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Black Swan Events and the Pursuit of Fake Alpha: Critical Factors in the Risk Management of Financial Firms The Financial Executives Networking Group Webinar April 22, 2010 Presenter: Bernard S. Sharfman 5613 Jordan Rd. Bethesda, Maryland 20816 301-320-0834 [email_address] 1 Copyright 2010 Bernard S. Sharfman
Black swan events are unpredictable, large impact events, both good and bad. (Taleb, Common Errors in Interpreting the Ideas of The Black Swan and Associated Papers , 2009).
We may be pretty good at predicting that certain events will occur, such as the emergence of the Internet, general housing price declines after 50 years of increases, WWI or a terrorist attack, but we are very bad at gauging their impact. (Id.)
Why?: The less frequent the event, the more we are going to error in estimating its impact. We simply have little information to make a good prediction. (Id.)
Black swan events reside in the tail of a statistical distribution. But the tail is fat, not thin as commonly assumed in the standard prediction and valuation models.
That is, they occur more often than is commonly assumed.
Our inability to predict or properly value black swans leads to the strong possibility that we may be significantly underestimating the business risks of highly leveraged entities such as financial institutions.
Fake alpha: Appearing to create excess returns but in fact taking on hidden tail risks, which produces a steady positive return most of the time as compensation for a rare, very negative, return. (Professor Rajan)
The event creating the rare, very negative return can be referred to as a disaster, such as a vicious black swan event. For example, the collapse of housing prices which led to the seizing up of the credit markets and general economic turmoil.
The difficulty of incorporating black swan events into prediction and valuation models means that those who manage financial institutions may continue to underestimate the business risk of their firms.
Competitive pressures may discourage looking too closely for the potential of black swan events.
For the financial sector, this most likely means trying to reduce financial leverage, the interdependency of our financial system and reducing the incentives to pursue fake alpha through gov’t action.