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Beware of 'Black Swan' Products

By Jacob Wolinsky   |   Thursday, 27 Oct 2011 09:40 AM

The phrase "Black Swan" has become one of the hottest lines in the financial community lately. With all the recent turmoil on the streets of Athens, New York and across the Middle East, many investors are trying to protect themselves against “black swan” events.

Many products are being offered to retail and institutional investors to “help.” According to Bloomberg, as of April 2011, about $38 billion had been raised by “black swan” funds designed to profit from extreme low-probability events.

The phrase black swan was popularized by a great thinker and best-selling author, Nassim Taleb.

Taleb describes Black Swans as:

1. Rare events that are beyond the realm of normal expectations.

2. The events cannot be predicted using computer models.

3. In hindsight, they seem obvious.

One good example would be the Earthquake in Japan earlier this year.

No one predicted it; it was massive, caused the death of tens of thousands of people, and caused disruptions to the entire world economy. Everyone said that it was obvious, one person told me “it was the most obvious thing in history,” and I asked if he prepared his portfolio for the event, he had no comment.

The problem with Black Swans is that no one knows how to predict the next one and therefore it is very hard to provide shield against them.

While many investors are protecting against a eurozone collapse, a “hard landing” in China or a double dip recession, however the next event will likely be none of these. It could be a massive earthquake in Turkey, which cripples one of the world’s emerging economies, or a war between Saudi Arabia and Iran, which would lead to skyrocketing oil prices.

These are just examples; no one knows what the next black swan will be. The creators of these products are merely profiting off the fears that investors have about the global economy, and they are doing a good job!

Investors should not expect the SEC to protect them from these products.

The SEC did not protect investors from Bernie Madoff’s Ponzi scheme, which lasted several decades.

Additionally when the market is volatile and people are scared like now these products are usually very expensive. Investors tend to hedge against black swans at exactly the wrong time. The best time to hedge against risk (assuming it could be identified) is when people are not fearful.

Next time a financial adviser, broker, or best friend tells you about the latest black swan product, take the advice with two grains of salt.

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