Another black swan?

In a blog post we published back in December of 2008, we discussed the term "black swan," coined by Nassim Nicholas Taleb to describe statistically improbable "large-impact events."

We argued then that the events of 2008 should have caused a major re-evaluation of the world's rush to embrace "investing" via quantitative "black box" strategies and the other monstrous offspring of the "modern portfolio" theorists who for decades have attempted to pin down the markets with their mathematical algorithms.

Interestingly, Dr. Taleb figures prominently in this recent Wall Street Journal article discussing possible factors in the chain reaction that caused major indexes to drop precipitously last Thursday in a plunge that left even professional traders shaken.

While the hedge fund for which Dr. Taleb is an advisor argues that their large bet on bearish derivatives "couldn't have caused the meltdown" all by itself, it does appear that their trade caused more selling from other major market players, resulting in a downdraft that fed on itself. Although Dr. Taleb was not necessarily involved directly in Thursday's events, it is ironic that the hedge fund near the center of the incident would be one associated with the author of The Black Swan: The Impact of the Highly Improbable.

We view this irony as confirmation of the lesson that we take from Dr. Taleb's "black swan" concept, which is that modern portfolio theory has led portfolio management down the wrong road for over thirty years, because unforeseen (or, in many cases, foreseen but dismissed as too improbable) "black swan" events have a way of showing up and overturning even the most carefully-constructed computer algorithm, quantitative strategy, or financially-engineered synthetic debt instrument.

It is amazing to us that sophisticated professional investment firms and hedge funds continue to rely on "black box" strategies in which the keys to the car they are riding in are turned over to a computer, especially after 2008 and 2009 wiped out so many black box practitioners.

As we wrote in our previous post, investors whose strategy is to own good businesses through temporary market cycles should not have been hurt at all by the sharp one-day plunge.

However, there is the very real likelihood that events like last Thursday's "flash crash" will cause regular investors -- who should have nothing to do with such black-box strategies anyway -- to reach the erroneous conclusion that what we would call "real investing" is a lost cause as well, and we believe nothing could be further from the truth.

We believe that the follies that led to last week's short panic should drive investors back to real investing (for more on what we think that term means, see here and here for example). This is a very important point that is not being explained by the media in the aftermath of last week's selloff.

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for later posts dealing with this same topic, see also: