Posts Tagged ‘Black Swan’

Epistemic arrogance, running through traffic lights & Black Swans

Thursday, November 25th, 2010

Today, we received an email from one of our readers. After reading Failure to understand Black Swan leads to fallacious thinking, this is what he thought:

I liked your use of the term “Epistemic arrogance”. Recently I was driving and almost ran straight through a red light at a pedestrian crossing and I was trying to think how I could have been so reckless. I mean I am a great driver (?) and I had been down that road numerous times, yet I still almost managed to run down an almost-unfortunate couple. Sure the red light is in a seemingly random position, and the green light at the intersection 50m down the road can cause very slight confusion, but a red light is a red light.

Its then I theorised the issue. If it was my first time driving, or my first time driving down this road, there would be no way that I would have missed this red light. I would watch out for all hazards because I know that I don’t know. An arrogant driver on the other hand, as I was, thinking they know the lay of the land, can get into strife when the unexpected (in their mind) pops up.

Its this “epistemic arrogance” which leads the learned to cause crashes and accidents… I’m sure there are many top minds in the world who fail to look beyond their view… Learning from one’s mistakes is a great way to improve your management of risk!

This is a very great point. And by the way, it is Nassim Nicholas Taleb that came up with the term “”epistemic arrogance.”

We also have an example that is relevant to investing. Marc Faber once mentioned that the financial valuation of asset prices severely underestimate the possibility of geo-political Black Swans. The recent North Korean artillery pot-shots at their southern neighbour is a case in point. The US and South Koreans are planning to hold military exercises this coming Sunday in response to North Korea’s provocation. The North Korean had already warned repeatedly that they will be provoked with such actions, especially when they are happening so closely to the border. With a juvenile rookie dictator-in-waiting probably calling the shots in Pyongyang, we wonder at the wisdom of the American and South Koreans.

The Korean peninsular is just one example of geo-political Black Swans. We can also include Afghanistan, Lebanon, Iran, Pakistan as well.

Shhhh! Don’t mention the government debt

Thursday, December 17th, 2009

In the infamous September 11 terrorist attack, everyone, including the authorities, are caught completely by surprise. Who would have thought that even box cutters would be used to hijack airliners? Even the training given to instruct pilots in the event of hijacks were outdated- previously pilots were instructed to submit to hijackers. But on September 11, this piece of instruction proved to be a big fatal mistake.

In view of the lessons learnt from September 11, authorities have changed the procedures, training and instructions to ensure that a repeat will not happen again. But do you know what the problem is? The the next successful terrorist attack is likely to be another left-field event in which the current procedures, training and instructions are not designed to prevent. In other words, the next successful terrorist attack will be a Black Swan event.

Worse still, the absence of successful terrorist attacks is not evidence that the authorities are successful in combating terrorism. As we said before in Mental pitfall: Lazy Induction, the absence of evidence is not evidence of absence. For all we know, there could be a terrorist plot brewing right now that the authorities could not detect. The only evidence of such lack of detection is a successful terrorist attack. That is, if terrorists are to strike from the left field, it can only mean that the authorities are not successful in detecting their plot in the first place.

Now, back in the world of finance. The Panic of 2008 was indeed a trauma. In response to that, regulatory requirements, risk management techniques and financial processes are overhauled to either prevent or limit the damage of a repeat. Like the authorities after September 11, our guess is that the financial system is probably getting more and more prepared against a repeat of another 2008-style shock. Indeed, many businesses have sprung up to help measure and protect against such risks, post-2008.

But do you know what the problem is? The absence of such shocks does not imply that the authorities are successful in girding the financial system. All we need is another financial shock from the left-field to prove that the authorities are not successful in detecting it when it is brewing in the first place.

You know what is worrying? From this news article, Barnaby Joyce, Australia’s opposition finance spokesman was blasted by the Prime Minister Kevin Rudd for suggesting a debate for a contingency plan against the United States government debt default. As this article reported,

Senator Joyce told Fairfax Media he did not mean to alarm the public but there needed to be a debate about Australia’s ”contingency plan” for a sovereign debt default by the US or even by a local state government.

”How would Australia go forward in a position where the dynamics of the global economy are all changed,” he said on ABC Radio today.

