Blacks Swans & the Unknown

Black Swan coins

In media coverage of Coronavirus, there is one constant refrain: “Markets hate uncertainty,” to which one’s tempted response is: “Yes, and who doesn’t?” Uncertainty is a fact of life for all of us. The question is what do we do about it?

Uncertainty is often mistaken for risk, but these are actually two different concepts. Risk refers to something that can be measured – like the chance of flipping heads in a coin toss. (The odds are 50/50 regardless of what happened before).

With an investment portfolio, we can manage risk through diversification. Ensuring we invest in a range of asset classes – stocks, bonds, property, cash – can help moderate how we experience the ups and downs of markets.

And we can diversify within each asset class. So we can spread our equities investments across different stocks, sectors and countries. Within equities, we can choose a mix of small stocks, large stocks, low relative price stocks and more profitable stocks, which academic research shows offer different expected returns.

Understanding the risks we are taking, diversifying around those risks and being prepared for a range of outcomes can help us manage the inevitable emotions that arise when markets periodically become more volatile.

 

Unknown unknowns

But uncertainty is something else again. It can’t be measured. It can’t be modelled. Former US Defence Secretary Donald Rumsfeld, in the lead-up to the US invasion of Iraq, famously talked about ‘known knowns’ (things we know we know), ‘known unknowns’ (risks we are aware of) and ‘unknown unknowns’ (things that tend to come out of left field and that we can’t plan for).

A more technical term for these unknown unknowns is ‘Knightian Uncertainty’, named after the late US economist Frank Knight. In a work published in 1921, Knight contrasted risk and uncertainty. The former was governed by a probability distribution, he said, and could be measured and insured against. The latter couldn’t.

The peak of the global financial crisis in October 2008 is now seen as one of those moments of Knightian uncertainty. The complex risk models employed by major financial institutions failed, leaving policymakers unsure of a way forward.

An allied concept is the ‘Black Swan,’ popularised by former options trader Nassim Nicholas Taleb in a 2007 book of the same name. For centuries, the assumption was that all swans were white. But in the late 17th century, a Dutch explorer found black swans in Australia. Taleb used this concept to refer to unpredictable, outlier events that sometimes affect economies and markets.

According to Oxford University economist Professor Ian Goldin, our susceptibility to these left-field events is partly a result of the increasing complexity of a globalised and inter-connected world.

So while growing trade and connectedness lifts millions out of poverty, it also poses the risk of contagion. However, the answer to these issues is not turning inwards or building walls, he argues, but building greater cooperation and coordination, sharing information and exercising continued openness.

As an example, in response to the coronavirus, we have seen coordinated interest rate cuts by central banks and proposals by developed economy leaders to use fiscal policy to cushion the impact on economic activity.

 

From the macro to the individual

So at a macro big-picture level, while we cannot judge the probability of outlier events like global pandemics, financial crises and climatic disasters, we can put in place measures that will build our resilience to them when they occur and perhaps also lessen their severity.

Likewise, at an individual level, we can accept that uncertainty will always be with us. The answer, then, is to control what we can control. In protecting ourselves against Coronavirus, that means frequent handwashing, keeping a distance from anyone who may be affected and building our immune systems.

In wealth management, it is the same story. We can’t control the ups and downs of markets. We can diversify, we can ensure we only take risks we understand and can live with, and we can exercise discipline within a chosen asset allocation that is designed to maximise our chances of reaching a long-term goal.

Unexpected crises and resulting high levels of market volatility can be unsettling, no doubt. But responding emotionally and selling into the volatility can turn a paper loss into a real one. And, remember, being completely out of the market can be risky too if it means not reaching your goals.

As always, the prescription for living in an uncertain world is doing everything we can to give ourselves the best chance of succeeding in today’s one.

 

 

This article is shared by Stephen Lowry (CFP® Professional, DFP, AIF®) who is a representative of Alman Partners Pty Ltd, Australian Financial Services Licence No: 222107.

Note: This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.

 

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