Black Swans, Fat Tails and Your Money

On May 6th, 2010, the stock market suffered the worst one-trading day plunge in history as it dropped almost 1,000 points in less than a half hour. If you were watching CNBC, you would have thought we had been attacked by terrorists. People were screaming at the top of their lungs in the background, and the TV guests’ voices were fluctuating as though they had just seen a ghost.

This is what some people would call a black swan and these extreme events are expected in distributions that are known to have fat tails, like stock market returns. Black Swan events are described by Nassim Nicholas Taleb in his 2007 book, The Black Swan. The main idea Taleb seeks to drive home is that it is foolish to try to predict Black Swan events and that those events can have a significant impact for investors. One should instead make sure they are prepared to accept Black Swans in the short term and "time diversify" their investments over the long term, so that black swans become irrelevant. Investors should also beware that black swans are just as likely to be positive as they are negative returns and therefore over time the events offset each other.

"I think the machines just took over. There's not a lot of human interaction," said Charlie Smith, chief investment officer at Fort Pitt Capital Group. "We've known that automated trading can run away from you, and I think that's what we saw happen today." Likely, these words provide little comfort to the vast many investors or active fund managers who, with pre-set market sell orders or stop-loss orders, quickly had their money ripped out of the market as it sank like a rock; nor would they have been happy when they had no way to get their money back into the market when the market shot up like an Apollo rocket. The money people lost in the mind-boggling freefall created by automated computers and antsy money managers is money they will NEVER get back, except for those trades that were cancelled by the exchange. It was something straight out of a science fiction movie where machines started taking over people’s portfolios.

So you may be wondering how passively managed portfolios are impacted by such events? The rules of construction for the our favorite index funds from Dimensional Fund Advisors (DFA) allow for “patient trading” during the reconstitution or rebalancing of stocks in a fund.  Most index funds adhere to a strict reconstitution date which coincides with the benchmark index. In contrast, DFA's are reconstituted on an ongoing and opportunistic basis. The objective of this strategy is to avoid the announcement of when certain stocks are added or dropped from the fund, creating what we like to call a "silent index."

These passive strategies can serve investors quite well in cases such as the whopping drop of last Thursday, as savvy passive fund managers provide liquidity to sellers of large blocks of shares. In many cases, this ability enables shrewd passive fund managers to complete their trades significantly below the price of the previous trade. IFA advises their clients to utilize passive fund managers who patiently trade with intelligence and confidence, as they benefit from the over-eagerness of those playing the speculation game.

A Black Swan Sighting.. It is a Good or Bad Swan?

Stated another way, while most traders are liquidity seekers (trying to dump stocks so they can buy the next hot stock), passive fund managers act as liquidity providers, relieving impatient active investors of those unwanted stocks -- frequently at a deep discount.

We encourage IFA clients to tie themselves to the mast, keep their eye on the long-term horizon and ignore the short term black swans. We know that we can not predict these rare events and recognize that such events are one of the reasons that our clients are rewarded for their patience over appropriate holding periods.