A black swan is something unexpected.
The best way to guard against the Black swan is always be Prepared for the Unexpeccted, to expect the Unexpected, to be prepared to be wrong.