How Should "Black Swans" Affect Your Investment Plan?

(MoneyWatch)  In his book The Black Swan, Nissam Nicholas Taleb uses the term "black swans" to refer to rare events that are:

• Outside the realm of expectations
• Extreme in impact
• Easily explainable after the fact, though nearly impossible to have forecasted ahead of time

So, how should the "black swans" of investing impact our planning?

Taleb points out that black swans occur with greater frequency than would be predicted by a normal distribution. In investing, black swans refer to events such as the stock market crash of October 1987, the Asian contagion of 1997 and the current credit crisis. They are also refered to as "fat tails."

When investors ask me how fat tails impact investment advice, the first point I make is that Taleb did not "discover" the existence of fat tails in the distribution of returns. In his 1964 dissertation at the University of Chicago, professor Eugene Fama demonstrated that extreme returns do occur with much greater frequency than if returns were normally distributed. That was 45 years ago. Thus, the existence of fat tails has been well known in academia for a very long time.

The second point is that the presence of fat tails does increase risk. Thus, it seems likely that the existence of extreme returns is one reason why the equity risk premium has been so high -- investors are aware of the risks of fat tails and demand a risk premium as compensation.

The third point is that it is important for you to consider the risk of fat tails when designing your investment policy statement, making sure you do not take more risk than you have the ability, willingness and need to take. It is also important to understand that just because something has not happened does not mean it cannot or will not happen. The potential for devastating losses should not be ignored when designing a plan. Making that mistake can have disastrous results.

In summary, you are compensated for taking the risk of fat tails through the equity risk premium. However, do not ignore the potential for extreme results. Build that risk into your plan.