Black Swan Portfolio Construction – is it possible?

Black Swan events are events that come as a surprise … like the surprise of seeing a black swan when most swans are white in color. How do you invest in Black Swan markets?

Such events are “often inappropriately rationalized after the fact with the benefit of hindsight.” (Wikipedia).

Most people then try to rationalize some method to avoid badly misbehaving markets … believing that such avoidance is possible … as if they can just jump out at the proper time and then jump back in again at another proper time; believing they know when to Sell High and then Buy Low. Problem with such a view – emotions cloud when those proper times are actually here at the proper time. Hindsight suggests when you should have done something … but that doesn’t say anything about the moment looking into the future!

Sell High – elated emotion says why sell now when everything is going so well. Buy Low – frightened emotions say no way! There is a cycle of emotions that people feel as the market goes through its’ cycle. What you feel and what you should do are on opposite sides of the cycle.

One thing people should realize … events happen unexpectedly! Some events simply create normal oscillations  of the markets. Bernstein calls these shallow risk events. Other events are deep risk events. People can change a shallow risk to deep risk by acting wrong! How? Through actions, brought on by emotions, of buying high and selling low! The opposite of effective investing.

So … how can a person arrange their investments to handle black swan events? Notice I said handle – I didn’t say avoid. Events can’t be avoided. How you structure things ahead of time to handle events is what you should be thinking about.

Larry Swedroe’s book Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility explains how to construct portfolios that look at the range of returns and the area of that range where black swans occur.

Yes, the book is slightly technical with some statistics like standard deviation. However, it is a good basic discussion on what proper portfolio construction aims to do … reduce your volatility AND the exposure to what are called the left tails (poor returns). You want exposure to the right tails (good returns).

BOTH volatility reduction and left tail reduction are aims most people don’t even think about – all they seek are returns … and typically chase them trying to catch returns. When you construct a portfolio with these forgotten aims in mind, the returns naturally come too.

When you construct such a portfolio, there is little you have to change during market cycles – cycles happen and are expected and are part of the overall construction. This reduces trading costs since you don’t need to be constantly trading reacting to events.

With all else the same, lower volatility leads to greater dollars … and guess what? You spend dollars, not returns!

The reason I discuss this topic using the book as an example is because it describes precisely the thought and science I, and many professional advisers, use in portfolio construction using evidence based concepts developed by academia. These concepts are quite different than simply seeking yield or return.

You can’t avoid world events … you can reduce the impact those unexpected events have on your wealth. That is through planning ahead of time rather than emotional reaction at the time.

Photo source: By Mike Lehmann, Mike Switzerland 11:25, 1 March 2007 (UTC) (Own work) [GFDL, CC-BY-SA-3.0 or CC BY-SA 2.5-2.0-1.0], via Wikimedia Commons