In the past few turmoil-dominated weeks, many financial professionals have expressed utter shock at the dimension of the mayhem that has afflicted the markets. While the precise verbiage may vary, the central message has remained identical: such violent and volatile movements were totally unexpected, unprecedented and unpredictable. No one could see them coming, nor prepare for them. So, these pros seem to imply—do not be too hard on us for having experienced losses in such a devilishly implausible environment.
Sounds familiar? It should. Very similar arguments have been heard before. Take, for instance, the fall of the mega-hedge fund Long-Term Capital Management LP in 1998 and the Black Monday stock market crash in 1987. Both were also deemed (and, curiously, still are in some quarters) a freak event, an outlier, the perfect storm that only takes place once in a million years. Negligibly improbable. Or, as the chief financial officer of Goldman Sachs Group, Inc. put it the other day to explain a new set of unexpected losses: “a freakish 25 standard deviation event.”
The problem is that such arguments are based on the assumption that the returns from financial markets follow a “normal” probability distribution. The distribution is so called because it is found so commonly in nature. So if returns in markets varied the same way that, say, the weight of oxen vary, then the likelihood of any relatively largish deviation could essentially deemed to be zero. But financial markets aren’t normally-distributed. Those “one-in-a-million-years” events tend to take place rather more often than that.
Why do supposedly sophisticated investors keep falling back on this tired, statistically impossible alibi? Most of them are old enough to have previously experienced one or two “impossible events”. After all, you don’t need to live a million years to see one. And if they were too busy to notice, they could now study the best-selling and widely reviewed book, Black Swan. There veteran trader Nassim Taleb argues forcefully for non-normality—the real-life habitual presence of outliers, or black swans.
It is tempting to conclude that a bit of deceit is taking place. Perhaps the investors do know that the markets are not normal and that the 1,000-year hurricane stuff is nonsense. But they may want to feign ignorance. That way, they will be allowed to put on the market plays they really want, safe in the knowledge that if things turn sour, the perfect storm get-out-of-jail-free card will always be available.
Sophisticated investors need to publicly dismiss the possibility of the “black swan” in order to take black swan-exposed bets—such as subprime mortgage exposure or selling implied volatility, which could deliver outsized returns for a long time.
After all, it would be pretty foolish to take positions that could be destroyed by a large unfavourable move (a black swan) and then admit that you were well aware of the (huge) risks beforehand. “You mean you knew that this could happen?” is not what a money manager wishes to hear from his investors once mayhem strikes. It is better to claim prior ignorance about the real probability of trouble.
So perhaps these players always have accepted Taleb’s theories, but won’t say so in public. They don’t want to invest like he does. Rather than expose himself to a blow-up, Taleb waits patiently for a black swan to appear. This strategy—mainly implemented by purchasing deep out-of-the-money put options—entails suffering a constant stream of small losses before potentially enjoying a huge windfall. Many traders don’t like that style. They prefer quick profits with an excuse for big losses to years of bleeding with the possibility of no glory at all.