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Be ready for black swans

Wildly unpredictable events will hit much more frequently than a naive extrapolation of trends indicates, and such events will more likely be negative than positive

Be ready for black swans

Equity investing is always a struggle between the underlying natural growth of economies and businesses, and the multitude of uncertainties and risks that exist. Variability - the alteration between periods of sharp growth and steep falls - is the normal state of equity. When we invest in equity, we sign up for volatility. In fact, we should hope for it because if equity is to give outsized returns, it's only because there's a premium for the risks that equity investors take.

Often we investors fall into the error of believing that risks can come only from the financial, business or economic aspects of the world. The COVID-19 crisis is a reminder that this is not true. Black swans are everywhere. In fact, this is a good time for investors to re-familiarise themselves with Nassim Nicholas Taleb's idea of black swans. Consider the statement: if the coronavirus epidemic continues on its path, then... 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. It is outside the realm in which forecasting methods and tools operate.

Recently, you would have read a certain amount of financial and economic news that seems to imply predictability with the coronavirus black swan. A month ago, Goldman Sachs said that the impact on global growth will only be a 'modest hit' of 0.1 to 0.2 per cent 'to annual-average global GDP'. 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. 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 these is not that we must predict better and that everything hinges on the accuracy of those predictions. 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 per cent, 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 causes 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 - a 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.