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The Blackest Swan

The coronavirus disaster demonstrates something we should never forget - truly unpredictable negative shocks are almost a certainty

The Blackest Swan

This is a good time for investors to re-familiarise themselves with Nassim Nicholas Taleb's idea of Black Swans. Equity investors live in a bubble where analysts disagree on whether a company's predicted EPS growth two years out will be 10.2 % or 10.5 %, and economists argue about the second place of the decimal in GDP numbers. Meanwhile, here in the real world, an economy that is at least 16% of the world may not grow at all, or may go into a recession because of something that was unknown (or perhaps non-existent) about 75 days ago.

If China's coronavirus epidemic continues on the path it has so far, then... Here's the real problem - there is no way of completing that sentence which is not a blind guess. THAT is what a black swan event actually is. A black swan is far more than something that is unlikely. It's a type of event that cannot be predicted, whose very existence was not suspected. They are outside the realm in which forecasting methods and tools give an illusion of working.

In recent weeks, you would have read a certain amount of financial and economic news that seems to imply a predictability of a kind with the coronavirus black swan. Some of the usual suspects - big Wall Street names - have come out with precise numbers of what the impact will be. A week ago, Goldman Sachs said that the impact on global growth will only be a 'modest hit to annual-average global GDP' of 0.1% to 0.2%. They said that unless there was a significant change in the circumstances, the impact of the virus would be limited to companies that are most exposed to China.

This amount of confidence in one's ability to forecast a black swan is almost laughable. This is an event which is the very quintessence of unpredictability. Even by the Chinese government's own numbers (which need a large dose of salt), the number of cases and deaths have DOUBLED in the seven days since the report came out. Exponential processes (like compound interest) look very misleading in the beginning. Coronavirus cases outside China are a perfect example. A process that is compounding at this rate could have wildly different outcomes depending even on tiny changes in the growth rates.

The learning from events like this is not that we must predict better and that everything hinges on the accuracy of those predictions and that Goldman Sachs are the master predictors of the world before whose perspicacity we must bow humbly. Instead, the learning is that wildly unpredictable events will hit much more frequently than a naive extrapolation of trends indicates. What's more - and this is the key - such unpredictable events are overwhelmingly more likely to be negative rather than positive. Does that make sense? Let me explain what I mean. Can there be an event which causes the world's economic output to drop by some catastrophic amount, say 10%, in just a year? Yes, definitely. We could be in the first stages of such an event right now. However, can the opposite happen? Could something happen that could cause an equivalent boost in a year. No, the chances of such a miracle are as close to zero as possible.

This asymmetry is scale-dependent. Can an individual become wildly rich very quickly? Yes, it happens every day to many people around the world. Can the equivalent happen to a small business? Large business? Entire sector? A country? The whole world? As you go up in scale, the variability reduces. However - the big however - the size and speed of the negative shock possible is always much larger.

So what's an individual to do while saving and investing? The answer is simple - have some idea of what would happen if the worst crash takes place. As the years go by, your investing wealth will likely grow, but the blackest of swans could be just around the corner.

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