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Two Ways Of Building A Black Swan-Proof Portfolio

Summary

The Volkswagen emissions debacle exemplifies the unpredictable risks ("black swans") associated with investing in even blue-chip stocks.

Avoiding companies with high carbon emissions, as suggested by one author, won't protect us against the next black swan. For that, we need a black swan-proof portfolio.

We note two ways of building a black swan-proof portfolio, detail one of them, and provide an example black swan-proof portfolio.

Anticipating The Black Swan

Working in the mutual fund industry in the late 1990s, I sat through a number of presentations by fund company economists. They often had question-and-answer sessions, and I've forgotten about most of them. But one particular incident stayed with me, as the fund company economist touched on an idea Nassim Nicholas Taleb would later popularize in his 2007 book The Black Swan.

The year was in 1999, and if memory serves, the economist was Dr. Bob Froehlich. An investor asked him if we should be worried about Y2K, the widely-anticipated "Year 2000 Problem", when computer systems programmed to use two digits to record years might get confused by the switchover from "99" to "00". The economist answered that he wasn't worried about Y2K, because the electronic debut of the euro as the EU's currency earlier that year had been a similarly challenging computer problem, and it went smoothly. He then offered a Black Swan-like admonition:

If you've been hearing a lot about a problem in the news, that means experts are already working on it, so you don't need to worry about it. Worry about what you haven't been hearing about.

Two Types Of Black Swans

Black swans are the crises that you don't hear about in the news beforehand, and, broadly speaking, there are two types of them: systemic black swans, and stock-specific black swans. An example of a systemic black swan was the freezing of the credit markets during the credit crisis, which affected many companies. An example of a stock-specific black swan is the emissions scandal at Volkswagen (OTCQX:VLKAY), which was the subject of John Authers' "Long View" column in the Financial Times ("Carbon footprints loom for investors after VW scandal") last weekend.

From Blue Chip to Black Swan

Volkswagen, the blue chip automaker, had once praised itself for its putatively low-emission diesel vehicles by having its engineers sprout angelic wings in an ad campaign, as pictured above (image via this New York Times article on the scandal). In his column, John Authers argued that the VW scandal was a rare case in which the appellation "black swan" was warranted:

The phrase "black swan" - meaning an unprecedented low-probability event that prompts markets to overreact - tends to be overused. People will invoke it when really they have simply failed to hedge adequately against obvious risks. But Volkswagen, the German carmaker, produced a true "black swan" this week, as it was revealed that it had for years used complicated software that allowed its diesel-fuelled cars to "cheat" on emissions tests.

Drawing The Wrong Lesson

Authers went on to suggest that investors use data from MSCI and other index providers to lower their exposure to companies with large carbon footprints. With all due respect to Authers, that's the wrong lesson to draw from this disaster for Volkswagen shareholders. Authers' advice is an example of checklist investing, and as we pointed out in a recent article ("A Checklist To Save Your Assets"), those sorts of checklists don't limit risk. In that article, we recounted the history of a hedge fund manager who developed a 98-question checklist to reduce his error rate, and nevertheless added to a concentrated position in Horsehead Holding Corp. (NASDAQ:ZINC) at over $12 per share in 2013, and continues to be the largest institutional holder of that stock, which closed under $4 per share on Friday.

We then noted:

Like the margin of safety concept, 98-question checklists may be helpful for security selection. They just don't limit either of the two kinds of risk associated with stock investing: idiosyncratic risk, the risk of something bad happening to one of the companies you own, and market risk, the risk of your investments suffering due to a decline of the market as a whole.

Faulty carbon emissions are in the news now, which means experts are already working to resolve the issue; we need to worry about the next black swan. Of course, by definition, we don't know what the next black swan will be, or where or when it will strike. But, fortunately, we can build a black swan-proof portfolio without knowing the answers to those questions.

A black swan-proof portfolio is one in which both your stock-specific risk and your systemic or market risk are strictly limited. There are two ways to construct one:

  1. Use diversification to limit your stock-specific...

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