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As John Kay writes in this week's Financial Times:
"Every sophisticated institution has its own models back-tested against the experience of that institution. But this illustrates that the analytical problem is fundamental. The data used to back-test, of necessity, is drawn from a period when the institution did not experience the problems the risk models are designed to anticipate. The one thing we know with certainty about the banks, insurance companies and hedge funds that compete for our business is that they did not go bust in the period from which their historic data are drawn.
"That, unfortunately, is the only thing we know with certainty. The risks models financial institutions use insure that it is very unlikely that these institutions will fail for the reasons that are incorporated into the model. That does not mean they will not fail, only that they will fail for different reasons."
They will fail with the appearance of the black swan. Black swans are not in the models.
I am asked all the time if I worry about another Long Term Capital. The answer is no. Don't get me wrong, there will be big funds that fail from time to time. It is just that the next time it will not threaten to destroy the entire financial complex of the developed world. Every big institution that got burned on that one has safeguards to make sure it doesn't happen again. Next time the world is taken to the brink it will be something different, a new appearance of yet another black swan.
As Jon Sundt pointed out in his speech, the likelihood of a one-day market crash the size and magnitude of the '87 crash is statistically extremely unlikely - one to the power of minus 460! But it did happen, even though the historical data said it was improbable. The fingers of instability that connect seemingly random patterns struck all at once.
So as a professional worrier, I really focus my attention on what is not in the historical data that can create a black swan. Or maybe more accurately, what can change the data in such a way that a new pattern emerges, one for which we are not prepared.
We go through this process with the funds we manage and invest in, with portfolio analysis, and in general with every part of our business. You should do it as well for your business and portfolios. Will we find or think of everything? Of course not. There is always a black swan lurking somewhere. That is what keeps me up at night.
www.investorsinsight.com
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