Is a Black Swan Lurking inside Your Portfolio?
Ron DeLegge, Editor
April 26, 2010
SAN DIEGO (ETFguide.com) – During our life time we’ve witnessed many shocking and unpredictable events. Recent examples include the 2008 Credit Crisis, the 9/11 attack on U.S. soil and Iceland’s erupting volcano.
In the investment world, these large scale occurrences have come to be known as “Black Swans.” In his 2007 book titled, “The Black Swan: The Impact of the Highly Improbable,” Nassim Nicholas Taleb popularized the Black Swan Theory. Put another way, Black Swans are hard hitting random events that send shockwaves across the globe.
Investors everywhere should ask themselves: Are Black Swans sleeping inside my investment portfolio? And what can I do to minimize the financial threat they pose? Let’s analyze these questions.
Unpredictable Business Risks
Any business you invest in has its own unique risks. Some of those risks are easy to identify while the unidentified others are categorized as Black Swans. Typically, large and complex enterprises have larger risks that are difficult to estimate.
One example of a Black Swan event is the crisis now facing BP PLC (NYSE: BP) in the Gulf of Mexico.
A drilling rig sank on April 22nd after a fiery explosion and the oil well it was connected to is still gushing crude oil as of the date of this article. According to estimates, around 1,000 barrels per day from the well are flowing into the ocean threatening all sea life in the surrounding area.
BP workers are scrambling to stop the oil spill from spreading but it’s a complicated task. The well is located in ocean water 5,000 feet deep.
Shares in the U.K.-based company traded around $60.50 just before the disaster and are now in the $58 vicinity.
Is there any oil analyst or investment research report that could’ve predicted this massive Black Swan event?
Unpredictable Legal Risks
Ascertaining the legal or regulatory risk of a business is one of the most difficult challenges for investors.
During the mid-1990s tobacco companies were sued by several U.S. states. The lawsuits claimed that tobacco makers knew about the health risks of their products but deliberately understated and hid them. Companies like Altria (NYSE: MO) and Philip Morris International (NYSE: PM) were engulfed in a legal mess that weighed on earnings and stock performance.
Today, legal problems face many businesses, particularly within the financial sector.
One of Wall Street’s leading investment firms, Goldman Sachs (NYSE: GS) is being sued by the Securities and Exchange Commission for civil fraud related to the sale of financial products tied to subprime mortgage debt. We could correctly classify this particular event as a “legal Black Swan.”
What thorough homework or deep financial research could’ve ever foreseen Goldman’s legal risks?
Unpredictable Corporate Managers
Currently, the automobile safety issues surrounding Toyota (NYSE: TM) are a textbook example of a significant business problem compounded by poor management decisions. Did Toyota’s management team try to hide manufacturing defects? And if they did, how much of a legal liability has their behavior created for Toyota’s shareholders? Over the past six months, Toyota’s shares have fallen from a high of $91.97 to around $79.
What’s the lesson learned?
Discerning the next move (good or bad) of the management team behind your company is next to impossible. This is true even if you’ve convinced yourself that the stock you’ve just purchased has the best corporate managers anywhere. The fact is that even the best management teams are prone to making bad business decisions. And worse yet, some corporate leaders go straight to jail!
Are there any Wall Street analysts or money managers that are able to consistently foresee management blowups before they occur?
Limiting the Black Swan Impact
King Solomon wisely observed, “The race is not won by the swift and the battle does not belong to the warriors and neither is bread to the wise nor wealth to the discerning nor favor to men of ability; for time and chance overtake them all.” Put another way, unforeseen occurrences befall all of us, regardless of how strong, wise or fast we believe ourselves to be. This is especially true when it comes to investing.
In summary, the best way to avoid Black Swans inside your investment portfolio is not to put them there in the first place! If you’ve built your investments around just a handful of individual stocks or individual bonds, not only are you taking more financial risk than realize but you’re a wonderful victim for whatever catastrophes lie ahead.
Diversification is one strategy that can help you to minimize the ever present danger of Black Swans. However, diversification in itself will never completely eliminate the threat of losses. Nevertheless, it can help to reduce the possibility of catastrophic losses.
How do you get diversified?
A portfolio of low cost index funds or ETFs that offer market exposure to different asset classes will do the trick.