Understanding Black Swan Investing
The term “black swan” is philosophical in nature. Eighteenth-century Scottish philosopher David Hume once stated, “No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion.”
The official black swan definition is: An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult to predict. In laymen’s terms, black swans are events that are typically random and unexpected.
The term – in regards to investing – was popularized by Nassim Nicholas Taleb, a finance professor and former Wall Street trader.
A Classic Example
The classic financial market example, which happened around the time Taleb coined the phrase, was the demise of the previously successful hedge fund Long Term Capital Management (LTCM). Its downfall should have been a precursor to the derivative problems we faced a few years back – but that’s another article. LTCM lost out when, in 1998, the Russian government decided to default on its debt. The Russian government’s default represents a black swan event because none of LTCM’s computer models could have predicted this event and its subsequent effects.
What is Black Swan Investing, Exactly?
The Warren Buffetts of the world have lived by the adage of “buy and hold,” and time will create profits. However, the past decade has been hard for the strategy. Many have bought stocks and made nothing. Or worse yet, some have bought in the wrong sector and lost a lot of money.
From 9/11 to the housing crisis to the European sovereign debt issue, we have seen the market take incredible negative hits. And now we have the surreal stories of the enlightened investors who made a boatload of money betting on catastrophe. And what’s better than being that guy who bet against all the little sheep that just got slaughtered in the market?
So black swan investing is a trading philosophy predicated entirely on the existence of black swans – the possibility of some random, unexpected event sweeping the markets.
You never sell options; instead, you’re proactive buying them. You don’t bet on the market moving in one direction or another – you buy options on both sides, on the possibility of the market moving both up and down. And since you’re counting on catastrophe, you buy out-of-the-money options.
The whole basis is that empirical evidence will never account for black swans in any of their models. If this is the case, then we can’t predict the market – so why try? There’s no need to take positions in investment vehicles because of this lack of unattainable knowledge. What we do know that somewhere, somehow and at some time there will be something to shake markets to their core – especially in the day and age of “too-big to fail” where markets and companies are so intertwined.
The Pros and Cons
I know what you’re thinking. What if there’s no catastrophe anytime soon? You die a very slow monotonous market death. On top of the ongoing losses, black swan hedge funds typically charge a 1.5% management fee and take 20% of any profit.
But on the flip side, Mark Spitznagel’s – a disciple of Taleb – Universa fund returned about 115% to investors in 2008. Three quarters into 2011, the fund collected gains of 20% to 25% for its 11 sovereign-wealth-fund and institutional clients, whose investments are run in separate partnerships and managed accounts.
The one thing you have to remember about this strategy is that it’s counterintuitive to most other approaches and, most importantly, human nature. Taking all those little daily dings in the market while waiting for something to go bad could be overwhelming and demoralizing. But I do think this is as contrarian as one can be.