In the breakdown of our current financial system, which many deemed impossible or at least highly improbable, I believe we have witnessed the appearance of a black swan. The term black swan comes from the ancient Western conception that 'all swans are white.’ In that context, a black swan was a metaphor for something that could not exist. (Source: www.wikipedia.org.)
In Nassim Taleb's book The Black Swan: The Impact of the Highly Improbable, he discusses how randomness and uncertainty are much more common than investors would like to admit. In our financial markets, what people perceive to be rare and improbable events do occur. Some examples of these are the stock market crash of 1987, the terrorist attacks on September 11, 2001, and the recent meltdown of our financial system. Yet investors tend to fight the acceptance of this reality. As a result, investors tend to make decisions based on certain assumptions. When markets move outside the realm of these assumptions many are confused, scared and panicked. This is because the reality of investing is much more complicated and unpredictable than many are willing to accept. Opportunities and dangers appear when we least expect them.
Therefore we must know and expect that any portfolio, even those considered to be the safest, will at some point experience a series of very bad returns. More importantly, we must accept that this series of bad returns is unavoidable and not a mark of failure. So with that in mind, even if you hold a portfolio of the safest assets in the world (US Treasuries, ITE) you will at some point see a loss on paper of your investment. In the last 82 years, IA US Intermediate Treasury Index has dropped as much as 6.50% in one month.
Most investors construct portfolios with a set of rules that hopefully allow them to achieve their investment goals under normal circumstances. However, investors must understand, study and appreciate abnormal events. Under these abnormal circumstances even passive investors must change their strategy to actively identify, avoid and adjust to game-changing events. A game-changing event is an event that would permanently change the rules that we use to manage our portfolios. The market dropping 20% in one day is not a game-changing event. In contrast, a permanent ban on short selling would be an example of a game-changing event.
One recent game-changing event my firm encountered was the selling of BearLinx Alerian MLP Select Index ETN (BSR). Once we identified that Bear Stearns, which backed this exchange traded note "ETN", was at risk of going under, we sold the ETN. On March 17th Bear Stearns was acquired. Once JP Morgan Chase (NYSE:JPM) announced that it would honor Bear Stearns debts we were able to buy back the ETN and continue with our strategy. We bought it to track the Alerian MLP Index. While we were willing to accept the credit risk inherent in an ETN, we were not investing in BSR to take on the credit risk of a company that might go bankrupt. As soon as we identified that this game-changing risk was present, it was time to exit the investment. While we were able to identify and manage this event, this will not always be the case.
It is true that over long periods of time investors have fairly accurately managed risk and return through asset allocation. I personally believe that we can effectively manage many investment risks most of the time, but not all of the time. Unfortunately and unavoidably, the asset class assumptions that we find relevant to average market situations are less relevant to irregular situations. Does this mean investors should drastically change their long-term strategy when the irregular situations occur? I believe the answer is only if the situation is deemed to be game-changing.
Disclosure: The Belray Asset Management has positions in the following: BSR.