Be Prepared For The Next Black Swan

Be Prepared For The Next Black Swan

By Larry Swedroe

 “Measures of uncertainty that are based on the bell curve simply disregard the possibility, and the impact, of sharp jumps… Using them is like focusing on the grass and missing out on the (gigantic) trees. Although unpredictable large deviations are rare, they cannot be dismissed as outliers because, cumulatively, their impact is so dramatic.”

— Nassim Taleb, The Black Swan: The Impact of the Highly Improbable

Over the course of the first two decades of the 21st century, equity markets faced three “black swan” events: the attacks of September 11, 2001, the Global Financial Crisis that began in late 2007 and the COVID-19 pandemic. Each resulted in steep falls in equity prices. The term “black swan” was a common expression in 16th-century London that described impossibility. It derived from the old-world presumption that all swans must be white—because all historical records of swans reported that they had white feathers.

Thus, a black swan was something that was impossible, or nearly impossible, and could not exist. After the discovery of black swans in Western Australia in 1697 by a Dutch expedition led by explorer Willem de Vlamingh on the Swan River, the term metamorphosed to connote that a perceived impossibility may later be found to exist.

With the publication of Nassim Nicholas Taleb’s 2001 book, Fooled by Randomness, “black swan” became part of the investment vernacular — virtually synonymous with the term “fat tail”. In terms of investing, fat tails are distributions in which very low and high values are more frequent than a normal distribution predicts.

In a normal distribution, the tails to the extreme left and extreme right of the mean become smaller, ultimately reaching zero occurrences. However, the historical evidence on stock returns is that they demonstrate occurrences of low and high values that are far greater than theoretically expected by a normal distribution.

Thus, an understanding of the risk of fat tails is an important part of developing an appropriate asset allocation and investment plan. Unfortunately, many investors fail to account for the risk of fat tails. Let’s look at some evidence on their existence.

Javier Estrada, author of the 2007 study Black Swans and Market Timing: How Not To Generate Alpha, examined the returns of 15 stock markets and more than 160,000 daily returns. He sought to determine the likelihood that investors can successfully predict the best days to be in and out of the market. Following is a summary of its findings:

1. Stock Returns Are Not Normally Distributed

Black swans appear with far greater frequency than predicted by normal distributions. For example, for the Dow Jones Industrial Average, 29,190 trading days (107 years) produced a daily mean return of 0.02 percent and a standard deviation of 1.07 percent. Under the assumption of normality, 39 days would produce returns above 3.22 percent, and 39 would produce returns below -3.17 percent.

However, there were six times the number of returns outside that range—253 daily returns below -3.17 percent and 208 above 3.22 percent. Note that the maximum and minimum daily returns were 15.34 percent and -22.61 percent. The returns exhibited a high degree of negative skewness (the left tail of the distribution curve is larger) and excess kurtosis (fat tails)—clear departures from normality.

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https://www.evidenceinvestor.com/be-prepared-for-the-next-black-swan/