To Avoid Black Swans, Watch Out For Gray Rhinos

| About: SPDR S&P (SPY)

Summary

If you’re looking ahead of you for gray rhinos instead of behind you for black swans, you can get out of the way.

Rethinking how you define probability can shape your future views on the markets and your investment decisions.

Gray rhino watchers hedge their investments and lay out a plan for what to do when others run for the hills.

Was the Brexit vote a highly improbable black swan or an obvious gray rhino?

The answer to this question depends on just how improbable something needs to be to be considered unlikely, and on your own relationship with predictions. Rethinking how you define probability can shape your future views on the markets and your investment decisions.

Black swans are evident only in hindsight. By contrast, you can see a gray rhino coming ahead of time. You may not know exactly when it will happen, but the "if" is highly likely. You may even account for the possibility that it might change its path in time to avoid a trampling, but unless you have a plan to make that happen, don't bet on it.

The possibility of that Great Britain would vote to leave the European Union was something obvious that many investors did not want to see, as the market rout in its wake made clear.

Months back, when polls were showing the odds of a Brexit vote at 17 percent, brushing off the possibility was perfectly logical. But as polls tightened, with a smattering of polls showing Leave ahead by between 5 and 10 points just two weeks before the referendum, the line between reasonable doubt and willful denial widened.

Writing off either a Brexit or a Bremain as the referendum approached would have been foolhardy.

Yet even after the vote, the number of talking heads saying they did not see it coming was astonishing.

Now that the vote has taken place, nobody in their right mind should ignore the potential damage that the nationalist populism that drove the vote can do. Brexit is not a one-off market event. It is just the beginning.

If a Brexit vote is possible, then so is a President Donald Trump. Nate Silver at Five Thirty Eight has just given Trump a mere 20 percent chance of winning the election in November. Did I mention that Brexit was at 17 percent earlier this year? There are many strong reasons why Trump's numbers are not as likely to swing as dramatically as Brexit's did.

But even if the predictions hold, nobody is out of the woods. A mere election result doesn't resolve the underlying gray rhinos that have fed Brexit and Trump's candidacy. If Great Britain, Europe, and the United States fail to address concerns about slow growth, economic insecurity, and widening inequality, and to contain the growth-quashing xenophobia that has accompanied the new normal in the global economy, then all bets are off.

If enraged voters did not care that a Brexit vote would hurt their own pocket books, they certainly don't mind, and more likely are celebrating, that the 400 richest people in the world just lost $200 billion. Or that those who are least well off will suffer even more.

If you're looking for the wrong thing, you're more likely to miss what is right in front of you. So, to avoid the next black swan, you need to watch for gray rhinos.

Gray rhino opportunities happen when all the warning signals are there, but a significant part of the market continues to deny them. Before the rhino's charge happens is the time to put in place a plan for what to do when full blown panic sets in. Gray rhino watchers hedge their investments and lay out a plan for what to do when others run for the hills.

Ask yourself what your gray rhino is; what you can do about it; and whether you have done everything you can to get out of the way, to find opportunity in adversity, or to change its path. Whose opinions do you respect the most on what's coming down the pike? How confident you in your predictions and those of the market? Have you protected your portfolio? Have you decided what triggers will tell you it's time to get out or get back in?

Or are you so afraid of missing that last bit of upside that you are failing to protect yourself from the downside? Are you scrambling for reasons why "this time is different"? If so, then you, my friend, are in for a trampling.

Just remember that if you're looking ahead of you for gray rhinos instead of behind you for black swans, you can get out of the way. It's your choice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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