Kittens, Lions and Black Swans

There is no getting by our emotions at any time, especially when it comes to investing. The same brain chemicals and responses to kittens (friendly), or lions (fear) right in front of us, also happen when we look at our investments; good markets (friendly) and bad markets (fear).

Add to fears of misbehaving markets, are recessions, inflation (or stagflation), global conflicts real or feared, as well as possible personal employment or earning problems. All of these have occurred before. What’s new is that we came to believe otherwise when they didn’t happen in our own recent memory. That is not the lesson history teaches us.

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? More on this question below.

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 now 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! I’ll just lose more money.” There is a cycle of emotions (what does that mean?) 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 … you should do the opposite of what emotions tell you!

One thing people should realize … events happen unexpectedly (expected events are already priced by the markets because everyone’s already expecting something)! 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 into 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 – we all live on the same marble called planet Earth. How you structure things ahead of time to handle events is what you should be thinking about. This is called a structured investment policy and plan.

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). The “Rewarding Distributions” graph below represents left and right tail returns by year they happened.

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 that only come in the right tail; thinking they can somehow avoid the left tail. When you construct a portfolio with these forgotten aims discussed in Swedroe’s book in mind, the returns naturally come too.

Remember a basic tenet of investing: you captured the returns of past markets you were in then, and capture future returns by staying in them. You miss out of future returns when you’re not invested. Why? Because you don’t own shares when you’re not invested in the first place.

In the graph below, “The Rewarding Distribution of US Stock Market Returns,” you can see the left tail (red) and right tail (green) returns each year. Notice the number of positive years that exceed inflation over the long run (long term equals the rest of your life). Also notice there are more positive years (green) than negative (red). You invest for the rest of your life and thus short term deviations should not influence decisions based on emotions of the moment while losing sight of what long term history shows us. A lot of different events occurred over all those years, both good and bad. That fact will continue with both good and bad events still happening over the rest of your life.

When you construct such a portfolio, based on evidence-based principles, there is little you need 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 by constantly reacting to events outside your control.

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 and chasing yield or return.

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

Think back to the world events since 2002 as you view the graph below “Can You Pick the Next Winner?” Each color representing an asset class continually change positions and it’s impossible to know how they’ll stack up at the end of this year!

Rewarding Distribution of US Stock Market Returns (SlideShare link – click to enlarge).

Can You Pick the Next Winner (that will end THIS YEAR at the top and repeat it again NEXT year, and the NEXT, and the NEXT for the rest of your life?)? (SlideShare link – click to enlarge)

Moral of the story: Just like you can’t control the value of your house, you can’t control the markets or the economy either. You should realize that value goes up and down for each unit of what you own. You own your house. You own shares in companies (stocks and bonds). What should you focus on? Retaining the number of shares you own (don’t sell emotionally). When the bottom comes and markets begin their historical climb again (evidence are all those green years in the “Rewarding Distributions” graph above), those shares you still own will again go up in value. In the meantime buy more shares with dividends, interest, etc., from the shares you do own. Even contribute more money if you can to buy shares when they’re “on sale” with lower prices per share. Why? Because you’ll buy more shares with the same amount of money. You don’t accumulate wealth if you don’t own anything.

Yes, value goes up and down in the short term. But investing is for the long term and long term means the rest of your life. How many times have you experienced poor returns and a bad economy up to now in your life? You should expect as many market and economic turmoil events in the future (rest of your life) as you experienced in your past (most people forget about past experience over time). What do you think the markets and economy will do (when you remove the emotions of this very moment and think about it rationally based on historical evidence); and more importantly, do over the rest of your life, because the rest of your life is what matters now?

Photo by Travel Photographer on StockSnap

Lion Photo by Tom Skarbek-Wazynski on StockSnap

Black Swan Photo source: By Mike Lehmann, Mike Switzerland 11:25, 1 March 2007 (UTC) (Own work) via Wikimedia Commons