Of Black Swans and Big Juicy Turkeys

A few years ago, Nassim Taleb published a couple of books (Fooled by Randomness and The Black Swan) that analyzed, among other things, how highly improbable events can have a powerful effect on the economy and on one's portfolio. For those that haven't read the books, the black swan reference comes from an analogy devised by British philosopher David Hume, who said that just because an event hasn't happened yet doesn't mean it can't happen. Back then, no Englishman had ever seen a black swan. Later, when Europeans happened upon Australia, they discovered that black swans did indeed exist. These are excellent books, and Nassim Taleb, though a bit of a pretentious boob, is one of the sharpest minds who comments on markets.

Akin to Gladwell's "Tipping Point" in its pop-philosophical repercussions, the "Black Swan" analogy has bumrushed its way into the lexicon. And the horrific market turns of the last couple of years have certainly helped it along its path. For those masochistic enough to frequent television market commentary, it has become common for talking heads to posit that we've experienced a black swan event, that an unpredictable state of affairs has befallen us, and it's just hard to know what to do. I think this commentary completely misses the point in Hume's analogy, but I'll get to that later.

This commentary is delicious in its irony, because they, the very folks whom Mr. Taleb lampooned in his book, are using it to justify their own incompetence. They think that the "Black Swan" excuses them for the role they played in the collapse. Whether it's the regulators who failed to anticipate the impact of excessive leverage or a housing downturn, or an investment manager who couldn't have fathomed a 38% year-over-year market decline, the Black Swan has become the blankie your mommy drapes over you before you go to bed. Everything's going to be fine. It's not your fault, Junior, it's the Black Swan. No one could have seen it coming.

This line of thinking is insanity on a stick. First, the existence of Black Swans does not justify the failure to prepare for them. Knowing that highly improbable events occur is the reason you take precautions to protect yourself, your constituents, or your clients. You never know for certain what you're going to wake up to tomorrow. It's the reason we have (or should have) regulators, emergency preparation, and competent money advisors. Everyone makes mistakes, but leaders limit the impact of those mistakes. If you lost more than 20% of your clients' money last year, I'm sorry, but you shouldn't be advising people on how to manage money. Period.

Second, this wasn't a frickin' Black Swan event. It was a big juicy turkey sitting there for anyone with an inclination for analysis to see. When you have a 100% run-up in housing prices in ten years, a 40% draw down is not a black swan event. When you have a 1500% explosion in stock prices in 26 years, a 38% haircut is not improbable at all. When total credit market debt extends beyond 3.5 times GDP, one should expect credit seizure and convulsions. Massive credit expansion has historically always been followed by a massive credit contraction. This was as true in Rome, Mesopatamia, and Post-Renaissance Holland as it is today. The Panic of 2008 was highly probable and, dare I say, predictable.

Since we know what a black swan isn't, let's discuss what it is. A black swan, in the Humian sense, is not only something that's never been seen in your lifetime, it's something that's never been seen in anyone's lifetime. It's not a hundred-year flood or a biblical flood. It's not even Jesus walking on water. It's something that no one has ever claimed to have seen.

A black swan event is not the stock market falling by 38% in a year. A black swan event is the Dow Jones Industrial Average going to 0. Zilch. On Monday. And everyone's wiped out. You were managing $10 billion? Guess what, now you're managing no money at all, because you had all of your assets in US equities, and those don't exist anymore! A black swan doesn't appear when your 401(K) fails to perform as you had hoped. A black swan appeared in Argentina this year when the government decided to take over private pensions and give the pension-holders soon-to-be-worthless government bonds in return.

Now, lest I confuse my point, I'm not saying that good money managers and regulators should have to protect 100% of their client/constituent interests when the Black Swans come. But having a contingency plan for the highly unlikely is what separates the ho-hum from the exceedingly competent. Drastic events are not so impossible as the fatuous like to think. Americans have had a great run of it in the last 63 years, but we are not immune from history. While severe dollar devaluation, government confiscation of property, and wholescale reallocation of wealth are not likely in the immediate future, they are not impossible. For those who think that all the Black Swans already happened in 2008, be careful, because you might end up feeling like a turkey again in the not-so-distant future.