Did We Just Get Hit by a Black Swan?

Mark Hulbert looks at the recent stock market declines to understand the role of risk and the investment lesson to be learned.
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Was the stock market’s Covid-19 triggered plunge over the past few sessions a Black Swan event?

This is more than just a matter of idle semantics. The question goes to the heart of understanding the role of risk in the stock market.

Unfortunately, references to a Black Swan have become so ubiquitous that the phrase is in danger of losing its meaning.

Many commentators are throwing the concept around with abandon to refer to anything that is unexpected. Some disingenuous advisers go further and use the concept as an excuse for why they (and their clients) lost money.

In the process, we miss out on the insights that come from appreciating what a Black Swan really is.

Though the concept of a Black Swan has a long history in philosophy and mathematics, its use in investment circles traces to the work of Nassim Nicholas Taleb, a professor of risk engineering at New York University. He wrote a book in 2007 titled Black Swan: The Impact of the Highly Improbable, in which he defines a Black Swan as a highly improbable event that has major consequences.

The Covid-19 stock market correction would certainly seem to qualify.

But what Taleb argued, and yet which many of his readers missed, is that probability is partly a subjective matter. And that in turn means that labeling something a Black Swan event is partially in the eye of the beholder: What is a Black Swan event for the turkey, to use one of Taleb’s examples, is not for the butcher.

The goal, Taleb therefore argued, is figuring out how not to be the turkey. Far from seeing the Black Swan as a valid excuse for why an adviser has lost money, Taleb believes that it’s incumbent on us to construct our investment strategies so that they are resilient in the face of Black Swans.

By doing that, of course, they stop being Black Swans, and instead become Grey or even White Swans.

Though by definition we can’t predict which particular Black Swan events will materialize, we know with confidence that one or another Black Swan will at some point. Consider the Covid-19 virus: If you think of the virus as appearing out of nowhere in December 2019 at a market in Wuhan, China, then it will appear to be almost unbelievably improbable.

But you can view the virus differently: What is the likelihood that, in our globally interconnected world, a new virus will at some point crop up somewhere in the world that sickens millions and kills thousands? Asked that way, of course, and Covid-19 seems almost routine. In fact, what we’re experiencing currently was eerily foreshadowed nearly 30 years ago in the book The Coming Plague: Newly Emerging Diseases in a World Out of Balance, by Laurie Garrett.

So is Covid-19 a Black Swan event, or is it not?

While you’re pondering that, consider big daily drops in the stock market, such as those over recent trading sessions. If you ask how likely it is that the Dow Industrials would drop a particular number of points on a particular day -- such as the 1,031.61 drop on Monday, Feb. 24, or 3.56% -- then it would seem to be incredibly improbable.

But your answer shifts completely if you instead ask the question: How likely is it that the market will at some point in the next couple of years suffer a daily decline of at least 3.56%? The answer, as I discussed one week ago, is highly predictable: An average of once every 7.3 months over long periods of time.

In fact, as I pointed out, researchers have devised a precise formula that can be used to predict the long-run frequency of daily drops of any magnitude.

So even though the formula can’t predict the day on which a drop of given magnitude will take place, it can tell us how often such drops will occur over long periods of time.

We return to the same fundamental question: Is a big daily drop in the market a Black Swan event, or not?

Expect the Unexpected

Rather than try to answer these questions in any definitive way, I think the investment lesson to draw is that we should expect the unexpected, and plan accordingly.

Unfortunately, this goes against what almost all financial planners tell their clients. They reassure us that, provided we only hold on long enough, then the stock market’s returns are fairly predictable -- around 10% annualized.

This is false comfort, according to research by Lubos Pastor of the University of Chicago and Robert Stambaugh of the Wharton School at the University of Pennsylvania. They found that, as our investment horizon extends further into the future, the range of possible outcomes widens instead of narrows.

A good analogy is to the possible impact of global warming. Over the short term, the range of possible consequences is minimal. Even the most dire of climate models predicts tiny increases in global average temperature over the next 12 months. But over the next century, in contrast, the range of possible impacts of global warming extends from none (in the event it doesn’t exist, as some allege) to catastrophic.

Some of my clients are upset upon being confronted with this widening range of possible outcomes as they gaze further and further into the future. But it’s only upsetting because they have been lulled into falsely believing that the future is predictable.

It is not. To state the obvious: It is not preordained that the stock market will go up every year, or that it should produce long-term annualized returns of 10%.

We should take this uncertainty to heart and focus on constructing investment portfolios that are resilient in the face of that uncertainty. What might that look like in practice? Taleb in his book suggests what he calls a barbell strategy:

“If you accept that most ‘risk measures’ are flawed, because of the Black Swan, then your strategy is to be as hyperconservative and hyperaggressive as you can be instead of being mildly aggressive or conservative. Instead of putting your money in “medium risk” investments… , you need to put a portion, say 85 to 90%, in extremely safe instruments, like Treasury bills… The remaining 10 to 15% you put in extremely speculative bets, as leveraged as possible (like options).”

Hulbert Chart 030320

One exchange-traded fund that is pursuing this barbell strategy is the Amplify BlackSwan Growth & Treasury Core ETF  (SWAN) - Get Report. It is constructed to be 90% invested in a Treasury ladder and 10% in long-dated call options (LEAPs) on the SPDR S&P 500 ETF. And though it began trading in November 2018, and is therefore less than two years old, initial results are promising, as you can see from the accompanying chart.

Notice, for example, that the ETF lost a lot less than the S&P 500 during both the recent Covid-19-induced pullback and the market’s late-2018 correction, and yet largely held its own during the market’s strong 2019 rally.