Black Swan Crisis #74
Market Meditations | January 14, 2021
In today’s newsletter, we take a look at Black Swan events. Low probability, high impact events that can have a huge implication on traders and investors.
Dear Meditators
In today’s newsletter, we take a look at Black Swan events. Low probability, high impact events that can have a huge implication on traders and investors.
What are they? What do they teach us and how can we utilise this knowledge to be more profitable? Let’s tick those off one by one.
Black Swans: Profitable Trading in a Crisis
In today’s letter, we explore the key takeaways from Nassim Taleb’s The Black Swan.
Taleb spent 21 years as a highly successful trader before becoming a researcher in mathematics, philosophy and practical problems with probability.
His publication The Black Swan has been described by The Sunday Times as one of the 12 most influential books since WWII.
This book forms part of a 5 part collection called Incerto.
Let’s dive into the key concepts and most importantly, how we can apply them as traders and investors.
1) What is a Black Swan?
More often than not, it is the common, everyday things that affect markets—things like a company decreasing guidance or releasing less than positive earnings, new product launches, institutional upgrades or downgrades, etc. Sometimes, however, there are particularly special and rare events, that leave such a profound impact that move markets in a severe and unpredictable way. We categorize these events as “Black Swan” events.
Contrary to popular opinion, a Black Swan event is not always negative. Rather, it can be negative or positive.
A Black Swan event only needs to meet 3 criteria:
1️⃣Outlier
Nothing that has happened in the past could have convincingly pointed to the possibility of the event at the time.
2️⃣An Extreme Impact
It carries an extreme impact. Low predictability, high consequence.
3️⃣Explainable After the Fact
It is only really explainable after the fact. Human nature then convinces us that we should have known the event would happen all along.
To use a cryptocurrency example: think of $XRP.
Earlier this year, Ripple found itself in hot water after the SEC sued both the company and executives over claims that they fraudulently sold $1.3bn of $XRP in an unregistered sale.
The event was an outlier in that Ripple was deemed to be amongst the most regulator friendly crypto firms out there. They prided themselves on this. The price of $XRP took a serious hit and so too did the traders who held it. Therein lies the extreme impact. Retrospectively, many people are no longer treating this as an outlier but rather embedding it in the wider narrative of the increased role of regulation in our space.
For more on the Ripple story, check out our ? YouTube video ?.
The basic idea is that there are great difficulties when trying to forecast the future based on the knowledge of the past.
How can one figure out properties of something that is infinite and known based on something that is finite and known?
2) The Implications of Black Swan Blindness
✅ So the first takeaway for traders and investors should be the existence of Black Swan events. The past is not a reliable indicator of the future and this is an important lesson for all of us.
Next we should explore what Black Swans reveal about our behaviour. Taleb highlights the following implications of Black Swan events:
Human Error Confirmation. In other words, the fact that we are too quick to jump to conclusions.
The Narrative of Fallacy. When analysing situations, our love for stories over statistics cloud the facts and our ability to make rational decisions.
We Are Not Programmed For Black Swans. Humans are prone to believe in linear progression. We think that a certain input will gradually result in a desired output. As $XRP holders found out the hard way, this is not the case when Black Swans exist.
The Distortion of Silent Evidence. We view historical evidence with a filter that selects the rosier parts of the process. Many people in our space for instance talk about the 2 bull runs we have seen these last few years, leaving out all the long, difficult and bearish sides of the story. We exclude evidence that does not suit our mental models.
Tunneling. Our tendency to focus too much on what we know and shy away from what we don’t know. We are willing to bet that if you knew about the $XRP story, you read that paragraph carefully. If not, you probably glossed right over it.
? These are key concepts in behavioural finance that all traders and investors should acknowledge when designing their trading strategies. Beware of these limitations that exist in your psychology.
3) How to Act as an Investor in an Environment of Black Swans
What we have covered so far is that we are in a world dominated by Black Swans.
What’s more, we have a tendency to fool ourselves with tunnelling, the narrative of fallacy and all the other behavioural weaknesses highlighted in section 2 ☝️
What should we do?
In essence, Taleb suggests that we should expose ourselves to the possibility of positive Black Swans and limit our risk by decreasing our exposure to negative ones.
Taleb suggests two approaches to achieve this:
1️⃣The Hyper-Conservative and Hyper-Aggressive Approach
Taleb suggests that you don’t put your money in ‘medium risk’ investments. The possibility of Black Swans means that we can’t be sure they are medium risk at all.
Instead, he claims you should put the majority of your capital in something extremely safe (such as government bonds) and the rest of your capital in something extremely speculative, like angel investments.
With this type of portfolio, you are limited in your risk because of your hyper conservative investments but you are also exposed to the possibility of hitting a positive Black Swan with your hyper-aggressive ones.
In Taleb’s own words, you have a ‘convex combination’.
2️⃣The Speculative Insured Portfolio
The second option is to have a very speculative portfolio but to insure it against losses that are greater than, for example, 10%.
This doesn’t just refer to traditional insurance. You can create this effect yourself by putting up stop losses at minus 10% and taking multiple bets with small parts of your equity.
Again, you have a convex strategy where your risk is limited but your upside is exposed to positive Black Swans.
Conclusion
Black Swan events exist. They have occurred in the past and they will occur again. That’s the first point. Also important is all the different behavioural weaknesses that are the implications of Black Swan events. Such weaknesses hinder our ability as traders and investors to make logical decisions. And, as we know, there is no place for emotions in the market. Finally, Taleb suggests two approaches to leveraging positive Black Swans and minimising your risk to negative ones.
The more you learn, the more you earn. Keep reading, applying and growing. You’ll thank yourself for it later.
? In crypto Black Swan events are not unheard of. We aim to guide our readers through every single one. If you’re serious about 2021, subscribe and join our community?
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Disclaimer: The content in this newsletter is for informational purposes only. Nothing in this email is intended to serve as financial advice. I am not a financial advisor. Every investment and trading move involves risk. Do your own research when making a decision.
