The Rarity of Black Swans

Last week we talked about September volatility in the markets, and how September is typically the worst month for investment returns. Despite all that, we suggest the right thing to do is to stay invested in the market. Most market corrections are minor, and are recovered relatively quickly. As a follow-up on that topic I thought I would talk about why we often are so eager to sell when bad news arrives.

2008 was a rough year in the markets. Stocks all over the world were badly beaten down, portfolio’s losing 20, 30, 40% or more. Just this week I had dinner with my uncle, and we talked about how 2008 whacked around 35% off the top of his portfolio, and how he has had to adjust his retirement forecast because of this. Those are the kind of stories that make us all think twice about staying invested in the markets when rough seas hit our shores.

However, it’s important to keep in mind the black swan nature of that event. Black Swan events, made famous by author Nassim Taleb, tell of the impact of the highly improbable event. Typically when we discuss black swan events, we think of them in terms missing the extreme event that hurts us. In fact, the 2008 financial crash is a perfect example of this. Very few people saw it coming, and it caught most of the financial world off guard. However, with hindsight it seems obvious. How could we have missed it? The signs were there, but nobody was looking for them.

The flip side of this, is the mentality of turning a black swan, into a white swan. White swans are, of course, much more frequent that black swans. What happens when we turn a black swan into a white swan? We overstate the occurrence of extremely rare events. In our case above, we overstate the recurrence of the 2008 financial collapse. It was a rare historical event and it is still fresh in many of our minds, but it is important to remember how rare it actually is. These type of collapses seem to occur once every 40 years or so, which is typically the amount of time it takes for investors to forget about them.

Yet every week there is an article detailing how we are on the brink of another collapse just like 2008. These articles are intended to do two things, 1) get your attention (checkmark), and 2) maybe get you to click a sponsor link on their website, allowing them to make a living. After-all, the financial punditry has to publish something everyday, why not the most extreme thing possible? It’s much more likely to get people’s attention then another article about how the market will not change much day-to-day, despite the fact that the latter is much more likely to happen (while that may sound self-serving, since it is often what we write about here, it still is true).

Yes, bad things happen in the markets. Just remember that these are rare occurrences for a reason; they don’t happen that often.

 

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