Friday, April 1, 2011

Black Swans

Hey there

I guess this post is sorta a follow up from the last post because it is also centered around selling shares.

At about the time of my first post, Japan had one of its biggest natural disasters. The last time I read the news, the death toll topped 10 000 and they had 17 500 missing. On top of that, about a quarter of a million people were living in shelters. As if all those weren’t enough, they also had a six-reactor nuclear plant to worry about.

This kind of events are said to happen once every few decade or even a century. Some might call it a black swan event. Wikipedia explains the black swan theory as “a metaphor that encapsulates the concept that the event is a surprise and has a major impact. After the fact, the event is rationalized by hindsight.” They are considered as extreme outliers that are almost impossible to be predicted, unless of course you practice magic.

As a trader, I hate outliers. I very much prefer trends to be predictable and consistent, i.e. either upwards or downwards, not jumping all over the place (whipsaw). Every time an event such as this occur, the global markets go crazy, usually crashing, while you stare at the news thinking what The F*** just happened. This when I start to lose rationality, I stop thinking about my trading decisions thoroughly. This is when I am most prone to make bad mistakes, mistakes that can cost a lot.

So what should we do to avoid making horrible mistakes when we are caught by surprise? We prepare for it. The Japanese people are taught drills to perform when an earthquake occurs. I guess this is mainly because they are on the Pacific Ring of Fire, and have more than 100 active volcanoes. Hence, it is always important to be educated and prepared.

Hypothetically, black swan events are suppose to happen only once in a blue moon but if you think back, they probably happen more often than we think.
September 11, 2001 – more than 2900 dead and 14% or 1.2 trillion dollars drop in Down Jones in a week.
2004 Tsunami in Sumatra – more than 230 000 deaths, one of my best friends were there, luckily they were fine
Sichuan earthquake
Lehman Brothers failed and Bear Stearns was liquidated. 30% drop in US home prices
Global Financial Crisis
Haiti Earthquake
Bushfires in Victoria
BP’s oil spill
Middle East is getting more and more unstable
Floods in Queensland
Earthquake in New Zealand
Earthquake and tsunami in Japan
And I’m sure we can list a few more unfortunate events that I cannot remember from the top of my head.

As traders or investors, I believe that we need to be prepared and have an exit strategy or a rough guideline to be implemented when something bad occurs. It is probably too late to be looking for the exit, safe spots or safety gear when an earthquake happens. That is why we have to be prepared and have a plan to be implemented as soon as it occurs.

Just like emergencies, we cannot anticipate black swan events. And just like emergencies, we should be prepared.

So what is your exit strategy when outliers occur? What do you do when all of a sudden the market starts to freefall? Do you cash up and buy more? Do you go short? Do you close all your positions? Please leave comments or drop me an email. I would love to hear what you thoughts and strategies are.

Thanks for reading!

2 comments:

  1. Nice post :) have you read the book "The Black Swan" ? its a lot more than just about highly improbable events, Taleb's work revolves around determining what systems are fragile and what systems are robust. Very good read.

    Strategy- black swans are the best time to buy stocks. When there is fear in the market- stocks are underpriced - no better time to buy.

    People who picked up stocks after crash (late 2008- early 2009) made a killing during the recovery. times like those don't come around that often.

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  2. Yeah that is true, if only I had more capital back then. Even the blue chips were highly discounted.

    Sounds like a good book, I'll definitely add it to my library very soon.

    Thanks for your comment!

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