We think Barnaby Joyce is right in this instance (note: the word “default” is a loaded word. It does not necessarily mean a literal repudiation of US government against its debt- it can mean repudiation in the metaphorical sense of “printing” money to inflate the debt. The purpose of such a debate is to trash out such subtleties). As we wrote in What will be the next market panic?, our suspicion is that the next financial shock will have something to do with currencies.

Joyce’s idea of contingency planning is the whole point behind what we wrote in Failure to understand Black Swan leads to fallacious thinking,

First, as contrarians, we are not in the business of prediction. Rather, we prepare for Black Swans. To give yourself an idea why such preparation is important, ask yourself this question: Why do parachutists pack a second reserve parachute? Since the statistical probability of a parachute failure is extremely low, does that mean we should completely ignore such a possibility (of the primary parachute not opening)? Therefore, those people who fallaciously believe that preparing for Black Swans is ?predicting? is like believing that the parachutist who packs a reserve parachute is ?predicting? that his/her primary parachute will fail.

So, what is Kevin Rudd’s response to such a suggestion? That’s what was reported in the papers,

Mr Rudd dismissed the senator’s comments, describing them as ”not responsible economic policy”.

He accused Senator Joyce of engaging in a series of thought bubbles that were unbecoming of a senior economics spokesman from either government or opposition.

Barnaby Joyce was labelled as an “extremist” for even suggesting that Australia needs a contingency plan. Is there anything wrong with planning for a contingency? The military always do that because they always have to be prepared. Disaster planning is all about planning for contingency. Hospital emergency departments are in the work of contingency planning.

Our stand is that we need a contingency plan. Having a contingency plan is not predicting that it will happen. Without a contingency plan, we will be like a parachutist jumping without a backup parachute. Kevin Rudd’s response gives us the impression that Australia should be jumping without a backup parachute. That’s because, according to him, entertaining the thought that there is always the slim chance that the primary parachute may fail, is “irresponsible” and “unbecoming.”

If this is real stand of the government, than we can be sure that the government will not “see” a brewing crisis.

Which asset class for the next financial markets panic?

Thursday, November 19th, 2009

If you still have lots of spare bullets in your investing arsenal (i.e. lots of spare cash free for investment), it is very tempting to use them up in fear of missing out on further rally. But if your over-riding concern is to preserve your capital in real terms, this is a very difficult market to invest.

For value investors, the proportion of undervalued stocks is decreasing as the stock market continues to trend upwards. Recently, a highly prominent banking analyst, Meredith Whitney has turned the most bearish for over a year:

If you are a technical analyst, you will see that stocks are at an extremely overbought territory. According to the Market Club Trade Triangle, the trend for the S&P500 is still at a very strong up-trend. Statistically, this is the point whereby the risk of a major correction is very high. The previous one is too mild to be counted as a correction (see Aborted correction?).

In terms of property prices, Hong Kong luxury apartments are bubbling away. Base metal prices (especially copper) have recovered strongly from the Panic of 2008. Chinese fly-by-night bidders are reportedly appearing in Australian residential property auctions. The Aussie dollar is approaching parity with the US dollar.

It looks very much like bubbly 2007 all over again.

We are not prepared to use our spare bullets in such a bubbly environment. But if you are based in Australia, we do see a silver lining. The price for gold is rising rapidly in terms of US dollars. But in terms of Aussie dollar, it has hardly risen. In fact, even though it is at a record high in USD, it is down 20% from the March 2009 record high in AUD.

Let’s say there’s going to be a short covering in the USD (see Currency crisis ahead? Part 1- Potential short squeeze on the US dollar) due to some deflationary threat. Chances are, gold price (along with commodity and stock prices) in USD will come down. At the same time, stocks worldwide will be down as well, along with the depreciation of the AUD. A falling gold price in USD will be mitigated by the depreciation of the AUD. As a result, Australian holders of gold may not suffer as badly as gold prices in AUD may not fall as much, perhaps even rising should the AUD depreciates very rapidly.

But even in this scenario, there will be a limit to a fall in gold price in USD. As we wrote before in Has gold moved on to a secular shift?, central bankers have crossed the line from being a collective seller of gold to a collective buyer of gold (e.g. Mauritius central bank is now buying gold). The Chinese will see any temporary strengthening of the USD as an opportunity to get rid of them to buy gold.

On the other hand, if there’s going to be a currency crisis, our guess is that gold prices will soar in USD. If the AUD depreciates against the USD as well, we will get soaring gold prices in AUD.

