by Henry Oliner

The ‘black swan’ (explained in Nassim Taleb’s book by that name) is that rare statistical outcome that lies far outside the realm of prediction. But if the particular event that is rare is severe and threatens the existence of the system it can only be ignored at great peril.

We will often take great pains to avoid a severe outcome even if the chances are small, if that outcome is so emotional or fearful that we may obsess on it more than is merited by mere statistical probability. But more often in the financial world we will take bigger risks than we realize by underestimating the chance or the cost of a black swan event, such as the recent housing collapse.

Even Phd Nobel prize winning economists achieved the financial disaster at Long Term Capital by leveraging a model that ignored the “black swan” event.

Frank Raines the reigning head of Fannie Mae during its period of dangerous growth addressed Congress and stated that the risk of a housing collapse was so low that his mortgages had much less risk that any other comparable investment. We are now paying an enormous cost for his misjudgment and Congress’s acquiescence in spite of numerous warnings to the risk.

We tend to greatly underestimate the role of probability in our lives. We prefer the delusion of control.

Yet we can be equally deluded by the chance repetition of a random event. In a large enough sample the chance of flipping a coin 14 times in a row and coming up heads every time is much larger than in a smaller sample group.

If we flip a coin 100 times the odds of a 14 flip repetition is small, but if we flip the coin 5,432,586,187 times the chance a 14 series flip of heads is much higher.

So if a money manager beats the Dow for 14 consecutive years what are the odds it was just luck?

In a report of one such money manager CNN said that the odds of such a record being just chance was one in 372,529.

But Leonard Mlodinow points out in “The Drunkard’s Walk” that while that number may be accurate in determining the odds of a specific manager achieving this performance based on chance, it is the wrong question.

The odds that some manager out of the thousands in the business at some time in the last 40 years could beat the Dow for 14 consecutive years out of just chance is actually 75%. He calls it the illusion of patterns.

While the chance of the next flip of the coin will always be 50/50, there is a regression to the mean that explains why most of the best performers from the last 5 years are not the best for the next 5 years. That warning on your mutual fund prospectus is is more than a warning; it is a likelihood.

So how does one manage for random events? Understand that there is much that we do not know, and there is always that which we do not know we don’t know. Leverage, especially for an illiquid asset such as real estate carries more risk than one with a ready market. Lack of diversification carries enormous risk.

Certainty is deadly and its antidote is humility.

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