The concept of black swan events was popularized by the writer Nassim Nicholas Taleb in his book, "The Black Swan: The Impact Of The Highly Improbable" (Penguin, 2008). The essence of his work is that the world is severely affected by events that are rare and difficult to predict. The implications for markets and investment are compelling and need to be taken seriously.
Black Swans, Markets and Human Behavior
Classic black swan events include the rise of the internet and personal computer, the Sept. 11 attacks and World War I. However, many other events such as floods, droughts, epidemics and so on are either improbable, unpredictable or both. This "non-computability" of rare events is not compatible with scientific methods. The result, says Taleb, is that people develop a psychological bias and "collective blindness" to them. The very fact that such rare but major events are by definition outliers makes them dangerous.
Implications for Markets and Investing
Stock and other investment markets are affected by all manner of events. Downturns or crashes such as the dreadful Black Monday or the stock market crash of 1987 or the internet bubble of 2000 were relatively "model-able," but the Sept. 11 attacks were far less so. And who really expected Enron to implode? As for Bernie Madoff, one could argue either way.
But the point is, we all want to know the future, but we can't. We can model and predict some things (to an extent), but not others - not the black swan events. And this creates psychological and practical problems.
For example, even if we correctly predict some things that impact on the stock and other financial markets, such as election results and the price of oil, some other event like a natural disaster or war can override these other factors and throw our plans totally out of kilter. Furthermore, events of this kind can happen any time and last for any length of time.
To illustrate the unpredictability of these events, we'll look at past wars. On the one hand, there was the incredibly short Six Day War in 1967. But on the other hand, in 1914, people thought "the boys will be home by Christmas." In fact, those that survived were home four years later. As for Vietnam, that did not exactly turn out as planned either.
Complex Models May Be Pointless
Not only does Taleb himself make some suggestions, but the work of Gerd Gigerenzer also provides some useful input. See in particular his book, "Gut Feelings: The Intelligence Of The Unconscious" (Penguin 2008). Gigerenzer argues that 50% or more of decisions are made intuitively, but people often shy away from using them as they are hard to justify. Instead, people make "safer," more conservative decisions. Thus, fund managers may not be contrarian, simply because it is easier at the time to go with the flow.
This happens in medicine, too. Doctors stick to known and familiar treatments, even when a bit of lateral thinking, imagination and prudent risk-taking would be appropriate in a particular case.
Complex models (such as Pareto optimality) are often no better than intuition. Such models only work in certain conditions, so the (complex) human brain is often more effective. Having more information does not always help, and getting it can be expensive and slow. A laboratory situation is very different - here, complexity can be handled and controlled.
Conversely, it is highly unsatisfactory and very risky simply to ignore the potential for black swan events to occur. To take the view that we cannot predict them, so we will plan and model for our financial future without them, is looking for trouble. And yet, this is often precisely what is done by firms, individuals and even governments.
Diversification and Harry Markowitz
Gigerenzer considers the Nobel Prize-winning work of Harry Markowitz on diversification. Gigerenzer argues that one would really need data extending over 500 years for it to work. He comments wryly that one bank, which promoted its strategies on the basis of Markowitz-style diversification, sent out its letters 500 years too early. After getting the Nobel Prize, Markowitz himself actually relied on intuition.
In the 2008 and 2009 crisis years, the standard asset allocation models did not work well at all. One still needs to diversify, but intuitive approaches are arguably just as good as complicated models, which simply cannot integrate black swan events in any meaningful manner.
Taleb warns against letting someone with an "incentive" bonus manage a nuclear power station - or your money. Ensure that financial complexity is balanced with simplicity. A mixed fund is one way of doing this. Certainly, these vary substantially in quality, but if you find a good one, you can really leave the diversification to one supplier.
Avoid hindsight bias. Be realistic about what you really knew back then, and don't bank on it happening again, certainly not exactly the same way. Take uncertainty seriously; it is the way of the world. No computer program can forecast it away. Don't place too much faith in predictions. Markets can be clearly too high or too low; it is not as if we know nothing. But really reliable, accurate forecasts that you can bank on are just a fantasy.
The Bottom Line
Predicting financial markets can be done, but their accuracy is as much a matter of luck and intuition as of skill and sophisticated modeling. Too many black swan events can happen. All manner of factors can nullify even the most complex modeling, because one just cannot include the truly unknown into the model.
This does not mean that modeling and prognoses cannot or should not be done. But we also need to rely on intuition, common sense and simplicity. Furthermore, investment portfolios need to be made as crisis- and black-swan-proof as possible. Our old friends - diversification, ongoing monitoring, rebalancing and so on - are less likely to let us down than models that are fundamentally incapable of taking everything into account. In fact, the most reliable prediction is probably that the future will continue to remain a mystery, at least in part.