PREDICTING A BLACK SWAN EVENT IN THE FINANCE WORLD
It’s kind of like planning a Vikings Super Bowl parade
November 8, 2021
I remember reading Rich Dad, Poor Dad, by Robert Kiyosaki, as a 19-year-old. It was the first finance book I had ever read, and it significantly changed my view on money. I know I’m not the only person who had it on my Mount Rushmore of formative books. If you’ve been in our Lake Elmo office, you’ve even seen it on our shelves! The book got my wheels spinning in a different way about concepts like compound interest and passive income, and I have to give some credit to this book for the direction I took in my career. Naturally, the influence of this book has led me to listen to Kiyosaki’s opinions on finance and the markets when he offers them, for better or worse.
We all have people like this that have left an imprint on us at some point in time. We recognize them as teachers, mentors, and inspirations. Inevitably, the consistent appeal to their authority and credence we give them can become a form of bias in our everyday lives. So, what do we do when a trusted authority in our life tells us to prepare for doom? The quick and easy solution is to listen and take note. However, there are higher expectations on us as wealth management professionals, not to mention greater responsibilities, to vet declarations like this, so let’s do that now with one statement that got a lot of buzz recently.
On September 26, 2021, Robert Kiyosaki tweeted: “Giant stock market crash coming October. Why? Treasury and Fed short of T-bills. Gold, silver, Bitcoin may crash too. Cash best for picking up bargains after crash. Not selling gold silver Bitcoin, yet have lots of cash for life after stock market crash. Stocks dangerous. Careful.”
Now, if you’ve watched any financial news lately, you’ll recognize that these types of predictions are running rampant. Mr. Kiyosaki isn’t the only one making them. A Yahoo! Finance article from July compiled a list of famous investors who were warning against an epic market crash, including the likes of Michael Burry who you probably know from “The Big Short,” to Kevin O’Leary, also known as Mr. Wonderful from Shark Tank.
I’m not here to tell you that these predictions are dead wrong. I’m not here to tell you that there aren’t valid reasons to be concerned about the market. The truth is we don’t know what’s going to happen in October or November; what direction the market will go, the magnitude of the gain or loss, which asset classes will be winners or losers, etc. We’re also not here to discuss the 7 other tweets I could find from Robert Kiyosaki since 2011 preparing all his followers for a massive crash while the U.S. continues its longest-running bull market in history. In fact, I don’t have a problem preparing for a bear market. We’ve seen 11 of them since 1932, and we should know they’re inevitable. The real problem is when preparing for a bear market turns into preparing for a Black Swan event. I can’t help but think John Stuart Mill was right when he said back in the 19th century, “I have observed that not the man who hopes when others despair, but the man who despairs when others hope is admired by a large class of persons as a sage.”
In case you haven’t heard the term “Black Swan” before, it was coined by Nicholas Nassim Taleb to describe an event that has three important components:
- The event is so rare that even the possibility of it happening is unknown.
- The event has massive consequences.
- We believe, after the fact, that these events were completely predictable.
Before we dive into Black Swan events in the finance world, a little back story. Before 1697, it was unanimously believed that all swans were white until Dutch explorer, Willem de Vlamingh, discovered black swans in Australia. This event was truly unexpected, changed zoology, and in hindsight made it seem obvious that black swans had to exist as there are plenty of other animals that exist with varying colors. However, if it was so obvious, why was it a surprise?
Events happen like this all the time: the sinking of the Titanic, the arrival of Europeans in the New World from the perspective of the Aztecs, and most recently, the sub-prime mortgage crisis (how’s that for three examples all over the board). All these events were caused by unknown unknowns which is what makes them impossible to predict. How can you predict something if you don’t know a variable exists? Therefore, if Black Swans can’t be predicted, we certainly can’t know what the correct preparation for said Black Swan event is. This is the logical fallacy that people are falling for.
The predictions we read in the news don’t have to label themselves Black Swans. We can recognize who’s attempting to predict one based on their language. How do we do that? The prediction discusses strategies that include market timing, overconcentration in one or two asset classes (i.e. cash and commodities), and broadly warns that all stocks are bad. When someone offers advice that hasn’t tended to work historically, it’s safe to say they’re attempting to predict an event that we haven’t seen. In the case of the finance world, this would be a different kind of market crash. If we haven’t seen an event like it before, what are the odds someone can know every implication of said event and how can they know the impact? It’s simple. They can’t.