Our speculative view is that (and this is NOT financial advice) if you want to be on the other side of the trade in the next panic (i.e. on the winning side, not on the panicking herd’s side), the currently high AUD may prove to be a stroke of good luck for Australian investors because it gives them a wonderful opportunity to buy gold on the cheap. Not only that, if you are planning to buy physical gold, it helps that Australia is a gold producing nation (you may want to read our book, How to buy and invest in physical gold and silver bullion).

Only time will tell whether this idea will be a winning Black Swan trade.

How should you go about investing in silver?

Friday, July 10th, 2009

After having read our series of articles on silver, you may wonder how you should go about investing in silver. Knowing about the potential for silver prices to sky-rocket is one thing. Benefiting from it is another. Today, we will go into that.

First, as you may already have known by now, when we used the word “silver,” we mean physical silver bullion. Financial assets disguised as silver (e.g. silver ETF, silver certificate, etc), at the end of the day, are just paper assets- they are not the real thing. This is especially true for silver ETFs. For example, in the SEC filings for the iShares Silver Trust, it has clauses that say something like “the liquidity of the iShares may decline and price of the price of the iShares may fluctuate independently of the price of silver and may fall” and the “iShares are intended to constitute a simple and cost-effective means of making an investment similar to an investment in silver.” Silver paper assets are great for trading silver, but you may not want them as long-term investments.

Next, if you are very sure that silver prices will roar mightily in the future, should you pour all your life savings acquiring it?

To answer this question you have to understand that investing in silver falls under the Black Swan investment category. For those who haven’t already, we urge that you read Failure to understand Black Swan leads to fallacious thinking first. We encounter frequent and stubborn misunderstanding of the concepts of Black Swan. As we wrote in that article,

As we talk to more and more people, we encounter a very frequent lack of understanding of Black Swans (for those who wants to learn more about Black Swans in detail, we recommend this book: The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb). As a result, many people have this erroneous belief that contrarians are predictors of gloom and doom. The more entrenched this lack of understanding (of Black Swans) is, the deeper the fallacy one will fall into. This lack of understanding will degrade the quality of one?s thinking, which can translate to severe financial loss when investing.

Today, we will again attack the stubborn entrenchment of this conception black hole.

Many people have heard of and read Nassim Nicholas Taleb’s book, The Black Swan: The Impact of the Highly Improbable. But not many really understand it properly. It took us a few re-readings of Taleb’s winding meandering prose to fully grasp the concept of Black Swans. If you have not read Failure to understand Black Swan leads to fallacious thinking, please read that first…

… now that you have read that article, you should be able to appreciate this fact: when we talk about the potential of silver prices to explode, we are not making a ‘prediction’ of the future. As we wrote in that article, a parachutist packing a backup parachute is not making the ‘prediction’ that his primary parachute will fail. The backup parachute is there to ensure his survival should his primary parachute fail, which is unlikely based on statistical probability. In the same vein, based on statistical probability, it is improbable that the silver fuses (that we wrote before) will light up because it had not happened before. But should the fuses light up, you can be sure that the price impact will be massive.

Therefore, to profit from Black Swan investing, you have to implement an asymmetric pay-off strategy. This idea is very similar to the one that we wrote in the guide, How to profit from a stock market crash?. As we wrote in this article in that guide,

The basic idea behind the asymmetric payoff strategy is simple. First, you structure your bet in the market such that if you lose the bet, your loss is very tiny, but if you win, your gain is very massive. Next, you bet that the market will crash within a specific period of time. If you lose that bet, place another bet for the next period of time. You do this repeatedly until the day of the Black Swan event when your profit overwhelmingly overshadows your accumulated small losses.

Obviously, the disadvantage of this strategy is that it requires fortitude to absorb small losses indefinitely while waiting for a highly rewarding final vindication in the end.

In the same vein, investing in silver means accumulating it slowly, bit by bit and patiently waiting for the silver fuse day. Because you are investing one tiny bit at a time, it should not have any material financial impact on your day-to-day life. In other words, you are investing with your ‘loose change.’

Maybe the day of silver fuse will never come. In that case, the most you will lose are your ‘loose change.’ But should the day of silver fuse arrives, your ‘loose change’ is going to be worth many times over, maybe even a fortune.

Remember, do not bet a large chunk of your life savings into the silver fuse story.

