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July 13, 2007

Are Black Swans Relevant to Your Portfolio?

Nissim Nicholas Taleb has written two books about black swans for the lay investor. Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets and more recently The Black Swan: The Impact of the Highly Improbable. They are full of erudition from Karl Popper to frequency distributions. But, is any of that relevant to "YOUR" investment portfolio?

Having read a large number of the over 400 book reviews at amazon.com, I'm amazed to learn that this is not a question people seem to ask. They seem to assume that, yes, black swans are important in their lives and in their portfolios. Mostly the reviews deal with Taleb's writing style, as they should, and with the minutiae of black swans such as the improper use of normal distributions in portfolio strategies.

My own interest in the books was to discover how to harness or how to avoid black swans in my portfolio. I only read the earlier book, Fooled by Randomness, and that one was of no help in my quest. From reading The Black Swan book reviews, I came to the conclusion, possibly in error, that this one didn't reveal the secrets either. I found a New Yorker article by Malcolm Gladwell, Blowing Up, that finally explained what Taleb does. With this came the realization that the black swans he is talking about are mostly irrelevant to my portfolio.

Taleb is a derivatives trader, specifically, he buys out of the money puts, usually a losing proposition, waiting for the black swan that will make him rich. The downside is that he might have to wait in pain for a very long time. The upside is that he won't blow up.

Why does Taleb not trade stocks? Because to trade stocks you have to believe that the future will be better than the present and black swans can wipe out that possibility. Taleb is profoundly pessimistic probably because his family lost their fortune and position in Lebanon during the civil war. To make his position tenable, Taleb has to prove that the great fortunes made in the stock market are not the product of expertise and skill but pure dumb luck. Malcolm Gladwell describes Taleb's thought experiment as follows:

For Taleb, then, the question why someone was a success in the financial marketplace was vexing. Taleb could do the arithmetic in his head. Suppose that there were ten thousand investment managers out there, which is not an outlandish number, and that every year half of them, entirely by chance, made money and half of them, entirely by chance, lost money. And suppose that every year the losers were tossed out, and the game replayed with those who remained. At the end of five years, there would be three hundred and thirteen people who had made money in every one of those years, and after ten years there would be nine people who had made money every single year in a row, all out of pure luck. Niederhoffer, like Buffett and Soros, was a brilliant man. He had a Ph.D. in economics from the University of Chicago. He had pioneered the idea that through close mathematical analysis of patterns in the market an investor could identify profitable anomalies. But who was to say that he wasn't one of those lucky nine? And who was to say that in the eleventh year Niederhoffer would be one of the unlucky ones, who suddenly lost it all, who suddenly, as they say on Wall Street, "blew up"?

But there is a serious flaw in the argument. Taleb wants to convince us that people like Buffett and Lynch were just lucky and that they can blow up at any moment. After all, his hero, Victor Niederhoffer, blew up. So did LTCM. It's just a question of time until Buffett and Munger blow up. The flaw is that Taleb, Niederhoffer, and LTCM are in a different business than Buffett, Munger, and Lynch. The first three place bets at the race track: options, like bets on horses, become worthless once the race is over and you can just drop them on the floor. There is no "real" value in derivatives which is why they are so dangerous. Stocks, on the other hand, represent real world value, a piece of a business.

With that in mind, let's revisit the 9/11 black swan that wiped out Victor Niederhoffer. How badly did 9/11 affect a portfolio of stocks? Hardly at all if you were an individual investor, all you had to do is do nothing for a few days or weeks. The exchanges helped by closing down for a few days not allowing skittish investors to trade.

The October 1987 crash was another black swan. Here is what Peter Lynch had to say about it in the Prologue to One Up on Wall Street:

The Lessons of October
I've always believed that investors should ignore the ups and downs of the market. Fortunately, the vast majority of them paid little heed to the distractions cited above. If this is any example, less than three percent of the million account-holders in Fidelity Magellan switched out of the fund and into money-market funds during the desperations of the week. When you sell in desperation, you always sell cheap.

Even if October 19 made you nervous about the stock market, you didn't have to sell that day -- or even the next. You could gradually have reduced your portfolio of stocks and come out ahead of the panic-sellers, because, starting in December, the market rose steadily. By June of 1988 the market recovered some 400 points of the decline, or more than 23%.

[snip]

Whether it's a 508-point day or a 108-point day, in the end, superior companies will succeed and mediocre companies will fail, and investors in each will be rewarded accordingly.

According to Lynch it's not plain dumb luck, but then, what does he know that Taleb doesn't? :-)

Denny Schlesinger


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