In the 18th century, it was assumed that all swans were white. No one in the civilized world had ever seen a swan of any other color. The statement: “Swans are white” was as self evident and obvious as any other fact taken for granted, such as the fact that the sun rises in the east, or that water is wet. Then came the exploration of Australia and the discovery of black swans, which are endemic to that continent.
This was considered to be a bizarre discovery which upset people’s expectations. Why? Because we are hard-wired to find order to randomness, to turn scattered points into a coherent narrative, and to expect identified patterns to last forever. In periods of time in which events fall within the expected range of outcomes, we become emboldened to believe that we have a grasp on the full range of possibilities. Yet the search for patterns and order can be a perilous trap, making us blind to the impact of the highly improbable. A highly improbable event that has a large impact has come to be known as a “Black Swan”. The Financial Panic of 2008 was so unusual and had such impact that I consider it to be a Black Swan.
Consider the confluence of unusual high impact events: 1. The uncovering of huge government-caused distortions in the mortgage marketplace. 2. Extreme deleveraging in the financial markets. 3. A chain of major bankruptcies and the extinction of the entire investment banking business model. 4. Massive arbitrary Government Bailouts that dwarf FDRs New Deal in scope. 5. The crippling of the free market in America, replaced by unprecedented Government ownership of big business. 6. A likely return to deflation after 70 years of systemic inflation. 7. A drop in short term interest rates to historic lows, at or close to 0%.
Sound judgment in finance includes a certain humility and the admission that we cannot predict events and therefore we cannot predict the future direction of any security or market. I repeat my admonition and quote myself from The Spring 2008 Newsletter:
“A good rule of thumb is this: Never be surprised. Don’t be surprised if we do enter a recession and markets crash. Don’t be surprised if the economy recovers and markets soar to new all time highs. Either can happen and both will eventually happen.”
Our advice does not hinge upon predictions of the future price movement of securities. When you hear pundits talking about their stock picks, along with their reasons that a security will appreciate, you are listening to someone who does not understand the efficient pricing of securities. When you hear someone making a convincing argument that the market will rise or fall over the next few months, that person is either a fool or a prophet. These pretenders do not have the humility that I speak of, and they do not account for the Black Swan; the highly improbable event that changes everything.
Our advice is the result of discipline and rational thought. The massive diversification that we practice is an admission that we are not so arrogant as to believe that our opinions are infallible, nor are we willing to gamble with our client’s success by concentrating accounts into a few favorite holdings or sectors that may result in complete disaster. Although with this Black Swan it has been difficult, we strive to introduce some degree of predictability to portfolios which is necessary when attempting to make financial plans.
Disclaimer: There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market loss.
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