Two major Black Swans looming ahead for the global economy

Sunday, May 3rd, 2009

When you look at today’s global market rally, it seems that the bottom of the global financial crisis has already reached. In reality, the global economy had not improved by many measures. It had merely become less bad, compared to the precipitous decline in the second half of 2008. Financial markets tend to anticipate the future by recovering before the actual recovery of the real economy. That curious phenomenon should not be interpreted as foresight. Instead, the market has the habit of jumping the gun- the presence of bear market rallies is a testament of that fact.

This bottoming makes the market more vulnerable to Black Swans. Currently, we see two Black Swans that the financial market has not yet factored in. This is probably the time to put in their contingency plans for adverse reactions from the market (e.g. hedging, stop-losses, etc), especially for traders.

The first one is very well-known- the probability of a swine flu pandemic. In the 1918 Spanish Flu pandemic, killed anywhere from 20 to 100 million people. Half the world’s population was sick. Nobody knows how this swine flu will turn out. Should the virus reach Asia, the crowded and unsanitary conditions make it an ideal ground for further mutation and proliferation. Medical experts pointed out that the world is overdue for a pandemic. Since we have more faith in medical experts than in financial market pundits, our belief that this time round, the death toll may not be as bad as the Spanish Flu pandemic. Whatever the death toll of this potential pandemic, we believe the bulk of the economic damage will be caused by disruptions on daily life and the human fear factor.

The second Black Swan has received less prominence from the media- the situation in Pakistan. Last month, the Taliban had captured the Buner district in Pakistan (not Afghanistan!), which is merely a few hours drive from Islamabad, the national capital. Other reports revealed that the Taliban had advanced to within 96 km of Islamabad. This event is part of the bigger picture of the Taliban’s consolidation of control of north-western Pakistan. With the Pakistani army larger than the US army, the audacity of the Taliban shows how internally weak the Pakistani government is. The situation is so bad that the US Army’s General David Petraeus commented that “there may be just two weeks left to prevent the Taliban from overthrowing Pakistan’s Government” (see “Two weeks to save Pakistan”).

This is a very worrying situation because Pakistan is a nuclear-armed nation. The control of Pakistan’s nuclear weapons by the Taliban is a very dire scenario. Not only that, such an event can potentially fracture the huge Pakistani army (the Pakistani population is fractured too). India will be very worried because they have their own insurgency to fight in the Kashmir region and are always at odds with Pakistan since independence- the Taliban will be a much less rational and predictable enemy. China shares a very long border with Pakistan and will be very worried too. The US and its NATO allies, already having difficulty containing the Taliban in Afghanistan, may lose Afghanistan to them. The Taliban, who shares the same Wahabi school of the Sunni Islamic  fundamentalism, is at loggerheads with the designs of the Iranians for influence in the region. Iran almost fought a border war with the Afghan Taliban a few years ago. Worse still, the Taliban is allied with Al-Qaeda, which will surely turn Pakistan into a haven for terrorists.

Gold will thrive in these two Black Swan conditions. But it is something no one will welcome.

Australian government’s contingent liability to exceed AU$1 trillion

Sunday, March 29th, 2009

In October last year, the Australian government splashed its AAA rating to bank deposits (including the deposits of credit unions and building societies) and wholesale bank debt. Last week, there’s news that they’re splashing their AAA rating to state government’s debt.

This is akin to parents giving their children supplementary credit cards unsupervised. Indeed, a particular child named “Macquarie Bank” used the Australian government’s ‘supplementary credit card’ on a debt-gouging spree overseas.

Altogether, the Australian government is projected to have a contingent liability of more than AU$1 trillion, which is almost the entire GDP of Australia (compare that to the last budget surplus of around a puny $20 billion). The nature of contingent liability is that it is not really a liability- it is a liability that arises if certain events arises. This may not be a problem if debt defaults follow a nice Bell curve. But in the real world, is this a realistic assumption? As we said before in How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud,

Bell curve simply means that things revert to the mean in the long run. Also, as you deviate further and further away from the mean, the probability of that deviation will drop faster and faster. Therefore, by the definition of the Bell curve, extreme deviation from the mean is extremely unlikely, so much so that it is close to impossible.

Very unfortunately, it is obvious even from just a casual observation of the world around you, the universe is often not ruled by the Bell curve. Extreme events occur frequently, which by definition of the Bell curve is close to impossibility.

