Black Swan and predictive skills By Dr. Bobby Srinivasan and Dr. Sudhakar Balachandran

April 12, 2016 | Posted by bobbysrinivasan << back to blog

Most of the times, the stock market behave well and continue to stay within a manageable range. A normal range for one year could for example be 15% around the median. For example if Nifty is 7500 today we can normally expect a range of 6375 on the downside and 8625 on the upside. This range is broad enough to deal with the broad fluctuations of the market. However, there are times when the market prices create a huge change that it can only be called a rare event. Black swan being rare, symbolizes a rare event. This is a conversation between a student and his professor.

Student: Prof. I was reading the book by Nassim Nicholas Taleb titled, “Fooled by randomness the hidden role of chance in life and the markets” where the words black swan was repeatedly used. Does such an event happen?

Professor: Yes, you better believe it. Black swan refers to a rare event that happens in the financial market. For example, during the sub-prime crisis in the US the US market Dow Jones index dropped from 14500 to 6000. At the same the Indian Sensex falls from 21000 to 8000. These drops arose out of panic as to what will happen to the global stock market because of the crashing of US banks and brokerage houses. These are terrifying experiences for an investor who is naïve about many things that can shake the financial markets.

Student: This scares one. How rare are these rare events?

Professor: They are called outliers and beyond the 3 sigma limits. Also on the positive side, the Indian Sensex jumped from 10000 to 19000 in 2007 which again is an extra-ordinary event. The global financial system is really in a topsy turvy and investors all over the world hold on to positions with great anxiety. In the financial history of the world there has never been a time when negative interest existed (as far as I know) but today Eurozone, Japan, Sweden, Switzerland, Denmark have all adopted negative interest. Basically the bank is saying to its customers. Spend your money and if you want to keep your money in the bank we will charge you interest. Again look at countries like Argentina, Venezuela they are knocking on bankruptcy. They are in no position to meet the foreign debt. Look at the Baltimore dry index which is an indicator of the merchant ship usage. From a high of 12000 a few years ago it is around 500 now. One more example the price of iron ore dropped from 200 dollars a tonne to 20 dollars a tonne. All these are examples of black swan.

Student: How do I take care of myself if black swan were to hit the market?

Professor: The first step is to accept that black swan exists and often happens. In your investment strategy you should also include a clear cut exit plan. Use the strategy of stop loss at a level comfortable for you. Watch and learn about the global events. In the US stock market companies like Bear Stearns and Lehman shares were trading above 100 US dollars before they touched zero value. You must develop the habit reading financial newspapers. Text books are generally way behind time and all the theories contained in them may not be totally relevant to deal with the modern day problem. Being completely involved in the market will give you that rich experience you need. Good luck.

Student: Thanks Professor.

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