Does Your Portfolio Have Black Swans?
Ron DeLegge, Editor
August 15, 2011
Over the past decade, we’ve witnessed many shocking and unpredictable events. Recent examples include the 2008-09 Credit Crisis, the 9/11 attack on U.S. soil and the BP oil spill disaster.
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.
The Black Swans in Your Stock Portfolio
Any business you invest in has its own unique risks and the stock market (NYSEArca: VTI) can be an extension of that risk. Some of those financial 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 recent Black Swan event is the Deepwater Horizon disaster that embroiled BP PLC (NYSE: BP) last year.
A drilling rig sank after a fiery explosion and the oil well it was connected gushed almost five million barrels of crude oil into the Gulf of Mexico. Efforts to restore the damaged oil well, were complicated by the depth of it - some 5,000 feet deep.
Before the disaster, whares in the U.K.-based company traded around $60.50, but one year later are now in the $41 vicinity. Anyone who banked some or all of their investments on BP, have been snake bitten by the Black Swan. And there's not an any oil analyst or investment research report that could’ve saved them.
Failing Sovereign States
Historically, the debt of countries is always thought of as a safer bet than investing in the debt of corporations. The main reasons cited are that countries have the ability to strengthen their financial position by increasing taxes or creating more currency.
Interestingly, none of these "powerful tactics" helped Argentina (NYSEArca: ILF) or Russia (NYSEArca: RSK) to avoid defaulting on their debt. Yet, the erroneous belief that government bonds are a sure bet has even made its way into the curriculum of educational institutions with economic textbooks teaching students that U.S. Treasuries (NYSEArca: TLT) are a "risk-less investment."
Complicating matters even further, are the inconsistent financial opinions of credit raters, like Standard & Poor's (NYSE: MHP) and Moody's Corp. (NYSE: MCO), who's cheery opinions just before the crash, have been a virtual given.
Limiting the Black Swan Impact
In summary, the best way to avoid Black Swans inside your investment portfolio is not to put them there in the first place. What 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 may realize but you’re a wonderful victim for whatever catastrophes lie ahead.
Now more than ever, Black Swans lurk everywhere. They are waiting to devour your money and they will if you let them. The prudent step, of course, is not to let them.
Even during Black August's tumble, ETFguide's Ready-to-Go ETF Portfolios have performed. The secret isn't market timing or even genius, but rather a no-nonsense approach to making low cost ETFs the foundation. Don't let the Black Swan get you.