Who is Steve Darcis?
He's a Belgian tennis player ranked 135th in the world who on June 24 defeated Spain's Rafael Nadal in the first round of the Wimbledon tennis tournament in London. Nadal, you may recall, is an Olympic gold medalist in tennis and has a dozen Grand Slam trophies to his name.
Nadal's loss to Darcis was deemed a nearly impossible event. The betting odds were 1/500 in favor of Nadal (source: metro.co.uk, a British online news publication), which means the probability of Nadal losing this game was 0.20%. In other words, if you had wagered $10,000 dollars on Darcis, you would have earned $5,000,000.
Are there lessons for the investor in Nadal's shocking loss? This turn of events reminds us of the Black Swan Theory as described in Nassim Taleb's 2007 book, The Black Swan: The Impact of the Highly Improbable.
Briefly, a black swan is a highly improbable event with the following three characteristics: It's unpredictable; it has a massive impact; post facto, we concoct an explanation that makes the event appear less random-and more predictable-than it actually was. The financial collapse in the fall of 2008 was a black swan; so was last autumn's Hurricane Sandy.
Protecting Against the Unpredictable
In investing there are known risks and unknown risks. Inflation, for instance, is a known risk. Markets do a good (but not perfect) job on average of pricing risks such as expectations for economic growth, earnings and tax changes into securities prices. But they don't price in what they can't know-the black swans-and can thus quickly become vulnerable and volatile.
The existence of black swans underscores the limitations of using probability in the investment business as described by the normal distribution of the bell curve. For example, on a normal statistical distribution the likelihood from Dec. 30, 1927 of the S&P 500 falling 20% in a single day (as it did on Oct. 19, 1987) is 16 standard deviations away from the mean. On a normal distribution, that's about as likely as one person winning the Powerball lottery four times and getting struck by lightning four times in a given year. It's just not supposed to happen-but as we have learned, it's important to view extreme events as more likely to occur than is the norm when planning your financial life.
Since we know that these rare, unpredictable but potentially devastating events do occur, how can we prepare ourselves as investors? It's all about managing risk. By all means, look out for systemic risks, but trying to predict the unknown is highly likely to be futile. So what can you do?
First, prepare for what you can: This includes both high probability negative events such as loss of a job or longevity risks, as well as low-probability negative events with high impact, such as becoming disabled. Insurance, for instance, can be helpful to address risks such as longevity and disability. Substantial stock market declines are another example of a high-probability negative event.
Our research shows that, since the early 1900s, stocks have, on average, fallen 30% once per three-year time period. Thoughtful portfolio diversification, which will likely include an allocation to high-quality fixed income, should provide some stability and peace of mind during the inevitable periods of turbulent equity markets (and don't neglect to rebalance portfolios to maintain risk exposures).
Some of these strategies may require investors to fight instincts like fear or greed. And, by all means don't forget mundane but important strategies such as saving more, incurring less debt and maintaining ample cash reserves.
In an age in which technology is revolutionizing investing, it's important to remember that no model is perfect-though some are better than others.
Taleb's theory is not an attempt to predict black swans, but rather to raise awareness about the need to construct robust defenses against the extreme events that do occur and to be able to exploit positive events.
For many of us, perhaps the most relevant risk is the risk of not having the money we need when we need it.
In statistical terms, Rafael Nadal's loss at Wimbledon was almost a black swan event. Investors can't expect to predict statistical outliers like these, and the markets aren't good at pricing them.
But investors can still build some risk management strategies into their portfolios to prepare for the unexpected.
Gregg Fisher is chief investment officer of Gerstein Fisher, an independent investment management and advisory firm that he founded in 1993. Gerstein Fisher manages investments on behalf of individuals, families and institutions using a scientific, quantitative research-based approach that is grounded in economic theory and common sense.