Readers we are not planning to take you through a virtual jungle safari. But, it seems the financial world we live in is no less than one in the current times! The Covid-19 catastrophe has led to an unprecedented fall in the GDP growth numbers for India. We may consider the break-out of this devastating pandemic a black swan event. But the consequences that we are facing and may continue to face on the macroeconomic front are the jarring pink flamingos following the atrocious black swan (pun intended)!
Black Swan, a popular term in the financial jargon, refers to a highly improbable event with a major impact. On the other hand, Pink Flamingos refer to a predictable event that is ignored due to cognitive biases of a senior leader or a group of leaders trapped by powerful institutional forces. So, if the pandemic break-out is the black swan, the ‘obvious’ macro-economic spill-overs are the pink flamingos. As an investor, we must learn to deal with both while on this financial safari. The plummeting of the GDP growth rate, increasing upward pressure on the inflation, RBI’s monetary policy actions, corporates slow pace of reviving the production, and more are all the contagion effect of the pandemic. We must not be surprised by these pink flamingos rather be prepared for these macroeconomic shocks.
The Black Swan event usually sits at the tail of the financial curve. If we plot out that chart, the ‘tail risk’ appears on either side of the mean. Tails refer to the end portions of the distribution curves, showing the probabilities of variety of outcomes. The tail risk represents the chance that a dramatic, unexpected event can cause a significant swing in value. These ‘black swan’ events are rare, but very important. However, what takes the centre stage are the tails, and most of us investors are rather worried about the left tails only. We must sharpen our focus on not what tail risk is but what it means for the investment decisions. It is both critical and smart to not ignore these highly impactful and highly improbable events!
Making investment decisions based on the expected outcome as measured by the averages can lead to huge portfolio losses. One can often make money in trades that have horrible remote loss scenarios but excellent expected returns. Extreme outcomes with low probability should be given importance in such situations. This is an important learning from such ‘black swan’ events. As nonagenarian Warren Buffett mentions – ‘Many people don’t think deeply enough about the consequences of remote loss scenarios. Instead, they only focus on weighted average expected returns which look so good because the weights of the remote loss scenario are so small in the expected value table.’
The black swan is an occurrence where nothing in the past could convincingly suggest it could have happened and its impact is massive. Economies have stalled, markets have plunged and there is widespread panic across asset classes. The macroeconomic tail risk i.e. the left tail of the distribution is positively correlated with slack in financial conditions. Financial conditions create downside risk to the economy. And when the distribution is not normal, all the analysis based on this assumption of normality fails.
Left tail events have had a devastating impact on portfolio returns, impeding investors’ potential to achieve their financial objectives. How well we manage these unlikely outcomes largely defines us.
As an investor, we must be aware about the tail risk, and not be influenced by averages and standard deviation but focus on what appears to be realistically possible. We must identify our degree of risk tolerance – whether your portfolio has the capacity to bear losses up to and including the left tail or not. If you have that risk appetite then stay invested for the long term. It is often difficult to find refuge or seek protection in any asset class in the financial upheaval but while you do security selection – look for extreme volatility/ values in the returns, and the frequency of its occurrence, i.e. how fat the tail is and with that awareness make the investment decision. Another alternative is to identify sectors which are antifragile. In simpler terms, the sectors that gain in this VUCA (“Volatile,” “Uncertain,” “Complex,” and “Ambiguous.”) world. These sectors – the known knowns are our pink flamingos as well in the current scenario. In contrast to the downside beta, one can look at tail beta, which measures co-movement with the market if the downturns are extreme.
So, readers, let’s not get swayed by the black swan event we are in. These tail risk events should be hedged appropriately and treated as an opportunity to make higher returns. Besides, it’s more critical to keep our eyes open to the pink flamingos that shall follow.
Here’s wishing us all abundant luck to survive the Indian Economic Jungle!
Dr. Tarunika Jain Agarwal Ph.D.