Your Quarterly E-Zine
Edition 11 • December 2019

This website contains the latest edition of Forsyth Barr Focus, a quarterly on-line magazine written by senior members of Forsyth Barr's investment team.

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SWANS AND BUTTERFLIES

A decade ago, Nassim Nicholas Taleb chose “The Black Swan” for the title for his book about the causes of unpredicted events, including historic financial market calamities. A well-diversified portfolio is the best way to manage unexpected market events.

Until they were discovered in the seventeenth century, black swans were considered to be an ornithological impossibility. That they actually did exist came as something of a surprise to the world, with consequences for science and scientific thinkers of the time.

In Taleb’s theory, a “black swan event” is one which is unexpected (based on current knowledge and past experience), has a significant impact (when it occurs), and then is retrospectively explained, (as being predictable with the benefit of hindsight).

In the world of finance, historic events which have earned “black swan” recognition include the Asian financial crisis of 1998, the dot com crash of 2000 and the global financial crisis (GFC) of 2008. In each case, these fast-moving events were unexpected, but in hindsight, there were signs indicating that they were possible.

Today, the world is continuing to enjoy nearly a decade of unparalleled growth in financial markets, with our local and many global equity markets repeatedly surging to new historic peaks, on the back of historically low interest rates, low or dis-inflation and consistently positive consumer sentiment. However history has shown that financial markets are cyclical over varying time periods, some shorter or longer in duration. Experienced investors believe that the current era is no different to the past and that a change in current market conditions should be expected at some point.

However it’s worth noting that even in the event of significant market correction, the recovery time has been analysed to be not as long as is sometimes suggested. According to one study[1] of down-markets since 1900, the average recovery time following a major US market fall was just over two years, when factors like inflation and dividends were taken into account*. In times of severe market volatility, staying invested is often the hardest strategy to contemplate, but is always the most important one to objectively consider with your Investment Adviser.

The potential global catalysts for an unexpected market event are many and varied.

In the current era of instant information, many of the known triggers have been reasonably well-aired. For example, at the more obvious end of the risk spectrum, sabre-rattling from (and in the direction of) North Korea could potentially trigger a military confrontation which could have a negative effect on the global economy.

At the other end of the spectrum, the catalyst may be much less obvious.

US mathematician and meteorologist Edward Lorenz coined the term “the butterfly effect” to describe a system in which a tiny input (such as the flutter of a butterfly’s wings) can produce a large chaotic outcome (such as a hurricane in the Atlantic). In today’s world of automated market trading, a market event could just as easily be triggered by a sudden change in investor sentiment, as by a geo-political event.

In this country, the habitat of black swans is well known; if you want to find one, it’s relatively easy to do. However in financial markets, while black swans have been proven to exist in the past, not all investors are convinced they will be seen at any stage in the future.

In each of the black swan events referred to earlier, investors with well-diversified portfolios who chose to stay invested were well-rewarded as the associated negative market cycle inevitably turned positive. All investors should expect market conditions to change from time to time. Whether such change is caused by the equivalent of the beat of a butterfly’s wings, or has the unexpected impact of a black swan appearing, remaining invested across market cycles (both positive and negative) and continually assessing market opportunities is the only proven way to ensure that your investment objectives are achieved.

By Gordon Noble-Campbell
Director,  Private Client Services

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