Afraid? You will be… you will be

Last week, amidst the internet-wide reminiscing about the October 1987 stock market crash, we joined in with our own take on the lessons of that day. However, one of our readers and a blog author himself – Michael Harris – raised a few points of contention with our post. Since there are few things we love more than a good debate, we decided to continue the conversation.

In truth, we don’t really think there’s much disagreement. Michael’s main point is this: if you’re too afraid of a 1987-style crash taking place, you won’t take the kinds of risks necessary to obtain a respectable return:

Suppose a trader with $100K gets a long signal for SPY, the ETF that tracks the S&P 500 index. The trader can tolerate a drop of 2% in his bankroll for this particular trade. The entry price is at $145 and he will exit with a loss if the price gets to $140 or with a profit if the price gets to $150. It is easy to calculate that the position size to accomplish his risk and reward objectives is 400 shares, although he could actually purchase a total of 690 shares with his capital based on entry price.

Now, let us see what happens if after reading some book about rare events the trader gets scared and he wants to factor in the possibility that while his position is open, SPY can drop 20% in one day, just like the S&P 500 index did back in 1987. In this case, it is easy to calculate that he should buy only 69 shares, one order of magnitude less than what he could buy if fully invested. Of course, this diminishes any potential for profit from a good signal. If the previous case, the purchase of 400 shares allowed a potential 2% gain (400 shares x $5). In this case, the potential for profit is only 69 shares x $5 = $345.

On this point, we agree. There’s also a non-zero chance that the Earth will be hit by a meteor tomorrow and we’ll all be wiped out – but you can’t just give up and crawl in a hole. You have to live your life, even knowing there is a greater than 0% probability that the sun won’t come up tomorrow. And knowing that the market might plummet tomorrow doesn’t mean that you should keep 99% of your money under your mattress, either.

But – that doesn’t mean that you should ignore the fat tails completely. Instead, you should have a contingency plan. After all, NASA has worked on plans to save us from a doomsday asteroid. Our main goal is to criticize overconfidence in the predictability of markets. Talk to Long Term Capital Management, Lehman Brothers, or AIG about the risk of ignoring fat tails…

Wise investing involves knowing the market can crash, and adjusting your strategy accordingly (rather than practicing buy, hold, and hope). What we’re advocating is akin to bringing an umbrella when there is a small chance of rain, or keeping a spare tire in your car. A happy medium – where you realize that the ultra-rare catastrophe is much more likely than a normally-distributed curve would have you believe, but you don’t allow that risk to keep you locked up in your house all day, afraid to go outside. And in the end, that’s pretty much what Michael’s is advocating, too:

A better suggestion is to never risk money that you cannot afford to lose.  This takes care of any rare event that can occur. Even better is this one: Risk only half of what you can afford to lose and keep the other half in case of rare events. Actually, rare events present great opportunities for those who have kept cash aside. This is another reason such events cannot be called “black” whatever in general.

When you recommend only trading money you can afford to lose (or only ½ the money you can afford to lose), you are applying the knowledge that market returns are not normally distributed. You are protecting against a worst-case scenario – so in the end, his conclusion is same as ours.

And, as Michael points out, “black swan” events need not be disasters for everyone – indeed; they can be excellent opportunities for those who are prepared. When we talk about investing during a drawdown – that’s viewing one person’s pain as another’s opportunity. We don’t bring up black swans to try to scare people out of the market – but rather, to get investors thinking about how to prepare before the crisis strikes.

One comment

  1. Thanks for the reply. We certainly agree here. I also think that your effort to make your clients aware of potential risks arising from non normal events shows a highly professional attitude, when most in the industry talk about safe returns and try to lure in investors that way.

    However, I still have one last point make. It is something that you are aware of but I think those who overhype the “black swan” event theory often underestimate. Even if “black-swan” rare events are unpredictable, still an investor can be ruined by a series of normally distributed events, i.e. a series of bad trades. In my opinion, more traders and investors have been ruined by consecutive streaks of small and low probability losses than by rare and unexpected large losses. Focusing on the expected is more important than focusing on the unexpected.

    Investopedia states that:

    “Black swan events are typically random and unexpected. For example, the previously successful hedge fund Long Term Capital Management (LTCM) was driven into the ground as a result of the ripple effect caused by the Russian government’s debt default. The Russian government’s default represents a black swan event because none of LTCM’s computer models could have predicted this event and its subsequent effects.
    Read more: http://www.investopedia.com/terms/b/blackswan.asp#ixzz2A7wokLPc

    In my opinion, the cause of the collapse was the over-leverage of the fund which according to some had reached 20:1 and according to some others it was as high as 100:1. As a result, any news could have triggered the collapse but also a series of normal adverse price movements. Thus, any direct causality between a specific event (Russian collapse) and a specific cause (fund collapse) is elusive.

    It is also a red herring in my opinion asking for a computer model to predict a Russian collapse. This is a backwards approach. There are so many things that can go wrong unexpectedly and trying to model them is the wrong way of doing business. To make a long story short, as you have also pointed out, unpredictability is part of life but in my opinion, the connection between “black swan” events and investment results is elusive and often the outcome of a straw man argument. It is rather bad risk management that is the cause, not the “black swan” event.

    More importantly, this “black swan” theory offers an alibi to all those bankers and structured product developers who did not do their job right. They blame some “black swan” not their inability to exercise prudent risk and money management.

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Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

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