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Was Yesterday a Black Swan Event?

As you probably know, there was quite a bit of excitement on Wall Street yesterday. Apparently a panic was caused by images of rioters in Greece. And then it was announced that there was some kind of trading errors that caused or perhaps exacerbated the selloff. Was this really what happened, or is it just a way of trying to calm the markets?

I thought it was an interesting question because it shows the difference between what people expect and what people don’t expect. Events like the Asian Financial Crisis and the Russian default in the 90′s were largely unexpected, and these were termed Black Swans. They had massive effects on the economies and markets of the world, and caused the largest Hedge Fund collapse in history.

Many people are concerned that Greek’s problems will spread to other countries throughout the world. So, that is a risk that people are factoring into their thinking. But there are other risks that most people never imagine. And a technical error where one trader pushes one button by mistake is a good example.

Most people assume that the markets will not be disrupted by technical glitches. And, as technology improves, we expect to see this kind of thing happen less and less. But no matter how much technology improves, it will never eliminate the problem of the Black Swan: that we are subject to risks that we never imagine.

Yesterday’s chaos led to a fall in Treasury yields, as people bought tons of U.S. debt. Why? Because it is regarded as “safe”. However, there are some people who think that the U.S. government’s debt is anything but safe. They think that debt levels have risen so high that the government will not be able to pay. It’s just a matter of time before the rest of the world finds out.

That is just the kind of Black Swan event that could cast the world into a global depression. It has the characteristics: massive effect and completely unexpected. If it does happen, people will see all the telltale signs, but only in hindsight. They’ll say,

“It was clear that debt levels were too high, and they were increasing at ever higher rates.”

By definition, Black Swans are events that people cannot accurately predict. So, how could we protect ourselves from such an event? Nassim Taleb, the author of The Black Swan, suggests putting most of our money in safe investments, and the remainder in disaster insurance. That means buying instruments that will rise in value dramatically when the “unthinkable” happens. That might mean buying an option on the DOW that makes big money if the index falls below a certain level.

No one can tell the future for sure. But there is no reason that we cannot prepare for it. Living in La-La Land and ignoring the possibility of market crashes, financial crises and other Black Swan events is just irresponsible and foolish. Closing our minds and blindly following financial advice of “experts” is equally dangerous. I think each person needs to find out about such possibilities and decide what is best for themselves.

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  1. May 7th, 2010 at 18:28 | #1

    One of the things that really concerns me is the increasing complexity surrounding the financial markets. Not only do we have the equity markets themselves, but there are also massive amounts of derivitives, and all kinds of technical layers to the system that seem to be making the markets less transparent all the time.

    Then there’s globalization…hiccups from all over the world are affecting the markets, as we’ve seen this past week with Greece.

    Notwithstanding the run up in stocks since March of 09, caution should be the order of the day. The events of this week show that this is a very nervous market.

  2. May 7th, 2010 at 18:55 | #2

    Hi Kevin,

    I totally agree. Derivatives mixed with globalization is a recipe for financial chaos. And virtually nobody understands the complex math behind derivatives anyways. It’s interesting to see that Obama actually wants to solve a problem that 99% of the people are completely oblivious about.

  3. May 8th, 2010 at 06:39 | #3

    I think it was more of a black swan dive…

  4. Patent Dugan
    May 8th, 2010 at 11:39 | #4

    I think it’s much more probable that this event was a co-ordinated blackmail against washington which succeeded in de-railing an audit of the Fed. They just turn off the HFT faux-liqudity machine and pile-drive the sell orders, and then the PPT via JPM comes in to pick it back up to 1100. Listen to the tape from the pit: http://www.zerohedge.com/article/panic-and-loathing-sp-500-pits

    At least, it was HFT going berserk without any sort of conspiracy behind it. This was not an isolated mistake. Have you looked at FX? How could you have the same pattern in every USD and JPY pair was well as every major foreign equity index? CoMe oN.

  5. May 9th, 2010 at 13:17 | #5

    I think it was more of a “Black Eye” event. It’s embarrasing that a single trader’s mistake can drop the Dow 1,000 points. It seems like Wall Street is a casino right now. The Black Swan is more of an excuse than a cause. During the Financial Crisis of 2008, I heard this over and over again from investment banks and it was hogwash.

    The fact that our markets are so volatile is an indicator that there is way too much leverage, in the form of dervatives. Until this is corrected, we are going to continue to have financial panics, from a variety of causes. This is highly predictable.

  6. May 10th, 2010 at 18:13 | #6

    Hope to Prosper – Well put. When ever anything gets complicated, it also gets confused, and that opens the door wide for…ANYTHING!

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