As the year winds down, we find ourselves reflecting on the unusually low volatility we see across financial markets and what that may be telling us about the outlook for the year ahead. With Thanksgiving just a few days away, what better time to revisit the classic analogy provided by Nassim Taleb in his 2007 book, The Black Swan.
“[There is] a turkey that is fed for 1,000 days by a butcher, and every day confirms to the turkey and the turkey’s economics department and the turkey’s risk management department and the turkey’s analytical department that the butcher loves turkeys, and every day brings more confidence to the statement. So it’s fed for 1,000 days. Fatter and fatter. On the day when its comfort will be at its maximum, there is going to be a surprise. There will be a surprise for the turkey...
Consider that the turkey’s experience may have, rather than no value, a negative value. It learned from observation, as we are all advised to do (hey, after all, this is what is believed to be the scientific method). Its confidence increased as the number of friendly feedings grew, and it felt increasingly safe even though the slaughter was more and more imminent. Consider that the feeling of safety reached its maximum when the risk was at the highest!”
The lesson from the unfortunate turkey in Taleb's story is that risk is highest when it seems lowest (and vice versa). While investors have become accustomed to global central banks stepping in to "feed them" a constant diet of low rates and monetary stimulus, we should be careful not to view current low volatility as an excuse to abandon prudent diversification and risk management... at a time when we may need them more than ever.
The chart below can be downloaded here.
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