How to Kill a Black Swan Remy Briand and David Owyong ...

Talking Indexes
Managing The Risks In Ourselves
We simply attempt to be fearful when others are
greedy and to be greedy only when others are
fearful.
—Warren Buffett
By David Blitzer
The financial markets turmoil of the last year has
taught, or retaught, all of us a lot about risk and
risk management. In the halcyon days before
2008, risk management was an occasional activity that
we believed we knew something about. Today we are
serious about it. Further, in the short space of about a
year, we may have learned a little—now we know that
the normal distribution is often abnormal, that “impossible”
events happen and that all those uncorrelated
asset classes can sink together—at exactly the moment
you most need the correlation benefit. Our respect for
market turmoil is much greater and our understanding
of markets, maybe, has increased.
However, for investors, the market and its gyrations
are only half the problem—we’re the other half. Or, in the
words of Pogo, 1 “We have met the enemy and he is us.”
As shocking and dismaying as the housing boom-bust
and financial crisis are, they are not unprecedented.
Housing is following the same boom-bust pattern
that markets have experienced for centuries. The oldest
commonly cited cycle is the Dutch tulip bulbs in
1637, as chronicled by Charles MacKay. 2 A more recent
analysis is provided by Charles Kindleberger in “Mania,
Panics, and Crashes.” 3 Kindleberger recounts a number
of infamous booms and busts and describes their typical
pattern as shown in Figure 1. The boom begins with
some event—“displacement” in Kindleberger’s terms—
that disrupts an otherwise normal market. With housing
in the U.S., this was the very-low-interest-rate environment
in 2002–2003, just as investors, shell-shocked by a
bear market, were seeking an alternative to investing in
stocks. Their homes—and second homes—offered the
best alternative. As the boom gathered steam, soaring
prices led people to believe home prices would never
fall, and generated positive feedback to drive the boom.
This psychology was soon joined by subprime mortgages,
which dramatically expanded the market. Everexpanding
securitization of those mortgages sparked
the speculative mania seen at the peak in 2006. By 2008
the boom had turned into a bust, or the “crisis and
revulsion” noted by Kindleberger. This pattern, with
minor changes, can be seen in other booms. Figure 2
tells the story for the technology stock market of 1995–
2000, alongside the housing cycle. One can easily find
Figure 1
2002
Displacement
Positive
Feedback
Euphoria
The Cycle
Speculative Mania
2006
Crisis
And
Revulsion
2008–2009
Source: Based on “Manias, Panics and Crashes,” Charles Kindleberger, 1978, 2005,
John Wiley & Sons, Inc.
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July/August 2009