In the July 20, 2015 issue of The New Yorker magazine, Kathryn Schulz laid out evidence that the Pacific Northwest United States has experienced a series of 41 devastating earthquakes that have occurred with surprisingly regularity over the past 10,000 years. That's roughly one every 243 years. The last one hit in 1700, meaning that we're past due for an earthquake on the so-called Cascadia subduction zone. Such a quake will bring commerce essentially to a halt in cities including Seattle and Portland.
Like many rare and important events, a devastating earthquake is a possibility someone has discussed. If the earthquake occurs next year, many will point to Schulz's article and other research to say that the event is not, in hindsight, a surprise. And if the earthquake hits, what impact would this have on the U.S. economy? The costs of rebuilding would surely be in the trillions of dollars. Where would the money come from when the government debt has grown to over 100% of gross domestic product? What would happen to bond prices if other countries started to lose confidence in our ability to pay back our debt?
Is it beyond the realm of possibility that the United States could go bankrupt as a result of a black swan?
Nassim Nicholas Taleb's book "The Black Swan" spent 36 weeks as a surprising best seller in 2007. The timing of its publication was impeccable, since Taleb argued in the book that traditional financial models that promised an ability to better predict and control financial risk were flawed. These models created an illusion of technical sophistication, but relied too much on observable historical data and not enough on the unseen, rare and dramatic events that could blow up the models and change the world.
Trading on Extremes
To academic statisticians, the argument that Taleb makes is not a new one. In a distribution of possible random events, there are always going to be observations that fall at the tails. These rare and significant events are built into conventional statistics in the sense that we know that big and nasty things can happen, but they are highly unlikely.
Financial economists have long been aware that financial asset returns exhibit extreme events. Stock returns exhibit a larger number of outliers than a normal distribution would predict. This is what's known as "fat tails." When we look at historical international asset return data, we see evidence of a larger than expected number of extreme return events. In other words, there are more big positive and negative returns than we would expect. Financial economists can even build these fat tails into their models to account for the possibility of extreme events.
That didn't stop Universa Investments, a hedge fund where Taleb serves as principal/senior scientific advisor, from earning over $1 billion this summer by betting that the market underestimated the probability of an extreme correction. In 2008, Universa doubled (instead of halving) its investors' money during the financial crisis. The same financial crisis that was arguably caused by mathematical modelers at financial institutions who underestimated what would happen to asset prices when their employers accepted risks that seemed acceptable until the market fell apart.
The market anomaly that Universa exploits is the tendency to misprice options that pay out when markets crash. Put options give investors the right to sell shares at a given price. If you believe that extreme negative returns happen more frequently than the market expects, then you can profit from buying put options when the market sees smooth sailing in the future. When a hurricane comes out of nowhere, traders will look for any safe port that provides insurance against a crash in asset values. Enter the hedge fund that's been stockpiling put options.
An easy way to see how the market feels about the likelihood of an extreme event is to look at the pricing of put and call options on the market. The VIX index, created in 1993 by the Chicago Board Options Exchange (CBOE), calculates how the market is pricing options that expire in a 30 day time period. When prices are high, the market expects a lot of volatility. One can simply back out the expected volatility from the prices of the options. Higher prices mean there's a lot of uncertainty or anxiety about the market.
A look at historical VIX reveals that the market seems to do a really terrible job of predicting when stock prices are going to go crazy. When the ocean is calm, people forget that risk exists. When the wind starts picking up, people start to get worried. This is a bit of a mystery, because the chance of a storm always exists and so the pricing of risk should always reflect this possibility. One could simply buy up options when the market isn't worried very much about risk and wait for the storms to come. They always do.
Black Swan Blind
The Goodfellow Rebecca Ingrams Pearson brokerage in England has reportedly sold over 30,000 insurance policies that will pay just over $150,000 to policyholders who are able to provide evidence that they were abducted by aliens. They get double if they became impregnated during the abduction (even men, because — who knows?).
It's tough to estimate the likelihood of alien abduction because our data set on past abductions is limited. Those of us who build models that project how financial strategies will pan out in the future rely on data from the past. Why? Because that's all we've got. We can't project things in the future that haven't happened in the past.
This is where Taleb takes up his critique of conventional statistics. Anyone living in Seaside, Oregon, will rely on past experience to judge the risk of building a retirement home in the coastal town. Has there been an earthquake or a tsunami in the last 100 years? No. In fact, since recorded history (of European Americans at least), the Oregon coast wouldn't seem like a particularly risky place to live.
Yet that doesn't prevent an astute observer from looking beyond recent history to imagine potential future risks. This is one of the most important points of the black swan concept. Taleb doesn't say that we should all insure ourselves against alien abduction because the risk is a remote possibility. He's saying that extreme events will occur with some regularity, they will have a big impact on our life, and they're often hidden in plain sight.
