The Black Swan and The Age of Insecurity

London, UK - 24th November 2008, 16:45 GMT

Dear ATCA Open & Philanthropia Friends

[Please note that the views presented by individual contributors are not necessarily representative of the views of ATCA, which is neutral. ATCA conducts collective Socratic dialogue on global opportunities and threats.]

The following interview with the Managing Editor, James Rutter, has just been published as the cover story in the Dow Jones Wealth Bulletin within The Wall Street Journal Europe.

The black swan survival guide

For a man who spends his waking hours pondering the inherent insecurity of 21st century living, DK Matai seems remarkably relaxed. Small, meticulously dressed and impeccably mannered, he perches on a sofa surveying the skyline of London’s Canary Wharf, the former home of collapsed US investment banks Lehman Brothers and Bear Stearns, and explains in measured, precisely pronounced sentences that the financial crisis is only the beginning of our problems.

“The stock market is an indication of instability from a geo-political standpoint and from a financial asset standpoint,” Matai says. “We are encountering the instability inherent in not being able to plan for the future.”

As founder of the Asymmetric Threats Contingency Alliance, a philanthropic network of 5,000 politicians, academics and business leaders, Matai spends his time thinking about the risks and opportunities the rest of us seldom contemplate: how the rise of nanotechnology might affect the environment, what genetic experiments could mean for mankind, how humanity might exist in a future dominated by mass robotics.

It may sound like science fiction but consider how rapidly technology has changed our lives and the planet in the past two decades. “We are converging on a bio, info, nano revolution,” says Matai matter-of-factly. “This creates unknown unknowns. These are the black swans.”

UNCERTAIN TIMES The black swan has become an emblem for these uncertain times. The phrase has entered common use thanks to the best-selling book of the same name published last year by Nassim Nicholas Taleb, a statistician, would-be philosopher and former options trader. In Taleb’s words, a black swan refers to an event “outside the realm of our expectations, because nothing in the past can convincingly point to its possibility.” It was understood that all swans were white, because only white birds had ever been seen, until a black swan was discovered in Australia.

Matai uses the term “asymmetric risk” to convey the same idea as a black swan – asymmetric because such risks fall outside the realms of “normal” assessments, the bell-shaped distribution of events that is the foundation of modern risk management.

Thierry Malleret, managing partner of Geneva-based Rainbow Insight, an advisory boutique for private clients, says: “As human beings we love stability and hate uncertainty. We like bell-curve distributions, which assume independence among components of a system, because they are predictable. Black swans don’t respond to normal, bell-curve distributions but to power-law distributions which are unpredictable, so we hate them.

Power-law distributions are found in most human, non-linear systems, where tens of millions of occurrences have no appreciable impact beyond their immediate sphere of influence while a small number of others, usually in unpredictable conjunctions, change almost everything.” Malleret is a member of Matai’s Asymmetric Threats Contingency Alliance and has published a book on how businesses might meet the challenge of black swans.

The alliance has a list of the top 10 asymmetric risks it believes we face, including pandemics, transhumanism, resource shortages and systemic failures in financial markets.

Experience tells us that these events should be so rare that they are hardly worth considering, let alone worrying about. Yet they are happening with increasing and alarming frequency. We face a 21st century in which black swans are likely to arrive in flocks.

Globalisation is partly to blame. “The global economy is like a spider’s web, with everything interwoven,” says Matai. During periods of calm, this gives an appearance of greater stability, which only serves to lull us into a false sense of security increasing the potential for devastating black swan events – exemplified by the speed with which the US sub-prime lending crunch has become a global financial crisis.

“Global swans will happen more and more because we live in a world where risks, like goods and ideas, travel very fast and are highly contagious, where little causes have big eff ects, and where changes happen dramatically, not gradually,” says Malleret. “The current debacle exhibits these three features. It is a black swan and we are just at the beginning of our surprises.”

PEACE OF MIND

But what does this mean for wealth management? In the age of insecurity, dive-bombed by black swans, people – at least in the developed world – will invariably feel less wealthy regardless of whether they are actually poorer. “All these developments impact on our peace of mind,” says Matai. “And what is wealth if not peace of mind?”

He once spent an afternoon trying to work out with a group of Swiss private bankers what attracted very wealthy individuals to their institutions. Achieving peace of mind, was the simple conclusion. But in recent years, on the back of economic stability and remarkable asset returns, the focus of wealth management shifted to taking risk and making money. Where previously people made a fortune and then looked to preserve it, instead they wanted to make more money from their money. Recognition of black swans may prompt a reversal, suggests Matai. “I expect a philosophical change in wealth management. The desire to grow wealth will be much less pronounced; instead it will be about the desire to safeguard wealth.”

Unfortunately, in a world bombarded by asymmetric risks, preserving capital is no longer straightforward because accepted models – spreading bets, building efficient portfolios – cease to work.

Taleb’s suggestion is to put 90% of your assets into the most secure government bonds (perhaps inflation-protected might be sensible), and invest the remainder in a wide array of high-risk ventures that provide exposure to the sorts of positive black swans that can generate extreme returns.

There are, of course, numerous obstacles to applying this in reality, the biggest of which is the psychological hurdle of throwing out whatever you have learned about portfolio diversification and trade-offs between risk and reward.

Philip Watson, head of investment analysis and advice at Citi Private Bank, is not convinced by Taleb’s suggested portfolio. “It is very risk averse and will severely limit potential upside,” he says. “The idea of not putting your eggs in one basket still makes sense, and certainly, in an age of insecurity, diversifying your counterparty and market risk is advisable.”

This is perfectly sensible advice within a conventional investment framework, established over many years. But accepting black swans takes you beyond the confines of the conventional to an uncomfortable hinterland in which you start to doubt hitherto basic beliefs.

Malleret says a growing number of wealthy families are moving to portfolios not dissimilar to Taleb’s. “They are starting to question all the hypotheses that underpin conventional asset allocation.” These are based on probabilistic risk assessments that do not work in a black swan world.

One of Taleb’s favourite illustrations of a basic black swan event is a turkey that is fed every day for over 1,000 days. Everything in the turkey’s experience points to the certainty it will be fed again on day 1,001. Instead, its neck is wrung. This basic assertion is that humans in general are like the turkey. We extrapolate from the past to the future without a second thought. When it comes to investment we are even more gullible. How many fund managers can point to 1,000 straight days of positive returns?

UNCOMFORTABLE QUESTIONS

More black swans mean a less predictable future. “The world of tomorrow will be less risky than today but much more uncertain,” says Malleret. “This disconnect between probabilistic risk and non-probabilistic uncertainty makes us very uncomfortable. More uncertainty means we should expect the unexpected, build resilience and be prepared. The exceptional investors are the ones good at joining the dots and making improbable connections.”

Your wealth manager is likely to be managing risk but ignoring uncertainty. And if you care about wealth preservation, that should be worrying. “If an individual is able to walk away from this debacle three years from now and say they didn’t lose anything that will be a great outcome,” says Matai.

Unfortunately, in the realm of the black swan there are no easy answers and plenty of uncomfortable questions. It may be time to start asking them.

[ENDS]

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