Wednesday, February 20, 2008

The Black Swan (when pigs fly)

Overlooking the Grand Place in Brussels, Belgium is an elegant and famous restaurant named, La Maison du Cygne, the house of the swan. In this former guild hall of butchers, Karl Marx wrote his Communist Manifesto. I suspect he would have looked askance at the very non-socialist prices on today’s menu.
During my time living in Brussels I ate only once at that opulent eatery after being taken aback by the very Belgian habit of taking one’s dog to dinner. Laying at the feet of a diner about two feet away was a huge black Bouvier des Flanders, one of the larger and hairier hounds on the planet. I am not a fussy eater, but where I find a $100 entrĂ©e, I do not expect to find even the best behaved sheepdog.

In the investment community there is a recent book that is becoming the years “must read” titled, The Black Swan. Like the Bouvier dog in the Maison du Cygne, a Black Swan is a rare, unpredictable event of high impact. I didn’t expect it and I never ate there again. Who would have predicted weeks ago that the U.K. government would nationalize a bank? Who predicted 9/11? Even looking back into the near past many of the events that shape the markets have been precisely those NOT predicted by most highly honed minds.

In 1998, a group of Nobel Prize winners got together to form the hedge fund, Long Term Capital Partners. The premise of their tireless computational style was to invest huge amounts of capital for very small and very frequent certain returns. They called it picking up nickels. Lots of people gave lots of their money to the Noble laureates because what could be more certain? They had written the book on risk. One certain nickel at a time and they and their clients would become even richer. Then they nearly brought the global financial system to its knees when they failed. Russia defaulted, the Asian tigers collapsed and the entire thing unraveled. The book When Genius Failed, is important reading for people who manage money and a strong reminder that certainty is anything but.

More recently, the discovery that one could borrow money in Japan for essentially free and then leverage mortgage securities in the United States to the hilt was a sure thing. All over the world pensions, investors, banks and funds of every ilk stepped in, assured that the US national residential real estate market simply never goes down. Treasury Secretary Paulson went to China to convince the Chinese they should get more innovative with their investments. It’s the new sure thing. More recently the Chinese brought needed capital and ownership of a slice of Morgan Stanley when innovation went awry. Playing with loaded dice is a good idea, until somebody switches the dice and you keep on throwing.

If the most meaningful events are unpredictable how one does find profit and protection from these Black Swans that occur not only unexpectedly but fly against the voices of reason? You diversify, you diversify, and you diversify and you do not confuse diversification with variety.
When will real estate return as a meaningfully profitable asset class? No one knows, but it is an asset that should be in the portfolio, even if only minimally. Commodities, same story. Gold, agricultural products, emerging market debt. The list goes on. None should be taken off the radar screen.

What about bond allocations. As we bounce along at historically low interest rates with greater and greater evidence of inflation pressures lurking how should you invest in fixed income as a diversifier. Heavy bond allocations found typically for older investors could have serious consequences if not immunized against inflation, or if structured with higher risk in the search of higher returns.

With all eyes on the economic risks to growth and possible recession, could the next Black Swan be the other side of that coin, inflation? Inflation has historically been the greatest risk to investors and savers. Like high blood pressure it is silent and deadly. If in a year or two that sleeping giant is again making headlines as it has not in twenty-five years are you ready?
John Barnyak