How to take advantage of an impending crash- Part 2: understanding a subtlety

June 19th, 2007

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In our previous article, How to take advantage of an impending crash- Part 1: the risky way, we used a bad strategy as a negative example to show you how NOT to go about seeking to profit from the coming Great Crash III.

In the days to come, we will show you some better strategies. Before you can appreciate why that previous strategy (the negative example) is a bad one and why the ones that we are going to show you are safer, you have to make sure that you understand a subtlety. It is easy to fail to see it, which can be detrimental to your wealth. So, here it goes…

If someone asks us, ?Is the market going to go up or is it going to come down?? a simple and direct answer of ?Up? or ?Down? will be too simplistic to reveal a subtlety. Back in How dangerous are credit derivatives?, we quoted a document from the Reserve Bank of Australia (RBA):

… It is possible that the very developments that have contributed to the increased robustness of the financial system to most events, through the wider dispersion of risk, could actually amplify the disruption following a serious shock….

This implies two things:

  1. In today?s market, the probability of the market going up is higher than the probability of it coming down. Hence, it is rightly called a bull market.
  2. But should it come down (which is unlikely), it can collapse at extremely great speed and magnitude.

Hence, the stronger and longer this uptrend continues, the greater in magnitude and speed (as in volatility, not timing) the Great Crash III will be. Hence, the coming Great Crash III is a Black Swan event?an improbable but colossal impact event. Note: For those who are interested in the subject of Black Swan, we highly recommend Nassim Nicholas Taleb?s book: The Black Swan: The Impact of the Highly Improbable.

The problem with Black Swans is that much of the world?s financial models have blind spots with regards to it (see Expect the unexpected with risk models that can?t anticipate the future). For us, as investors, it will be a folly to assume away Black Swans.