A problem for investors is that the perception of the potential for black swans to occur varies over time. Periods of relative stability can lead to investors becoming less risk averse and more confident in their ability to estimate returns and the potential distribution of the returns.
Thus, they understate the potential for black swans. And when black swans do occur, we see shocks to the uncertainty premium in stock prices. Panic often sets in, causing even well-thought-out financial plans to end up in the trash heap of emotions.
It’s important for investors to understand that, at best, we can make reasonable estimates regarding expected returns and the potential distribution of outcomes different from the mean. We cannot know the potential distribution, or even the odds. In other words, investing is always about dealing with uncertainty as opposed to risk.
Uncertainty Vs. Risk
With risk, we either know the odds, like at the roulette wheel, or we can make confident estimates, like with mortality tables. With that understanding, it’s important that investors not assume more risk than they have the ability, willingness or need to take.
Investors and their advisors should build into investment plans specific actions to be taken (what I refer to as a plan B) if a black swan event appears and it looks likely to cause that plan to fail. Battles are often won in the preparatory stage, not on the battlefield itself.
For investors interested in building a portfolio that addresses the risk of black swans in an efficient manner, my colleague Kevin Grogan and I discuss a strategy we recommend you consider in our book, “Reducing the Risk of Black Swans.”
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.