Understanding "Black Swan" Events and Investing Accordingly

As the horrors of the Japanese tsunami push the horrors of the Libyan Revolt from the front page headlines, the rest of us struggle to figure out what it all means…

These horrors do not merely force us to consider whether oil will surge past $100 a barrel and/or whether the Dow will tumble below 12,000, they force us to examine the “whys” of inexplicable human suffering – to assign a cause and/or to extract a value…to the extent possible.

As the images of extreme – and seemingly random – human suffering illumine our TV screens, atheists and theists alike must decide where Divine providence ends and bad luck begins. No matter where you might place your data point on the continuum between providence and luck, your “explanation” will seem woefully inadequate.

If providence be the cause, why is Capitol Hill still above water? If bad luck be the cause, why are governments along the seismically active “Rim of Fire” investing in tsunami-warning buoys instead of rabbit’s feet?

Although your editor, a Christian, believes in the “Hand of God,” he also believes that the Hand of God sometimes looks an awful lot like bad luck. In other words, your editor is not smart enough – or righteous enough – to know what God is up to. He simply knows that lots of bad stuff happens for no apparent reason.

The Christian imperative is not to know the unknowable; it is to respond to “bad luck” compassionately. Let philosophers debate the teleological context of human suffering…and let God decide it.

A little over six years ago, when a massive tsunami inflicted epic suffering from Thailand to Sri Lanka, your editor wrote a column entitled, “Cosmic Dodgeball.”

“In the span of a few terrifying minutes last Sunday morning,” he wrote, “120,000 human beings perished beneath a fatal wall of water. That’s more than double the number of American soldiers who died in a different sort of Asian cataclysm four decades earlier. But manmade disasters like the Vietnam War bear no resemblance whatsoever to natural disasters. Manmade disasters, despite their horrific consequences, seem almost tame and rational alongside the natural variety. In other words, the brutality of war is shocking, but not unexpected by those involved. The brutality of nature is alarming, precisely because it is so unexpected and so completely random.

“A soldier pinned down in a firefight on the beaches of Vietnam knows he may not see another sunrise,” your editor continued. “But a tourist relaxing on the gentle sands of Patong Beach does not doubt he will watch that evening’s sunset. Fate sometimes foils expectations and delivers utterly unimaginable outcomes.

“Whenever epic disasters occur, nature seems indifferent to both the laws of probability and to our human sense of fair play. Epic disasters just don’t seem right, but they happen nonetheless. And whenever they do, it feels as though we humans are engaged in a kind of cosmic dodge ball – a ‘game’ in which the balls are invisible to the human eye until the moment they strike. The object of the game, of course, is to avoid getting hit. But as the balls are invisible, we are never really sure how we should be bobbing or weaving.”

The game of investing sometimes feels just as random…and capricious.

Most investors trust the stock market to lap at their feet as soothingly as the waters of Patong Beach. They believe the stock market will be kind to them most of the time. That’s what history shows, after all. Therefore, very few investors bother worrying about the financial tidal waves that could wash their capital out to sea. And even fewer investors prepare for these exogenous, “Black Swan” events.

Instead, most investors simply hide their complacency and/or lethargy behind the phrase, “No one can see disaster coming.” But, in fact, that assertion is patently false. Scores of insightful investors saw disaster coming in 2008, well before the credit crisis rolled in and crashed atop the financial markets. A few of these insightful investors profited handsomely from the ensuing disaster, but most of them simply headed to higher ground before disaster struck.

Some of the very best investment strategies begin with mere survival – with mere capital preservation. When the ground beneath you begins shaking violently, it’s best to head to higher ground…even if it means missing a day of work…or missing out on a stock market rally.

Middle Eastern tyrants are murdering – or preparing to murder – their own citizens; oil is topping $100 a barrel; Ben Bernanke is pursuing prosperity through dollar-debasement; one-trillion-dollar government deficits are the “new normal”; the Chinese economy has stopped producing trade surpluses…

Do you feel the rumbling?

Eric Fry
for The Daily Reckoning

The Daily Reckoning