Anticipating (versus reacting to) the next black swan

The earthquake, tsunami and near nuclear meltdown in Japan caused world financial markets to briefly wobble — and my phones to light up. Every time we have a major financial crisis, I get the same calls from clients, media and friends: “What should investors be doing now?”

My answer is always the same: Follow your investment strategy. Stick to your discipline, including exit plans.

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What is that? You don’t have a strategy or any sort of exit plan? Well then, it’s time for you to get one. Now.

Emergency planning is what we do before an emergency — not during one. Being proactive, rather than reactive, allows you to avoid the emotional mistakes many people make during unexpected events. That is why you look for the emergency exits before takeoff, not when the wings fall off the plane.

The best way to do this is to have a plan in place. Ideally, you design this when you are objective, unemotional and calmly contemplative.

Three factors should persuade you to this conclusion: First, these “black swan” events are surprisingly common. The so-called 100-year floods come along far more often.

Second, history teaches us that markets wobble then resume their prior trend. Major investment changes during this wobble are ill-advised.

Third, you should have an exit strategy in place for any asset you hold, regardless of what is happening across the world. In our asset management business, we call this having a “stock prenup”: We know what will cause us to divorce any position in advance (regardless of its relationship with the pool boy).

Let’s consider each of these three elements.

Black swans

Do you need to be able to anticipate exactly when and where the next earthquake/tsunami/nuclear accident will happen? No, of course not (and if someone on Wall Street could, they would probably keep that info to themselves to trade off of).

Consider the following list, from hedge-fund manager Doug Kass:

Black swan events of the past decade:

• Sept. 11, 2001: attacks on the World Trade Center and Pentagon;

• 2000-02: 78 percent decline in the Nasdaq;

• 2003: European heat wave (40,000 deaths);

• 2004: tsunami in Sumatra, Indonesia (230,000 deaths);

• 2005: earthquake in Kashmir, Pakistan (80,000 deaths);

• 2005: Hurricane Katrina overwhelms New Orleans;

• 2008: earthquake in Burma (140,000 deaths);

• 2008: earthquake in Sichuan, China (68,000 deaths);

• Derivatives roil the world’s banking system and financial markets;

• 2008: failure of Lehman Brothers and the sale/liquidation of Bear Stearns;

• 30 percent drop in U.S. home prices;

• 2010: earthquake in Port-au-Prince, Haiti (220,000 deaths);

• 2010: Russian heat wave (56,000 deaths);

• 2010: BP’s Gulf of Mexico oil spill;

• 2010: market flash crash (a 1,000-point one-day drop in the Dow Jones Industrial Average);

• 2011: surge of unrest in the Middle East;

• 2011: earthquake and tsunami in Japan

Kass’s list suggests that these once-in-a-lifetime events happen all the time. The key point is that you do not need to anticipate what the next disruptive event will be or where it will occur; you only need to understand that there will be one.