Managing Black Swans
. . . there's a lot we can do.
We define Black Swan events as drawdowns of 20% or more (sometimes a lot more) from a previous highwater mark for the S&P 500 Composite Index. There have been 27 such events over the past 100 years, 24 of them taking the S&P down more than -25%.
To this point in financial history, US equity markets have always recovered and eventually moved on to new highs. Still, sometimes that took years, even decades. Even if that pattern continues, drawdowns of this magnitude and greater are still highly problematic:
(1) the size of these (paper) losses far exceeds the psycho-logical comfort level of investors, typically leading them to intervene emotionally with inappropriate timing;
(2) whenever a conservative portfolio experiences a large loss, the long-term mathematics simply stop working — you cannot inject a -20% or -30% return into a sequence of reasonable gains without greatly impacting that long-term return average.
It is critical that investment managers make a focused effort to manage their portfolios actively to avoid these damaging, recurring financial tsunamis — even when these efforts are only partially successful.
Our Trend Models (regime filters) do not predict black swan events, but they often identify environments when these are much more likely to occur — they study the tremors that precede the earthquake.
Whenever defensive measures are implemented with discipline and over time, portfolio drawdowns can be greatly reduced, often as much as by half. At the same time, the significant reduction of volatility causes Sharpe Ratios to improve dramatically.
Investing for real human beings always comes back to risk-adjusted returns (measured by Sharpe and Sortino Ratios).