The Telegraph’s Jeremy Warner wonders if the political crisis that recently overturned the government in the Ukraine could be “the next Black Swan for West’s financial markets?” It’s a reasonable question, although a true Black Swan event, by definition, is unpredictable. Thinking about uncertainty deserves attention in designing and managing investment portfolios, but there’s only so much blood to be extracted from this stone. What we can’t fathom can still hurt us, but substantially reducing the potential fallout from the unknown unknowns is difficult if not impossible as a practical matter. Market risk, by contrast (price volatility, for instance) can be slightly less threatening to our wealth, assuming that we manage it prudently.
As for the dark birds that upend the best laid plans of mice and money managers, there’s always another one lurking in our collective future, although we shouldn’t be so glib as to think that the next Black Swan is destined to arise only from chaos and negative trends. Sometimes the source of trouble is a byproduct of events that seem only to radiate good fortune and bull markets. Who in 2005 and 2006 knew that the boom in housing, along with the generally roaring bull market in macro and markets, was the raw material that soon after gave us a near-implosion of the global financial system and the worst recession since the 1930s? The answer: very few. Of those who genuinely had the prescience to see the future (a dubious assumption, but let’s run with it anyway), the lucky few who managed to squeeze out a statistically significant profit from the forecast are members of an even smaller minority.
Meanwhile, Warner reminds us that Black Swans can also “spring from the seemingly insignificant.” Looking for needles in haystacks, however, isn’t likely to yield much in the way of valuable information. There are lots of advances in the delicate art of tail risk, but much of this has come about since the 2008 crisis and so real-world tests are MIA.
The message, of course, is that the next Black Swan that will hit us over our collective heads and rob us of optimism and assets is and will remain a mystery… until it strikes. The appropriate hedge, in turn, is equally mysterious in real time. That doesn’t mean we should ignore the potential fallout from the Ukraine, or the possibility that a new conflagration in the Middle East could shut down the Strait of Hormuz and send oil prices to $200 a barrel overnight. Those and all the other demons we can conjure are worthy of attention in thinking about how to structure a portfolio and manage volatility. But let’s be honest and admit that when it comes to Black Swans we’re clueless, and will remain so evermore.
Okay, but how should we prepare for risk factors that are more conspicuous? The answer is worthy of a book (or five), but the short answer is that we should redouble our efforts at excelling with techniques that are within our capacity to control to some degree. The foundation here is the standard advice on these pages: diversify across asset classes and think long and hard about how and when to rebalance the portfolio. Yes, there are many additional risk-management overlays one could add, and perhaps doing so is prudent. But most investors do a poor job at asset allocation and rebalancing, which suggests that there’s plenty of room for improvement with the basics before moving into more sophisticated fare.
But let’s be clear: a small degree of improvement in your existing rebalancing strategy can deliver substantial benefits, and perhaps offer a bit more insulation from Black Swans along the way. In particular, spending more time on modeling expected return by way of analyzing risk can do wonders compared with what generally passes as the standard approach to investing by the masses. Cliff Asness of AQR Capital Management recently penned some great advice on this topic and so I’ll close by giving him the last word. Meantime, if you’re interested in a deeper dive on his observation that follows, see Antti Ilmanen’s extraordinarily practical guide on looking ahead: Expected Returns: An Investor’s Guide to Harvesting Market Rewards–a book, by the way, that also includes an inspired foreword by none other than Cliff Asness. Meantime, here’s the aforementioned quote from AQR’s chief:
One of the few things we do know is that over three to five years, pretty much everything has shown some systematic, if certainly not dramatic, tendency to mean revert (especially when one accounts for and avoids the powerful effect of momentum at shorter horizons). This means that when we rely on three- to five-year periods to make decisions—favoring things that have done well over this time period and shunning things that have done poorly (note the past tense)—we aren’t just using data meaninglessly; rather, we are using data backwards. Essentially, with a disciplined approach, value and momentum are both good long-term strategies, but you don’t want to be a momentum investor at a value time horizon.