The Dismal Science -- Economics:Black Swans and the Mortgage Crisis
“A single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans. All you need is a single black [one].”
From “The Black Swan”
By Nassim Taleb (2007)
Mr. Taleb’s book focuses on being fooled by randomness, a concept more recently referred to as [sic] ..separating signal from noise. A timely question would be ‘ Is the current crisis in banking and mortgages a “black swan”?
According to Mr. Taleb, a “black swan” event is (1) unexpected, (2) has extreme impact, and (3) is rationalized as predictable and explainable after the fact.
Certainly (1) and (2) apply to the present banking and mortgage crisis. I reviewed my newspaper clipping file back to 2004. Alan Greenspan in 2005 stated ‘… banks should take more care with home equity loans’, noting that such loans are …”subject to increased risk if interest rates rise and home values decline.” Later that year, …”They are exhibiting a seeming willingness to project stability and commit over an ever more extended time horizon”, meaning they (investors) have bid up stock and housing prices and accepted unusually low yields on long term bonds. The OFHEO (Office of Federal Housing Enterprise Oversight) noted in early 2006 …..”the increasing divergence between these two data points (the housing purchase price index rising at an annual rate of 6.98% while the housing refinance appraisal price index is rising at 11.40%) suggest that the most recent appraisals may have been significantly overstated (by as much as 5%-10%)” Wall Street Journal, September 2006 comments Merrill’s acquisition of … the nations No. 9 subprime lender … is the latest indication of Wall Street’s efforts to beef up in the mortgage space. … The deal comes as many observers think the mortgage market is peaking”.
Sounds like a “black swan”.
What are investment strategies for dealing with “black swans”? The author suggest 5 strategies:
- Make room for unanticipated contingencies in your decision making process
- Rank beliefs about the financial future not by their plausibility but by the harm they might cause if your are wrong.
- “Barbell” investment strategies, include some riskier investments with a conservative portfolio; or, insure investments in a riskier portfolio against losses in excess of some level.
- Turn “black swans” into grey swans, by replacing usual normal (mean and standard deviation statistics) decision making with “black swan” distributions that recognize outsize positive or negative return possibilities.
- Ask yourself “what impact do extreme return outliers (positive or negative) have on total returns.”
In everyday language, this means owning a variety of investments and investment approaches, keeping focus on performance of the overall portfolio (not on each single investment), and trying to change our hard wired tendency to focus on what we know while ignoring what we do not know.
Next week, a personal observation on how difficult it is to account for a “black swan” even if you know about it ahead of time.
Copyright © 2007 MWBoone and Associates, LLC All Rights Reserved. MWBoone and Associates is a Registered Investment Advisor. Further disclosures at www.mwboone.com. Securities offered through Linsco/Private Ledger Member FINRA/SIPC.