ad astra per alia porci

a constant reminder of risk and the chance of blow-up
April 16, 2007, 2:44 pm
Filed under: investments/finance/economics

The decision to have as my blog address is a practical one: it forces me to be constantly reminded of the existence of risks and the odd event that might happen in the markets at any moment, represented by the metaphorical “black swan”. Having more than one black swan serves to intensify this sense of fear, hence the use of the plural in the blog address. Try imagining one market crash happening after another in rapid succession. Keeps me awake at night.

The Scottish philosopher David Hume first coined the idea of a “black swan” incident. Deeply critical and sceptical of the use of induction as a means of obtaining knowledge, he cited the example of how people used to believe only white swans existed because thats the colour of swans they see back home in Europe. However the appearance of a black swan refutes the entire claim. In his book “Fooled by Randomness”, Nicholas Nassim Taleb used the term “black swan incident” to refer to an event that has a very very low probability of occurring (in statistical terms, an “outlier”) and based his entire investing philosophy around this central idea of the unforeseen, super-rare event that occurs in the markets and taking advantage of such an event should it happen.

Needless to say I have been very much influenced by Taleb’s fantastically readable book on the role of probability in life and (especially) the markets. For quite a while, I have always been pretty much set on parking and dumping my entire savings into a “diversified” portfolio of exchange-traded funds because of the various books i have read over the course of the past year or two. They include A Random Walk Down Wall Street by Burton G. Malkiel, various books by John C. Bogle of Vanguard fame and many ad hoc personal investment books. Most advocate index funds as a “safe” and surefire means of prudently investing one’s savings.

The main push factor for the use of index funds as an investment vehicle is the central assumption that the stock market will rise over time. Many studies, like Jeremy Siegel’s Stocks for the Long Run, have shown how since inception, stock markets, especially American ones, have been on the rise, despite the various market crashes and unexpected events that occur. For every fall, the stock market rises twice. One dollar invested in the 1900s will grow to tens of thousands in the 1990s. That sort of thing. I used to subscribe to this viewpoint wholeheartedly, largely because of the lack of a viable alternative to active management and the seductive allure of the simple logic behind the case for index funds.

About 70% of fund managers fail to beat their benchmarks; while it is possible to choose a manager with a market beating strategy, the main question is an epistemological one: how do I know if a manager has superior skill? Not by reading a fund’s investment strategy statement, thats for sure. Most fund descriptions are by and large similar, usually split in the value or growth camps. Can I analyse the fund manager’s stock picks and decide if he has a viable strategy? Of course I can, but if i have the skill to do that, I might as well pick stocks myself. Past performance is no indication of future performance; surely the past 5 years’ performance cannot serve as a usable proxy for the performance in the next, say 30-40 years that you will be vested in the fund. Hence choosing a correct mutual fund is really hard, if not impossible for an average investor. Index funds seem like the best choice of investment vehicle for the lack of a better alternative.

Like Descartes’ monster in the brain which draws all into doubt, Taleb’s book sowed the seeds of doubt in my head. What if a black swan event happens? Won’t it erase all my gains from my investments? Buying an index fund means gaining full exposure to the black swan event. I am not taking assymetrical risk, as espoused by Ineichen in his book Assymetric Returns. I am exposing myself to a potential fatal collapse in the market. Of course, one can point to the historical prices chart and say that if I just stay in the market and tide over the storm, my index fund will recover in time and appreciate.

The main problem is, what happens if the black swan decides to appear right at the end of my investment holding period? Doesn’t that mean I lose a large part of my savings? What if the market crashes at an entirely inopportune time? Yes, one can try to time the market, but studies show that no one can do that well. Timing the market also defeats the purpose of indexing.

Hence my current policy towards my savings. I will actively manage my own investments in a bid to preserve and enhance my savings. It seems that there is no other way. Not that I mind though, because investing so far has been fun and a real intellectual joyride.


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