Black Swan and The Age of Insecurity
London, UK - 24th November 2008, 16:45 GMT
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[Please note that the views presented by individual contributors
are not necessarily representative of the views of ATCA, which is neutral.
ATCA conducts collective Socratic dialogue on global opportunities and threats.]
The following interview with the Managing Editor, James Rutter,
has just been published as the cover story in the Dow
Jones Wealth Bulletin within The Wall Street Journal Europe.
The black swan survival guide
For a man who spends his waking hours pondering the inherent
insecurity of 21st century living, DK Matai seems remarkably relaxed. Small,
meticulously dressed and impeccably mannered, he perches on a sofa surveying
the skyline of Londons Canary Wharf, the former home of collapsed
US investment banks Lehman Brothers and Bear Stearns, and explains in measured,
precisely pronounced sentences that the financial crisis is only the beginning
of our problems.
The stock market is an indication of instability from
a geo-political standpoint and from a financial asset standpoint,
Matai says. We are encountering the instability inherent in not being
able to plan for the future.
As founder of the Asymmetric Threats Contingency Alliance,
a philanthropic network of 5,000 politicians, academics and business leaders,
Matai spends his time thinking about the risks and opportunities the rest
of us seldom contemplate: how the rise of nanotechnology might affect the
environment, what genetic experiments could mean for mankind, how humanity
might exist in a future dominated by mass robotics.
It may sound like science fiction but consider how rapidly
technology has changed our lives and the planet in the past two decades.
We are converging on a bio, info, nano revolution, says Matai
matter-of-factly. This creates unknown unknowns. These are the black
UNCERTAIN TIMES The black swan has become an emblem for these
uncertain times. The phrase has entered common use thanks to the best-selling
book of the same name published last year by Nassim Nicholas Taleb, a statistician,
would-be philosopher and former options trader. In Talebs words, a
black swan refers to an event outside the realm of our expectations,
because nothing in the past can convincingly point to its possibility.
It was understood that all swans were white, because only white birds had
ever been seen, until a black swan was discovered in Australia.
Matai uses the term asymmetric risk to convey
the same idea as a black swan asymmetric because such risks fall
outside the realms of normal assessments, the bell-shaped distribution
of events that is the foundation of modern risk management.
Thierry Malleret, managing partner of Geneva-based Rainbow
Insight, an advisory boutique for private clients, says: As human
beings we love stability and hate uncertainty. We like bell-curve distributions,
which assume independence among components of a system, because they are
predictable. Black swans dont respond to normal, bell-curve distributions
but to power-law distributions which are unpredictable, so we hate them.
Power-law distributions are found in most human, non-linear
systems, where tens of millions of occurrences have no appreciable impact
beyond their immediate sphere of influence while a small number of others,
usually in unpredictable conjunctions, change almost everything. Malleret
is a member of Matais Asymmetric Threats Contingency Alliance and
has published a book on how businesses might meet the challenge of black
The alliance has a list of the top 10 asymmetric risks it
believes we face, including pandemics, transhumanism, resource shortages
and systemic failures in financial markets.
Experience tells us that these events should be so rare that
they are hardly worth considering, let alone worrying about. Yet they are
happening with increasing and alarming frequency. We face a 21st century
in which black swans are likely to arrive in flocks.
Globalisation is partly to blame. The global economy
is like a spiders web, with everything interwoven, says Matai.
During periods of calm, this gives an appearance of greater stability, which
only serves to lull us into a false sense of security increasing the potential
for devastating black swan events exemplified by the speed with which
the US sub-prime lending crunch has become a global financial crisis.
Global swans will happen more and more because we live
in a world where risks, like goods and ideas, travel very fast and are highly
contagious, where little causes have big eff ects, and where changes happen
dramatically, not gradually, says Malleret. The current debacle
exhibits these three features. It is a black swan and we are just at the
beginning of our surprises.
PEACE OF MIND
But what does this mean for wealth management? In the age
of insecurity, dive-bombed by black swans, people at least in the
developed world will invariably feel less wealthy regardless of whether
they are actually poorer. All these developments impact on our peace
of mind, says Matai. And what is wealth if not peace of mind?
He once spent an afternoon trying to work out with a group
of Swiss private bankers what attracted very wealthy individuals to their
institutions. Achieving peace of mind, was the simple conclusion. But in
recent years, on the back of economic stability and remarkable asset returns,
the focus of wealth management shifted to taking risk and making money.
Where previously people made a fortune and then looked to preserve it, instead
they wanted to make more money from their money. Recognition of black swans
may prompt a reversal, suggests Matai. I expect a philosophical change
in wealth management. The desire to grow wealth will be much less pronounced;
instead it will be about the desire to safeguard wealth.
Unfortunately, in a world bombarded by asymmetric risks, preserving
capital is no longer straightforward because accepted models spreading
bets, building efficient portfolios cease to work.
Talebs suggestion is to put 90% of your assets into
the most secure government bonds (perhaps inflation-protected might be sensible),
and invest the remainder in a wide array of high-risk ventures that provide
exposure to the sorts of positive black swans that can generate extreme
There are, of course, numerous obstacles to applying this
in reality, the biggest of which is the psychological hurdle of throwing
out whatever you have learned about portfolio diversification and trade-offs
between risk and reward.
Philip Watson, head of investment analysis and advice at Citi
Private Bank, is not convinced by Talebs suggested portfolio. It
is very risk averse and will severely limit potential upside, he says.
The idea of not putting your eggs in one basket still makes sense,
and certainly, in an age of insecurity, diversifying your counterparty and
market risk is advisable.
This is perfectly sensible advice within a conventional investment
framework, established over many years. But accepting black swans takes
you beyond the confines of the conventional to an uncomfortable hinterland
in which you start to doubt hitherto basic beliefs.
Malleret says a growing number of wealthy families are moving
to portfolios not dissimilar to Talebs. They are starting to
question all the hypotheses that underpin conventional asset allocation.
These are based on probabilistic risk assessments that do not work in a
black swan world.
One of Talebs favourite illustrations of a basic black
swan event is a turkey that is fed every day for over 1,000 days. Everything
in the turkeys experience points to the certainty it will be fed again
on day 1,001. Instead, its neck is wrung. This basic assertion is that humans
in general are like the turkey. We extrapolate from the past to the future
without a second thought. When it comes to investment we are even more gullible.
How many fund managers can point to 1,000 straight days of positive returns?
More black swans mean a less predictable future. The
world of tomorrow will be less risky than today but much more uncertain,
says Malleret. This disconnect between probabilistic risk and non-probabilistic
uncertainty makes us very uncomfortable. More uncertainty means we should
expect the unexpected, build resilience and be prepared. The exceptional
investors are the ones good at joining the dots and making improbable connections.
Your wealth manager is likely to be managing risk but ignoring
uncertainty. And if you care about wealth preservation, that should be worrying.
If an individual is able to walk away from this debacle three years
from now and say they didnt lose anything that will be a great outcome,
Unfortunately, in the realm of the black swan there are no
easy answers and plenty of uncomfortable questions. It may be time to start
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