From the Black Monday of October 19, 1987, to the September 11 attacks: When the seemingly impossible comes to pass, has a massive impact and seems to be predictable in retrospect, then we have faced a “black swan.” IESE Prof. Javier Estrada, who has been studying this phenomenon for the past two years, turns his attention to emerging equity markets to measure the effect of outliers on investment performance.
How do investors know when to be in or out of the market? Can they ever really anticipate these outliers? As in nature, events defined as black swans are rare, but successful long-term investment in emerging markets through market timing, he finds, is even rarer.
The conventional wisdom is that investment is about putting your money somewhere and sitting tight, and your capital then compounds slowly but safely. Outliers, many believe, are as unlikely as flying pigs.
But such wisdom operates on the statistical assumption of normally distributed returns. Estrada questions this assumption, which he says is often used and abused in finance.
The author looked at more than 110,000 daily returns across 16 emerging equity markets. Results showed that, contrary to conventional wisdom, all markets had very large daily swings.
The highest of the maximum daily returns was in South Korea (51.24 percent) with an average of 24.50 percent across markets. The lowest of the minimum daily returns was also in South Korea (-51.16 percent) with an average of -20.27 percent across markets. All markets but Mexico registered a significant degree of skewness (asymmetry), and they all had a substantial degree of kurtosis (fat tails, which make large positive and negative returns more likely than the assumption of normality would predict).
Therefore, if investors had assumed normally distributed returns, as many most likely did, then they would have seriously underestimated risk.
Pigs Might Fly After All
No emerging market is safe from fluctuation, but how often do outliers occur in comparison with how frequently we expect them to?
Estrada defined “outliers” as daily returns more than three standard deviations away from the mean. His evidence suggests that they are indeed more frequent than many academics would have us believe.
In Argentina, for example, over the period studied, only 10 negative outliers were expected, while 29 were actually observed. Similarly, only 10 positive outliers were anticipated, while 80 were noted. So, over five times as many outliers occurred in reality than expected.
If we look at the bigger picture across all the markets, an average of 111 outliers were observed, almost six times as many as the 19 expected.
Just imagine how much money investors could have made if they had had the psychic powers to have predicted all those outliers!
Big Impact? Yes. Easy to Predict? No.
So, if outliers occur more frequently than we think they do, then what is their impact on the long-term performance of investors’ portfolios?
Estrada shows how much money investors would have had at the end of each market’s sample period if they had just left their money alone. He then compares this terminal wealth with the one that would have been achieved if investors had missed the best 10, 20 and 100 days in each market. On average, this resulted in a reduction of 69.3 percent, 84.8 percent and 99.4 in terminal wealth with respect to the passive investment. Avoiding the worst 10, 20 and 100 days, in turn, implied an increase in terminal wealth of 337.1 percent, 1,060.0 percent and 381,672.6 percent, again with respect to the passive investment.
These figures show that long-term returns are not created slowly and steadily over time. In reality, rewards are determined by a series of booms and busts. But, unfortunately, investors are extremely unlikely to successfully and consistently determine the right days to be in and out of the market. To illustrate, 10 days account for only 0.15 percent of the total number of days in the average market considered in the study; hence, correctly predicting on which dates these will occur is virtually impossible.
Diversify Rather Than Prophesy
“Attempting to predict the negligible proportion of days that determines an enormous creation or destruction of wealth is a losing proposition,” concludes Estrada, “like playing roulette.”
Thus, it seems black swans are something that investors must learn to live with. This is particularly true when putting money into emerging markets, where the impact of black swans on long-term performance is even greater than in developed markets.
But not all outliers are negative, so investors should make sure they have their fingers in several different pies. Rather than try to play fortune-teller, Estrada recommends having a diversified portfolio, thus having both some protection against negative black swans as well as exposure to the positive ones.