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.