Japan Reveals Hidden Risks for Investors
03/17/2011 2:00 pm EST
In less than five minutes, world markets were literally shaken to their knees once again by a “black swan,” Nassim Nicholas Taleb’s term for an unexpected and disruptive event. But we’ve had quite a few of these lately. Are these rare birds growing more common, and what can you do about them? MoneyShow.com editor-at-large Howard R. Gold explains.
It hasn’t been the greatest week for investors.
Global markets, already unnerved by rising oil prices and the looming threat of inflation, were sent reeling by the massive 9.0-rated earthquake and tsunami that hit Japan—and then the alarming accident at the Fukushima Daiichi nuclear power plant, 140 miles northeast of Tokyo.
As I write this, explosions have damaged four buildings at the site, and fears were mounting about core meltdowns and the dangers of radiation release.
The S&P 500 index is now off about 6.5% from its recent high a month ago, and other, more volatile indexes are down more. Japan’s Nikkei-225 has lost nearly 20% of its value.
Once again, investors have been thrown for a loop by events that seemingly came out of nowhere. The black swan is back, and this time she’s radioactive.
A black swan, popularized by Nassim Nicholas Taleb in his 2007 book of the same name, is a rare, unexpected, disruptive event. It has three attributes.
“First, it is an outlier, as it lies outside the realm of regular expectations,” Taleb wrote. “Second, it carries an extreme impact. Third…human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.”
A Whole Herd of Dangerous Swans
By Taleb’s definition, I can think of four major black-swan events over the past 15 years:
- the 1997-98 Asian currency crisis
- the September 11, 2001 terrorist attacks
- the housing crash and financial crisis
- and this.
(I don’t include Hurricane Katrina and the Deepwater Horizon oil spill because they primarily affected the Gulf of Mexico, while the dot.com boom and bust was a bubble within the market itself, not a “real-world” event.)
Taleb despised the academic orthodoxy of contemporary economics and finance, which he said focus almost exclusively on the most likely outcomes of economic and investment decisions—the big round bell of the bell curve.
Turning probability theory on its head, Taleb argued that the unlikely events on the far end of the bell curve will hurt you most, precisely because they’re unexpected and because “cumulatively, their impact is so dramatic.”
It all adds up to more uncertainty, or risk—which in many investors’ minds has been growing exponentially in recent years.
But Was This Really Such a Surprise?
Any natural disaster is by definition unexpected—on the day it occurs. But Japan is in an active seismic zone, with a big earthquake as recently as 1995. The island nation sits near four major tectonic plates, which makes it more susceptible to tsunamis, too. After all, tsunami was originally a Japanese word.
At first blush, the nuclear accident also came out of nowhere. But it, too, should not have been a surprise.
Tokyo Electric Power had a long history of problems in its nuclear facilities—it had to shut down all its reactors in 2002 for emergency inspections after the company failed to report many cases of falsifying inspection records.
These particular reactors were nearly 40 years old, with an antiquated design.
Granted, there was no way to anticipate the confluence of all three events, whose impact was devastating—but each discreet element was predictable.
That’s why despite the awful human toll of the earthquake and tsunami, the destruction wasn’t even worse: Japan was generally very well-prepared to deal with the natural disaster of the earthquake and tsunami, and undoubtedly averted even bigger damage. The nuclear accident is another story.
But the bigger question is, has the world changed so much that black swans are likely to happen more often?
Next: Financial Crises and Nuclear Meltdowns|pagebreak|
Taleb thinks so—and so does Richard Bookstaber, a former Wall Street risk manager (no, that’s not a non-sequitur), who wrote the book A Demon of Our Own Design back in 2007.
Bookstaber argued that the complexity of modern financial markets, and their critical interdependency (which he calls “tight coupling”), have made market crises worse.
“The more complex and tightly coupled the system, the greater the frequency of normal accidents,” he wrote. “Normal” accidents are accidents waiting to happen.
And lo and behold, what example does he use for a “normal” accident? Three Mile Island, the Pennsylvania nuclear plant whose 1979 meltdown stopped the US nuclear industry in its tracks for a generation.
“A nuclear power plant is a textbook example of an interactively complex system [that is] subject to failures that seem to come out of nowhere,” he wrote. “The start of the crisis can be something as trivial as a tag covering a warning light in the case of Three Mile Island…”
Or as serious as an earthquake and tsunami in Japan.
(Bookstaber, of course, isn’t saying all nuclear plants are dangerous, just that their complexity and interdependency makes them more prone to accident.)
You could have said the same thing about the housing market (where prices never fell, of course) and its tightly coupled derivatives churned out by Wall Street in the mid-2000s. Throw in the fuel rods of too much liquidity and operators asleep at the switch, and you had all the ingredients of a financial Chernobyl.
What You Need to Do
So, how should investors handle a world like this?
The first line of defense, of course, is true diversification—a mixture of stocks, bonds, cash, commodities, and some other hedges like currencies.
This is where individual stocks can be dangerous to your financial health. Just ask retirees who owned “safe,” dividend-paying stocks like Tokyo Electric Power—or BP (NYSE: BP) at the time of the Gulf oil spill.
That’s why I recommend that investors have no more than 10% or 20% of their holdings in individual stocks, though I really wonder why people own them at all.
But I think there are bigger lessons to be learned.
Unexpected events “should be viewed as the norm rather than the exception. During what we euphemistically call ‘normal’ periods, you are ignoring rare events,” said Michael Starbird, professor of mathematics at the University of Texas at Austin, who also has given popular courses on statistics and probability for the Teaching Company.
Of course, we may just have had a random run of these events that won’t be repeated. “Maybe three rare events in a decade is really quite rare,” Starbird mused. “You shouldn’t exaggerate the likelihood of more such events just because you’ve seen them recently.”
So, be nimble and flexible, and don’t bury your money in the back yard out of fear.
But in such a complex, interconnected world, I think “rare” events will become more frequent in the years ahead. The unexpected has become the new normal, and the black swans are coming home to roost.
Howard R. Gold is a columnist for MarketWatch and editor at large for MoneyShow.com. You can follow him on Twitter @howardrgold.