Fooled by The Black Swan
John, an electrical engineer living in New Jersey , was conversing on the phone with his close friend Bob. John tells Bob that the plan for himself and his wife to retire at 45 is going as planned. This required overtime at work, reduced consumption and traveling, and aggressive investing – all to be able to meet their goals. The two friends say their farewells. And John hangs up the phone.
Later that evening, John was up watching CNBC as his wife slept. Suddenly he spit his cognac out and could not believe what he was seeing.
“Bishop Regional Bank (BRB), a mid-tier lender, shockingly defaulted on their creditors. BRB declared huge losses in their after hours earnings release, startling analysts that expected a modest profit for the quarter. The CEO of BRB said the huge losses were from a substantial drop in their corporate debt portfolio. As the economy has slowed and the Federal Reserve recently raised interest rates, corporations have suffered diminishing profit margins. Junk bond yields have soared, crippling already suffering companies from having less sales. This comes as a surprise as 81 of the economists we surveyed expected stronger growth in the market this year. Aswell as consensus on The Street for BRB was safe of any toxic loans. Yet, it appears things were worse than thought.
The CEO went on to further state that the economy surprised everyone and that they will be entering talks with their creditors for liquidation. Be wary of what the contagion will be when markets open tomorrow. BRB stock is down 85% in the after hours and still falling.”
John feels he is going to vomit. Bishop Regional Bank was his largest position in his portfolio. How did this happen? His expensive financial adviser, that was an expert in the financial/banking sector, said this was a must own. He raved how it could pay its 6% dividend with no problems at all. He said it was risk free with big reward; a rare feat.
John looks at his portfolio – and feels tears swell up. His US 10 year treasury bonds were still intact. But bank stock as a whole were collapsing, and the market wasn’t even open yet.
He grits his teeth and closes his laptop.
How did this happen? 9 years of savings, wiped out within an evening, John thinks to himself.
Months passed by until John and his wife found solid footing. The majority of their portfolio suffered horrendous losses – roughly 75 cents on the dollar. They pushed their planned retirement out another decade. They stayed out of financial related equities and focused on bonds, cash, and gold (which jumped $215 per oz during the banking collapse contagion – the only thing offsetting the realized losses).
John was fooled by the experts and by himself. But mainly fooled by a Black Swan.
Black Swans and the Antifragile
Nassim Taleb, a prolific thinker and former options trader, wrote a book called The Black Swan and Antifragile (if you haven’t read it – do so immediately).
The premise was the following: Black Swan’s are events that can not be predicted. This would be, for example, a sudden volcano erupting which was supposed to be dormant. He states that most of all the important events in history were Black Swan’s that changed the course of mankind from sudden, unforeseen, and completely random events. An economist creating a model for the risks during the next 3 years in the economy is pointless as the risks that cannot be modeled. Imagine the 2008 housing collapse – no one knew what day Lehman Brothers would collapse nor did anyone plan for that.
There are 3 types of exposure: there is the fragile, which breaks and collapses during chaotic times (John’s over leveraged bank stock).
There is the robust, which resists shocks and can endure the calamity (the 10 year US bonds in John’s portfolio). Most individuals believe there is only the fragile