Our feeling is that a huge unquantifiable percentage of all these debts will have a high degree of correlation with each other. Another way to look at this is that what makes a particular debt go bad is what makes the others to go bad as well. This means these debts will not follow a Bell curve. If you look at Australia’s money supply graph in Australian money supply growth in September 2008, you can appreciate the level of leverage in Australia’s financial system. What if Australia faces a huge macroeconomic margin call? Should that happen, there goes the Bell curve.

We shudder to think how the Australian government’s sovereign debt rating will fare when the day of testing comes. With so much contingent liability on their shoulders, we believe the Australian government is setting itself up to be run over by a Black Swan. For those who are new to Black Swans, we recommend Failure to understand Black Swan leads to fallacious thinking.

What if the Israelis strike Iran?

Monday, January 22nd, 2007

Today, we will look at a Middle-Eastern geopolitical scenario that we believe can possibly happen?an Israeli strike on Iran. However, the likelihood of it is impossible to quantify. Nevertheless, it is our firm conviction that investors will do better to be prepared for it (even though it may be an arguably improbable event) than completely ignore it because its effects will have a massive impact on their portfolio.

It is interesting to note that ING, one of the world?s largest investment banks, had came up with an internal report to analyse the possibility and effects of this scenario. It is certainly even more interesting to note that they had come up with a possible timeframe (February to March 2007) for such an extraordinary event. For the sake of today?s discussion, we will assume that the report is genuine. We encourage you to read this report with an open mind. Please note that ING is not predicting that this scenario will happen?rather, they are saying that this scenario is possible and that should it happen, what the impact on the financial markets will be.

As we said in How the folks in the finance industry got the idea of ?risk? wrong!, this is an example of a ?fat-tail? scenario in which by definition of the normal distribution curve assumption (which we sees it to be an academic assumption that does not fully reflect reality), is so highly improbable that it borders towards the realm of impossibility. Hence, we believe that this scenario is a risk that is not fully appreciated and ?priced in? by the financial markets. Thus, there are some in the financial industry who have the mind-set that since it is impossible to quantify the probability of such a scenario, it should be ignored.

As contrarian investors, we believe that it is unwise to adopt such a mind-set. Firstly, though the probability of an Israeli strike is impossible to quantify, its impact on our investments will be extremely severe. Since the financial markets will be taken by surprise by such an event, we can be assured that it will trigger a massive shift of capital from one asset class to another. (No prize for guessing which asset class we prefer!) Thus, a high impact but low probability event is something which should not be completely ignored. Secondly, though we cannot do everything to hedge every aspect of our lives if such a scenario eventuates, we certainly can do something now to hedge ourselves in terms of our investments. Doing something now is certainly better than doing absolutely nothing.

Assuming that a military strike is being seriously considered, what is the most logical course of actions to take?

Definitely, military training is the first step. Indeed, there are rumours of it in this news report. Secondly, preparation for Iranian retaliation will have to undertaken. Already, there are unusually significant US navel and marines deployment in the region. The recent deployment of 20,000 more US troops in Iraq may perhaps be not what it seems. Thirdly, oil will have to be stockpiled because there is no doubt that oil supplies will be disrupted. The recent fall in oil prices in response to reports of rising oil inventories may be the result of such accumulation. Lastly, it is certainly interesting to note the Saudis? nonchalance about the recent falls in oil prices?they declined to agree on another OPEC oil production cut to prop up the price of oil. We do know that the Iranian economy is not in good shape and they have heavy reliance on oil revenues. The Saudis (who are Sunni Muslims) have the motivation to undermine the Iranians (who are Shias Muslims), who looks to be taking steps towards dominating the Middle East.

Are we implying that there will be military action? Again, we stress that we don?t know the answer. We believe it is possible. But we would not want to place our heads on the chopping board by making geopolitical predictions.

Is an Israeli strike on Iran so improbable and ?mad? that only those who belong to the conspiracy theorists fringe groups will even bother to consider it?

To answer this question, we have to consider this: As investors, since we may often see things through an economic prism, we can make the mistake of seeing certain actions as ?irrational? when it is completely rational in the context of the overall big picture. In this case, even though an Israeli military strike on Iran is ?crazy? in our eyes, it may be perfectly rational in the context of national survival. The Israelis may see that since the Iranian nuclear issue is such a serious threat to their national survival, if the world economy has to be damned to eliminate this threat, so be it!

In conclusion, our advice is: Be prepared.