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Black Monday and Black Swans

Friday, October 19, 2018 17:41

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“Black Monday and Black Swans”

by John C. Bogle, (October 11, 2007″

“Just a week from tomorrow, we’ll mark the twentieth anniversary of what came to be known as “Black Monday,” October 19, 1987. On that single day, the Dow Jones Industrial Average dropped from 2246 to 1738, an astonishing decline of 508 points or almost 25 percent. The drop was nearly twice the largest previous daily decline of 13 percent, which took place on October 24, 1929 (which became known as “Black Thursday”), a distant early warning that the Great Depression lay ahead.

From its earlier high until the stock market at last closed on that fateful Black Monday of 1987, some one trillion dollars had been erased from the total value of U.S. stocks. The stunning decline seemed to shock nearly all market participants. But there were some veterans whom it didn’t surprise. Ace Greenberg, former chairman of Bear Stearns, was quoted in the newspapers as saying, “So markets fluctuate. What else is new?” And only a year before Black Monday, I observed to the Vanguard crew that even a 100-point decline in the Dow – something that had never before occurred – was possible. Why? Because, as I observed, “in the stock market, anything can happen.”

That truism remains, but I’d argue the point even more strongly today. Changes in the nature and structure of our financial markets – and a radical shift in its participants – are making shocking and unexpected market aberrations ever more probable. The amazing market swings we’ve witnessed in the past few months tend to confirm that likelihood. While the daily changes in the level of stock prices typically exceed two percent only three or four times per year, in just one recent month we’ve seen 8 such moves. Ironically, 4 were up, and 4 were down. Based on past experience, the probability of that scenario was… zero.

So the first – and most basic – point I wish to make today is that the application of the laws of probability to our financial markets is badly misguided. Truth told, the fact that an event has never before happened in the markets is no reason whatsoever to be confident that it can’t happen in the future. Metaphorically speaking, the fact that the only swans we humans have ever observed are white doesn’t mean that no black swans exist.

Black Monday, then, was a Black Swan. Unlike its 1929 antecedent, however, Black Monday was not a warning of dire days ahead. If anything, it was, totally counterintuitively, a harbinger of the greatest bull market in recorded history. “The Black Swan,” as most of you are likely aware, is also the title of a new book by Nassim Nicholas Taleb. Here is his definition of the characteristics of a black swan, in our markets, and, for that matter, in our lives:

• An outlier beyond the realm of our regular expectations. (Rarity)

• An event that carries an extreme impact. (Extremeness)

• A happening that, after the fact, our human nature enables us to accept by concocting explanations that make it seem predictable. (Retrospective Predictability)

So there it is: Rarity; extremeness; and retrospective predictability. Together they define the occurrence of an event that is regarded as impossible, or at least highly improbable. What’s more, as Taleb notes, a Black Swan is also the reverse of this definition: The non-occurrence of an event that is regarded as highly probable. Life is full of them!

Today I observe little concern about the ever-present possibility that what will occur in our financial markets in the coming months (or years) might in fact prove to be a non-occurrence of what we expect. Indeed, despite the recent wild disturbances in both the stock market and the bond market, most market participants seem confident that future returns will resemble those of the past. Only time will tell whether yet another Black Swan, lurking out there beyond the horizon, will become part of stock market history.

Whatever the case, the fact that Black Swans can and do happen in our financial system holds important lessons for how we think about risk. While we look for corroboration of what we believe (confirmation bias), what we really ought to be looking for is the opposite – that observation that would prove us wrong. Sad to relate, we know what is wrong with a lot more confidence than what we know is right. Yet we continue to look ahead with apparent confidence that the past is prologue, based on our assumptions that the probabilities established by history will endure.

The idea of seeking out evidence that contradicts our belief goes far beyond the financial markets. It goes to the very nature of knowledge itself. For the eminent British philosopher Sir Karl Popper – well-known for his use of the Black Swan metaphor - the key question was “what if science didn’t proceed from observation to theory? What if it was the other way around?” Writing in The New Yorker, journalist Adam Gopnikdescribed Popper’s reasoning: No number of white swans could tell you that all swans were white, but a single black swan could tell you that they weren’t. Science, Popper proposed, didn’t proceed through observations confirmed by verification; it proceeded through wild, overarching conjectures which generalized ‘beyond the data,’ but were always controlled and sharpened by falsification (i.e., proof that the theory was wrong).”

“It was the conscious, purposeful search for falsification by refutation, by the single decisive experiment” (or swan), Popper believed, “that allowed science to proceed and objective knowledge to grow.” Yet most of us- in our investment ideas and political ideas alike – do quite the reverse: we search for facts that confirm our beliefs (reinforcement bias), not for the facts that would negate them.”

Please do view the rest of this highly informative article here:

- https://www.vanguard.com/bogle_site/sp20071011.html

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Source: http://coyoteprime-runningcauseicantfly.blogspot.com/2018/10/black-monday-and-black-swans.html

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