Turning the Black Swans White

Who believed that Ponzi 1 will turn out to be a swindler? Before 9/11 nobody would have believed that the twin towers will turn to ground zero in seconds due to a terrorist attack. Who could have thought that after the Great Depression there is going to be a credit and liquidity crisis in the year 2008? Invention of computers, black Monday, spread of internet, Lehman Brothers bankruptcy; collapse of Enron; earthquake in Chile; another earth quake in China; fads, hurricanes, and now charge on Goldman Sachs for defrauding investors; all seem to be sudden and improbable events to us due to our little understanding of the world. Future events are uncertain and highly unpredictable but they have their roots in past which was not known to us. We believe a lot but can prove very little. A small confrontation with reality can turn our world upside down, proving millennia of beliefs and conformities to be fakes. As Nobel Prize winning behavioral economist Daniel Kahneman said, The impossible sometimes happen; the inevitable sometimes does not. The happening of these impossible and unpredictable events needs the respect and attention of the investors in the deleveraged world. These events are termed as Black Swans by Nassim Nicholas Taleb in his book on highly improbable events. The events may include a catastrophic climate change, sudden market crashes, natural hazards, terrorist attack, regime change in technology and wars. A Black Swan is, one, outlier and highly improbable. Two, it has extreme impact and three, despite its outlying status we try to prove its predictable nature by giving some reason which actually does nothing more than just adding few more beliefs to safeguards the existence of the same millennia of beliefs mentioned above, the existence of which was in jeopardy due the occurrence of the events named after discovery of an ugly bird. Risk in the markets has increased radically over past few years for the reason that there is increase in frequency of such events. And because of internet and globalization, the world markets have become a complex system and in this web of relationships these eventualities are difficult to explain. We may calculate the probability of getting a particular return on our investment but there is a difference between the terms probability and possibility. The probability of using an aircraft as weapon to attack tall buildings in US or finding a black colored swan may statistically seemed to be very less, but events proved it not to be impossible. A couple of Black Swans are capable to explain almost the entire world, the
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Ponzi started earning through arbitrage in the international reply coupons. But later it was realized that his company was running in great losses and new money from investors was actually the means for giving returns to the existing investors. Soon there was a run on his company and he fell into a golden trap which tightened as investigations increased on the way he was earning money. Later he was charged with mail fraud and was imprisoned.

dawn and dusk of religions, the making of universe and even ups and downs in the markets. Many a times, black swans inadvertently become reasons for long term returns in financial assets. Removing these outliers from that time period might not be able to give the same return. But one thing is predictable that the investors who ignore the possibilities of Black Swan events will go under. The low predictability and large impact makes the Black Swan an interesting puzzle but unfortunately neither there is any tool to predict the occurrence of a black swan (except astrology, if someone believes in it) nor is to eliminate the risk of its occurrence in a portfolio. If we think we can minimize the risk by predicting the Black Swans, we are penny wise and pound foolish. Plus if we statistically analyze the historic data, try to find patterns and use hindsight as foresight, we make a bit more sense but still end up joining the same group. Since 1980s, there has not been any sudden decline in the stock market more than 10%. So as per data, there was no question of sudden and heavy movement in the market. But it did and market fell by 23% on 19th October resulting in Black Monday. Encashing the Black Swans in commodity market: The only way to encash such events is to evaluate them. We need to analyze the event based on the duration for which the impact will linger in the market and the amount of impact it can have on the market. Knowing this will help us to make out the time when the market will retrospect. Since the rise or fall in the market is sudden and because of an uncommon event, it is always likely to take correction and would move towards the opposite direction reaching the same level where it has been before. But the impact of any event will partially be for long term but foremost for short term. We can capture the short term impact of the event and take positions in the market and make money. For example: on the Black Monday, i.e. 19 th October, 1987, when the equity market in US fell by 23%, gold which closed at $465.25 last week rose to $481 on Monday. And as it was an abnormal rise, on Tuesday gold fell to $ 464.3. Similarly, there was a rise in the Gold prices on the WTC attack day and prices made a high of $292.5 closing at $286.25. Taking short position at this level would have gotten handsome returns to the investor since the very next day the market fell and closed at $278.25. The DOW index opened low after 5 days close on 17 th and closed even lower. It continued to fall till 21st of September and at the same time gold made a peak again and closed at $291.45 on 21st. So buying at the low level of $278.25 would be another strategy because it was an abnormal fall due to market behavior. Likewise, a number of strategies can be made to encash these moments and gold is not the only commodity which can give us opportunities to earn. Like after the WTC incident, oil prices also spiked upwards and gas prices in US also briefly shot up. After US was hit by Hurricane Katrina, prices of oil reached record high due to reduction in oil production. Affect of natural calamities can linger for a bit longer period on prices however the affect will descend and it has to be soon or else the economy will be affected which the government of any country wont entertain.

Conclusion: Besides this, we speak of probability and not of uncertainty. Uncertainty is immeasurable and is not subjected to probability. We can never see all the harbingers and make prophecies. If this was really possible, entire future events would be discounted on the prices today itself and there would be no scope for any abnormal return. Because future is uncertain; market should fluctuate. So it does and there is nothing new in it. But it entirely depends on us how do we take it. For an instance, the Great Depression, counter-intuitively, could be interpreted as an indication to life time high markets in future. Market is a game of business cycle where troughs are important to have peaks. Only thing we need to do is to learn from the randomness in the market and think differently about the risk. There may be another Black Swan in barely discernible state, waiting to become a part of finance history, but it cannot approach anyone without making the sound of flapping of its wings.