Black Swans, Red Flags:

While they may hate the analogy, Wall Street is subject to the same crowd psychology as the average investor.

Despite their sophistication, education and daily experiences, the majority of mutual fund managers look at the world the same way by virtue of their corporate cultures, financial motivations, and the ways they transform random bits of economic and financial information into their own realities.

Take the case of the current, seemingly random set of market events which does not fit into traditional economic or market theory. The severe recession started in the housing market, according to the prevailing wisdom, and the stimulus package a la John Keynes should eventually stimulate renewed lending and more willing borrowers.

The de-linking of financial assets, the decline in housing prices, bond yields, and plummeting stock prices was a statistical aberration. The new term for the near-simultaneous decline in the markets is a “black swan,” a term which comes from the 2007 book by Nassim Nicholas Taleb which described the discovery of a black swan in Australia which upset the dominant thinking that only white swans existed.

The situations which precipitated the current talk about “black swans” were the three consecutive years of declines in the S&P 500, accompanied by the near failure of the world banking system. Financial luminaries ranging from former U.S Secretary of the Treasury Robert Rubin to wealth managers at major Wall Street firms, say the current situation is the equivalent of suffering through a pair of 100-year floods in two years.

While the “black swan” analogy is unusual, it serves to comfort investors, rather than offer a complete explanation. Wall Street puts financial events into a historical context. But when the current context does not fit neatly into a past pattern, it becomes a “black swan” phenomenon.

A New Investment Reality?
An alternative explanation is that we are witnessing a period of renewed and continuous volatility, accompanied by rapid capital flows and new sets of motives from new market players. Central banks in Europe, the U.S. and Asia may no longer control the playing field. This helps explain the de-linking of markets, the failure of portfolio diversification, and the quiet discussion in mainstream media, such as Time magazine (“Are Stocks Still Good for the Long Run?” June 15, 2009), about re-thinking the merits of the sacred buy-and-hold investment philosophy.

At a higher investment level, PIMCO managing director Vineer Bhansali said that over the past 30 years, financial markets have experienced significant shocks roughly every five to seven years. In the past 12 years alone, the markets have suffered through the Asian financial crisis (1997); the Russian debt default and the collapse of hedge fund Long Term Capital Management (1998); the tech-stock bubble burst and consequent recession (2000 to 2002); the September 11 terrorist attacks (2001); and the current severe financial crisis, which began in early 2007. All of these events caused major market declines and exceptional Federal responses which led to long-term recessions. Bhansali then offers a sophisticated hedging strategy to counter these financial shock waves.

In his book, The Earth is Curved, author David Smick outlines the new investment reality caused by the global economy and it does not fit into the traditional view offered by Wall Street and most investment professionals. This new world view circa 2009 would make the canned portfolio optimization models based on age, risk tolerance, investment goals, and personal situations obsolete.

That’s because there are too many “black swans,” but the investment experts have taken a myopic view of these exceptionally stressful financial events. For example, a recent study by Harvard medical researchers released in June 2009 found that medical problems caused 62% of all personal bankruptcies filed in the U.S. in 2007.

To make matters worse, 78% of those who went into bankruptcy had medical insurance at the start of their illness, including 60% who had private coverage, not Medicare or Medicaid. These are often unexpected, serious, and seemingly random events which cause severe financial hardships, yet investment professionals would not consider them “black swans.”

Similarly, a job loss could be considered an unpredictable event accompanied by financial hardships, as could talk about the possibility of nuclear war coming from the dictator of North Korea or Iran. All of these should be considered “black swan” events, yet they are becoming too common.

Catastrophic Risk
This leads to the possibility of inventing a new investment paradigm based on the high probability of catastrophic risk, accompanied by a new definition of portfolio diversification.

While that will be a major project which could take us into the next decade, individual investors should realize that when your investment advisor presents you with a new canned asset allocation program specifying your exposure to small-cap, large-cap, munis, corporates, and value stocks over the next decade, you can ask about his underlying world view which made his model so neat.

It should be the basis for a good discussion.