Behavioral Finance

Obsessing Over Black Swans

These days there just isn't a lot of big news.

These days there just isn't a lot of big news. Imus' firing, an inane World Bank scandal, continued Iraq coverage. On occasion the mass media even throws in a dour story on US housing for good measure. Not much new or particularly impactful to markets.

The global economy continues to grow, inflation is low, stocks are up, earnings are good…this is great news for everyone but politicians and the press. The media can never allow us a dull moment because dull moments and good times don't sell newspapers.

In times of slow news and prolonged prosperity, many take to the enterprise of finding the next Black Swan, as discussed in Nassim Nicholas Taleb's new book. That is, the next big, unexpected, disaster that will topple our fragile economic house of cards.

The Black Swan: The Impact of the Highly Improbable
by Nassim Nicholas Taleb

Mr. Taleb's first book, Fooled by Randomness, is an excellent account of the brain's ability to fool itself when navigating markets, and more importantly, the brain's inability to draw proper distinction between pure chance and true causality.

The point of Mr. Taleb's newest offering is to draw distinction between the highly improbable and the impossible. Humans discount the improbable by considering it too remote to happen. But when it does, it's catastrophic and completely unanticipated. The world is too various and interconnected for us to induct future disasters, we can only see the causes afterward. Some examples of black swans include: the depression, the World Wars, the Kennedy assassination, October 1987, the Asian Financial Crisis, September 11th and so on.

This, we are told, is a result of a brain designed long ago to reduce problems to simple solutions for survival in the wild, which is true enough. Famous historian Niall Ferguson has used the Black Swan analysis to shed light on everything from the recent Virginia Tech tragedy to historical implosions in capital markets. We are told we rely too much on probabilities, don't purchase enough insurance on "remote" events, and think about markets in terms of being like a "casino" more than an accounting of economic reality.

We can see the causes of Cho's rampage now, so why not before?
By Niall Ferguson, Sunday Telegraph

Herein lies the error. While it's true that we cannot predict disaster, and that unexpected events are always a looming threat to markets, the fact is no Black Swan event in history has ever sunk stocks permanently (or for that matter even over the course of a relatively long investment horizon). Stocks have recovered every time the impossible has stricken. In fact, globally diversified investors are less likely than ever to feel the big jolts of regional fallouts.

Black Swan market fears are predicated on the false reasoning a single individual is wiser in the long run than the wisdom of markets. Fear is natural, and increasing instruments to hedge against risk are part of developing capital markets. Those that would make globalization and economic development into a risk rather than a boon are ignoring reality. The growing depth of capital markets and ever-intermeshing network of world economies are creating a greater degree of stability than most folks can fathom.

The result of an inane fear of Black Swans is that most end up too conservative in their investment strategy. Far too many investors have far too little exposure to equities, settling for the perceived "safety" of bonds and cash. In reality, these strategies only end up decimating future purchasing power and growth.

In the rare times we do get a dull moment, it's easy to let the Black Swan camp ruin the sunny outlook with more fear. But fairy tales are best left to bedside recitation, not financial advice.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.