Cyprus has been in the news a lot lately over a botched bailout from the European Union, the International Monetary Fund and the European Central Bank. Many smart people have commented on the issue, so I want to focus on a different angle. Additionally, the situation is flux, and no one knows what will happen the next hour.
Cyprus has an economy with a gross domestic product (GDP) of $10 billion. The world economy has a GDP of over $60 trillion. Cyprus is a drop in the bucket in terms of world economic output. Yet this country has caused the entire world to fear about the future of the euro.
The fear is well-founded. Who is to say that there will not be bank runs in Spain, Italy or other large European countries? Therefore, the reaction of the market may indeed be rational. It’s possible trillions of dollars were lost in stocks, currencies, bonds and other asset classes in the past few days.
So how does an investor protect against an event like this? The famous financial thinker Nassim Taleb has coined the phrase “Black Swan.” In short, it is an unexpected event that has a disproportionate effect and in hindsight seems obvious. In terms of politics, there have been many Black Swans in the past few years. While every “expert” has been predicting a war between Iran and Israel, not one of these so-called analysts predicted the civil wars in Syria and Libya. Those were totally not expected and while not in the financial realm, had a drastic impact in the geo-political area.
Since the publication of Taleb’s book and the aftermath of the financial crisis, many finance products have been created to protect against tail-risk events, which is a fancy way of saying Black Swans. James Montier, a famous behavioral economist and member of GMO's Asset Allocation team, has pointed out (as well as has Taleb) since it is by definition impossible to predict it is also impossible to hedge against the event. Some of the people selling these Black Swan products just want to make money, others think that they can predict future events.
If anyone saw the headline from Thursday on EU negotiations regarding Cyprus, no one would believe just a day or two later Cyprus would be threatening the future of the eurozone. This brings us back to Black Swans.
While in the case of Cyprus, it would be possible for investors to partially protect themselves by shorting the euro, for example, because Cyprus is tied to the European Union (although the residents of Cyprus certainly did not expect to wake up and hear that their savings would be confiscated).
While investors prepare for potential disruption of oil from Saudi Arabia or Iran, a eurozone blowup and a war between Japan and China, the next event to shock the world economy will be totally unexpected.
No investor will be able to protect their investments from an unexpected meteor storm that strikes a city and is 30 times more powerful than the atomic bomb used in Hiroshima. Therefore, it is best to stick to the good old fashion conservative investing approach.
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