Exploiting black swans

One of the main reasons why asset managers lost so much money in this crisis was because their risk metrics in most cases failed to account for extreme events, and in those few cases where they did, the probability of occurrence they attached to it was too small to have any significance on their strategy (i.e. the gaussian tails where way too thin and therefore distorted reality).

If the standardized risk measures adopted by our industry fail to take appropriate account of extreme events and if black swan events occur more frequently than expected, their destructive impact should come as no surprise. The challenge remains, however, that even if we are aware and accept that black swan events do occur, how do we integrate them into our strategy? A good analogy may be drawn from past military strategy with the example of the "Maginot" line whereby a series of concrete fortifications were built by the French along its border with Germany during the inter war period. The idea was to dissuade Germany from attacking or invading France, and although in the end it did work, it did not stops the Germans from invading France as they simply circumvented the line by invading Belgium first and then proceeding to cross the border into France. The example shows us that planning for an extreme event such as an invasion does not guarantee success. In portfolio strategy, it may not suffice to protect against large moves in the market. In an environment of great uncertainty, we need to take into account other extreme events such as hyperinflation, no matter how unlikely the probability of occurrence may be.