Anticipating (versus reacting to) the next black swan

Barry Ritholtz
Columnist April 2, 2011

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.

Ritholtz is chief investment officer of Ritholtz Wealth Management. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. View Archive

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.

Market response

We have had several hundred years of market history to see the impact of “externalities” on trading. Externalities are what market watchers call those events outside of the usual business cycle.

We see throughout history that the impact of these externalities is to make the markets wobble for a brief period of time, then return to what they were doing previously. Pearl Harbor, the Kennedy assassination and the Sept. 11 attacks were all followed by a sell-off then a snapback rally, and finally a resumption of their prior trends.

Indeed, the snapback rally since the deep Japan-led sell-off is reminiscent of these prior events. Fear creates panic, and markets quickly become deeply oversold. That creates the environment for a strong bounce and a return to normal trading.

So much for the “black swans.”

The stock prenup

The last aspect to your emergency financial plan is having an exit strategy.

Your goals:

•  Avoid owning the stock disasters that wreck portfolios.

• Steer clear of market sectors that are imploding.

• Avoid the worst of the market crashes that see stocks nearly cut in half or worse.

In terms of individual equities, stocks that go to zero are oh-so- dangerous to your portfolio. You cannot own the Enrons and Lehmans and GMs and AIGs as they go bust. So your plan will involve taking a small loss to avoid taking a giant 100 percent whack on those positions.

Market sectors can, at times, become terribly destructive as well. Consider the home builders, banks, telecoms and technology — all have had sectorwide losses of 80 percent or so during the past decade. When that happens, even the very best names in the groups get shellacked.

Last, you must be prepared to deal with the occasional market collapse. As we showed a few weeks ago, these occur more frequently than people realize. Your plan should incorporate the expectation that market crashes can and will occur.

Investors who have a plan to deal with these unexpected but unavoidable realities — and the discipline to see that plan through — will see drastically better results than those without one.

What is your plan?

Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, The Big Picture.

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