Saturday, December 15, 2007

The Black Swan: Unpredictable Random Events Impact The Markets

Earlier this year, Nassim Taleb released his book The Black Swan. This is a follow up book to his earlier reading, Fooled by Randomness. The Black Swan idea is essentially Taleb's idea that the major moves in the market are caused by "unpredictable" events. Taken a step further, Taleb's thesis somewhat refutes modern portfolio theory in that MPT is grounded in normally distributed statistical research. Taleb's definition of a Black Swan event is:
A black swan is an outlier, an event that lies beyond the realm of normal expectations. Most people expect all swans to be white because that’s what their experience tells them; a black swan is by definition a surprise. Nevertheless, people tend to concoct explanations for them after the fact, which makes them appear more predictable, and less random, than they are. Our minds are designed to retain, for efficient storage, past information that fits into a compressed narrative. This distortion, called the hindsight bias, prevents us from adequately learning from the past.
Taleb believes these unpredictable rare events account for the impactful occurrences in the marketplace and history. One of Taleb's favorite books at the moment is Happy Accidents: Serendipity in Medical Breakthroughs by Morton A. Meyers. This book tells how most of the major medical discoveries have occurred by accident.

Consuelo Mack of WealthTrack contains an interesting video interview with Taleb and Jason Zweig . Zweig describes how the investing portion of ones brain makes individuals do things that do not make logical sense. He covers this topic in detail in his recent book, Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich.

I do not believe an investor should blindly disregard theory based on normal statistical data; however, the successful investor should be aware of the randomness of major events. Additionally, an investor should understand how emotion can override good judgement. From an investment perspective, investors should maintain an investment approach that follows a sound discipline.


Nick Reilly said...

Behavioral Finance has been a recent focal point to those who study decision making while investing. Behavioral Finance studies emphasize the frequency in which people do NOT learn from past experience. This problematic scenario, coupled with unforeseeable random events, only exacerbates the reasoning that investors should not only diversify through single equities and bonds, but by use of multiple asset classes and investment products. It is my belief that more investors will see the value to non-traditional asset class selection in the years to come. Asset management institutions will offer more access to hedge funds, real estate, commodities, private equity, and structured products. It's no secret that this approach can greatly lower the volatility to an overall portfolio.

Anonymous said...

It can can greatly lower volatility ... til it blows up. I think you are missing the point Nick