Saturday, April 18, 2015

Black swans and white swans - managed futures



Our thoughts about tail risk have been profoundly changed by the Nassim Taleb's concept of the black swan event; however, swans come in all colors and these other swans can be just as problematic. The concept of the Black Swan was focused on highly improbable events that could have a major market impact. The actual risk is a combination of the probability of the event times the cost. You may not be able to forecast improbably events, but you still have to protect against the potential high negative consequences of these events. The third part of a black swan which has been given less focus is the fact that we form stories to make these rare events seem more likely. We then become slaves of the past.

You don't know when black swans will occur, but you realize that they are possible. The protective action required by an investor is to diversify in order to minimize the costs of the negative event. The diversification can take two forms: diversification across markets and across strategies. A combination of both is most effective when the form of the negative event is unclear. With black swan events, the key risk management principle is diversification, but since markets may correlate during an extreme, strategy differences are valuable.

There are also grey swan and white swan events. Grey swans are those that are probable or at least measurable and will have a strong impact. White swan events are those that are often certain or likely to occur and whose impact are measurable. While black swans need diversification as protection, grey and white swans can be exploitable. These are events that can cause harm because of poor judgement and errors in thinking. The harm is not reacting to what is measurable or likely.

There is shame in actually being bitten by white or grey swan events because they could be managed. We lose because of our own conceit. The 2008 market events may not be considered a black swan event because there were enough signs that there was potential for an impending problem.

For swans of other colors, there are strategies that can be effective at exploiting the opportunities. Following trends is an easy way to exploit non-black swans. Trading on historical risk premia is another simple approach. You don't have to forecast the event. Rather quick response before others may be a middle ground that can help take advantage of more likely events.

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