Black Swan Survival Kit for Investors

From  Black: Swans and Crude by Liz Ann Saunders, her tips for investing in a sideways market:

  • Be diversified, especially now that asset-class correlations have begun to recede toward normal levels.
  • If you like to be opportunistic, keep some powder dry in highly liquid investments for both cash needs and some flexibility to take advantage of volatility.
  • Consider more frequent rebalancing if volatility reasserts itself, allowing you to sell into strength and buy into weakness.
  • Focus on your long-term goals and not short-term market dips so you’re less likely to fall prey to panic selling (or buying).
  • Review your portfolio and asset allocation to confirm your risk tolerance matches your financial goals.

These suggestions line up well with the Pragmatist risk attitude of Plural Rationalities.  That is good because the Pragmatists expect an Uncertain Environment, which is what we hear over and over that we are experiencing.

A Pragmatist will seek to diversify.  Not only will they want to diversify their risks as Ms. Saunders suggests as her very first suggestion, but they will also be diversifying their approach to risks.  Pragmatists will sometimes look to limit their losses with a Conservator style risk management approach, to aggressively pursue profits with a Maximizer style approach and even sometimes to look at risk vs reward in a Manager style approach.

Notice the interesting twist in her first point “now that asset-class correlations have begun to recede”.  You see that she is not a card carrying Pragmatist either.  She fundamentally believes that the world should return to an orderly state where correlations and volatilities are more stable.

Mathematically, that is how you can define the uncertain market of the times – variable volatility and variable correlations, variable drift.  A market model that cannot support trading.

The models for the other three environments might be:

  • Boom – positive drift, low and stable volatility, low and steady correlations.
  • Bust – negative drift, low volatility, high correlations.
  • Moderate – near zero drift, moderate but stable volatility, moderate but stable correlations.

In her second point, she tells how to be ready for when the environment goes back to Boom or Moderate – by taking the classical Pragmatist position of under invested.

But the Pragmatist approach to risk is not really a Black Swan survival approach.  If you really believe that a Black Swan event is coming, you would have the Conservator view of risk.  That would lead you to move to a much lower expected upside and also a much lower likelihood of failure of your portfolio.  In its purest form, the Conservator would accept almost no chance of total ruin.  In actual practice, most Conservator leaning firms will accept risks that might cause a failure of the firm, but only if they have long experience with those risks and feel that they have them totally under their control.

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