Black swan and investment strategy in a Covid-19 world

Best thing under pandemic is to reduce risks to savings by playing safe

KARACHI: The Covid-19 pandemic has shaken the world to its core. It has shown the mirror to the spirit of globalisation. It has made evident the level and degree of interdependence that the world has developed over time.

The hustle and bustle of modern life has been brought to a forceful halt. People are forced to ponder their own existence. With all this, we must draw valuable lessons from an intellectual who had highlighted the possibility of this problem.

Let’s listen to Nassim Nicholas Taleb, a Lebanese-American finance guru and a practical philosopher. Taleb takes pride in being eccentric. He brought forward an interesting idea in his famous book “The Black Swan”.

According to him, there are certain events that have a very low probability of occurrence, however, if they happen, the impact that these events create is magnanimous.

The metaphor that he used for such events is that of a black swan. The idea is that before the discovery of a black swan everyone in their deepest of imagination always thought and believed that swans are white.

But when a black swan was seen in Australia, the imagination spanning over a period of thousands of years was destroyed. It took a single event to change the entire imaginative landscape. It was an event with very low probability but magnanimously high impact.

With his intellectual craft and genius, Taleb brought this metaphor to the financial world and became a devil’s advocate. He was one of the few financial traders (along with George Soros) who actually made money in the financial crisis of 2008 through his eccentric theory of black swan.

The idea behind this theory is very commonsensical, yet we fail to appreciate it. It rests on the pyramid of asymmetry of information. The world is changing and all evolving all the time. Hence, our knowledge of this world would always be limited. The most we could do is to reduce risks by playing safe.

Furthermore, one sure short strategy in this situation is not to do what everyone else is doing, and playing the devil’s advocate will bring dividends.

Zero probability

The pandemic is a classic black swan. Nobody foresaw this pandemic, although Taleb hinted at such a pandemic in his book. The probability of this event was almost zero, yet its impact is beyond imagination.

So, how should we do our investment in this world? Should we refrain from investment and fall prey to the analysis paralysis syndrome? No, Taleb did prescribe the medicine for such situations.

According to him, the best we could do in such situations is not to lose money that we have? He recommends investing 80-90% of your savings in fixed income instruments and keep them as safe as possible. The recommended investment products in this situation are treasury bills and Pakistan Investment Bonds (PIBs).

Now, these instruments are completely secure but the problem with them is that they do not offer any plausible return. They don’t even provide cover for inflation. So, the investment would lose value to inflation over time.

To cover this shortcoming, the investors are advised to invest the remaining 10-20% of their savings in high-risk investments ie stocks and real estate. This high-risk investment should be well diversified. It should be widespread and not concentrated in a single stock or real estate.

Sir John Templeton, one of the investors who have made most of the money from the stock market, used a similar strategy. At the time of Great Depression, he bought 100 shares of all companies the stock of which was worth a dollar or less on the New York Stock Exchange. There were 104 such shares and he made money on 100 of these shares and lost on four only.

Limited knowledge

The idea is that our information is limited but the possibility of a few of these high-risk investments going up is high. And a single winning bet would result in a sizeable increase in the value of the overall portfolio.

The black swan theory has brought forward an uncomfortable fact. It has highlighted the limitations of our knowledge and it has tarnished the illusion of control.

This theory is in line with the intellectual synthesis of Einstein’s theory of relativity. The theory says we fail to predict movements of electrons in the atom and hence this insight is a rebuttal to the theory of cause and effect.

The best in such a situation is to play safe and not to lose major chunk of money. However 10-20% of savings can be placed in a diversified high-risk portfolio so that overall return can be obtained.

The writer is an economics teacher and a treasury dealer

 

Published in The Express Tribune, June 22^nd, 2020.

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