Instead, what if we focus on the things we do know and adapt if needed? The cost of looking for a Black Swan and guessing wrong is too high. There were doomsday predictions ten years ago too, and the S&P 500 has nearly quadrupled since then. So, what can we be thinking about if we’re headed for a bear market or even a Black Swan bear market?
- Market timing doesn’t work. Dalbar, Inc. puts out a great study every year about investor behavior. From 2000-2019, average stock investors underperformed the S&P 500 by just under 2%. If these people invested $100K 20 years ago, that 2% annual difference sums up to be $109K. The thing that kept them from realizing that difference? Their behavior.
- Bear markets come and go. There have been eleven 20% or greater market declines since 1932. In ten out of the eleven, the market doubled from the bottom in less than five and a half years. If the money isn’t needed in that time, why panic and make moves that go against traditional investing wisdom? It’s kind of like planning a parade for a Vikings Super Bowl win. History is not on our side, and it’s likely going to result in the City of Minneapolis being out a lot of money. Now insert that logic into a complex system like markets…
- As Brent Schutte, Northwestern Mutual Wealth Management Company Chief Investment Strategist, wrote in his latest quarterly market commentary, “Diversification remains the best hedge for uncertainty, and the best means to capture upside in a future that cannot be predicted with great accuracy.” He goes on to say, “Market leadership is different in every cycle, which underscores why diversification is critical to long-term investing success. Investors are not well served turning to the rear-view mirror to position portfolios.” This reiterates the main point here. We can’t predict what asset classes are going to lead throughout the cycle, but diversification makes sure you have exposure to those leaders. That’s why we’ve maintained an exposure to commodities even as they’ve underperformed as a whole for about a decade. They’re the leading asset class in 2021.
- This is why you have bonds! They haven’t been super fun to hold lately with interest rates being at all time lows, but you need something to hold value in down markets and traditionally, fixed income has been the non-correlating asset people can count on holding value in those instances. To the pre-retiree, bonds can be used opportunistically to buy up stocks at a discount. For the retiree, this is why we recommend you have a number of years’ worth of income in bonds. Even in distribution mode, you shouldn’t have to sweat volatility in the stock market, big or small.
- Always leave margin for error. Black Swans may be rare, but they do happen, so avoid making decisions from a posture of overconfidence. Evaluate your risk tolerance in your portfolios, keep your debt-to-income ratio manageable, and be mindful of lifestyle creep. Benjamin Graham called it his margin of safety and summarized it as this: “the purpose of the margin of safety is to render the forecast unnecessary.” Wouldn’t that be nice?
I think if we’re honest, that’s the world we want to live in. For those who have been fortunate to build meaningful wealth, it’s a world that can be created. Forecasts can be rendered unnecessary when you build a plan that understands what’s most important to you and you invest accordingly. When you’re focused on the goal instead of your portfolio’s return, you make decisions differently. You alleviate a whole bunch of anxiety, and most importantly, you keep real priorities in focus.
Investing requires you to have traits of both a pessimist and an optimist. Living a life of naïve optimism may lead you to becoming the investor Warren Buffett talks about who isn’t wearing a swimsuit when the tide goes out. We don’t want that. But living an overly pessimistic life, sounding the alarms every couple of months for the next crash, can lead to a life of cynicism where priorities fall by the wayside. We’ve seen both in practice, but at Voyage Wealth Architects, we’ve found that the best results are found when we have a healthy relationship with the markets. We can’t control the outcomes, and we can’t control whether a Black Swan is coming. We can control our vision, our values, and our goals. We can control our behavior. We can choose to seek advice and build a personally crafted financial plan. We think there’s more joy found in that than spending 99% of our time worrying about 1% probabilities. Wouldn’t you agree?
THESE INDICES ARE UNMANAGED AND CANNOT BE INVESTED IN DIRECTLY.
ALL INVESTMENTS CARRY SOME LEVEL OF RISK INCLUDING THE POTENTIAL LOSS OF ALL MONEY INVESTED.
NO INVESTMENT STRATEGY CAN GUARANTEE A PROFIT OR PROTECT AGAINST A LOSS.
PERFORMANCE SHOWN REPRESENTS PAST PERFORMANCE AND IS NO GUARANTEE OF FUTURE RESULTS.
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