黑色星期一与黑天鹅

Financial Analysts Journal Volume 64 • Number 2 ©2008, CFA Institute

PERSPECTIVES

Black Monday and Black Swans

John C. Bogle

T he 20th anniversary of what came to be year, in the second half of 2007 alone, we witnessed known as “Black Monday”—19 October 15 such moves—9 downward and 6 upward. 1987—provides a memorable platform for Based on past experience, the probability of that considering, yet again, the role of risk in our scenario was . . . zero. financial markets. On that single day, the Dow Jones So, the application of the laws of probability to Industrial Average dropped from 2,246 to 1,738, an our financial markets is badly misguided. If truth be astonishing decline of almost 25 percent, nearly told, the fact that an event has never before haptwice the largest previous daily decline of 13 per- pened in the markets is no reason whatsoever that cent. The 13 percent decline, which took place on 24 it cannot happen in the future. As we have discovOctober 1929—known as “Black Thursday”— ered, the fact that up to some point the only swans proved to be a distant early warning that the Great ever observed had been white does not prove that Depression lay ahead. 1 no black swans exist. 2 The Black Swan: The Impact of From its earlier high in late August 1987 until the Highly Improbable, as most financial analysts are the stock market at last closed on that fateful Black probably aware, is the title of a recent book by Monday, some $1 trillion was erased from the total Nassim Nicholas Taleb (2007) in which he calls our value of U.S. stocks. The stunning decline shocked attention to the phenomenon and cites three charnearly all market participants, although some vet- acteristics of a black swan: erans were not surprised. For example, Alan 1. It is an outlier beyond the realm of our regular (“Ace”) Greenberg, former chairman of Bear expectations (rarity). Stearns Companies, was quoted in the newspapers 2. It is an event that carries an extreme impact as saying, “So markets fluctuate. What else is new?” (extremeness). And only a year before Black Monday, I observed 3. After the fact, our human nature enables us to to the Vanguard crew that even a 100-point decline accept it by concocting explanations that make in the Dow—something that had never before it seem predictable (retrospective predictability). occurred—was possible. Why? Because in the stock So, rarity, extremeness, and retrospective premarket, anything can happen. dictability together define the occurrence of an Not only can anything happen in the stock event that is regarded as impossible or, at least, highly improbable. What is more, as Taleb noted, market, but anything does happen. What is more, a black swan can also be the reverse of this definichanges in the nature and structure of our equity tion: the nonoccurrence of an event that is regarded market—and a radical shift in its participants—are as highly probable. making shocking and unexpected market aberra- Black Monday, then—with its rarity, extremetions ever more probable. In fact, during 2007, we ness, and retrospective predictability—was a black witnessed an unprecedented series of amazing swan. Unlike its 1929 antecedent, Black Monday did market swings. Whereas in the 1950s and 1960s, not prove to be an omen of dire days ahead. If the daily changes in the level of stock prices typi- anything, it was, quite counterintuitively, a harbincally exceeded 2 percent only three or four times a ger of the greatest bull market in recorded history (which itself may have been yet another black swan). Nonetheless, I observe little concern about the John C. Bogle is the founder and former chief executive ever-present possibility that what will occur in our of the Vanguard Group and president of Vanguard’s financial markets in coming years might prove to be Bogle Financial Markets Research Center, Valley Forge, a nonoccurrence of what market participants Pennsylvania. expect. Indeed, despite the recent wild disturbances Note: The opinions expressed in this article do not neces- in both the stock market and the bond market, most sarily represent the views of the Vanguard Group’s market participants seem confident that future present management. returns will resemble those of the past.

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Of course, only time will tell whether yet another black swan lurking beyond the horizon will become part of financial market history. But the fact is that the movements of the stock market exhibit a lot of randomness. So, the knowledge that black swans can and do occur holds important lessons for how we think about risk. Rather than slavishly looking to past market returns, we ought to be seeking out evidence that contradicts our assumptions. Indeed, this lesson goes far beyond the financial markets; it applies to the very nature of knowledge. The eminent British philosopher Sir Karl Popper (1902–1994)—well known for his use of the black swan metaphor— proposed that science does not proceed from observation to theory but proceeds the other way around. Describing his theory of science as critical rationalism, Popper held that scientific theories are abstract in nature and can be tested only indirectly. Writing about Popper in the New Yorker, journalist Adam Gopnik (2002) described Popper’s reasoning in this way: No number of white swans could tell you that all swans were white, but a single black swan could tell you that they weren’t. . . . Science, Popper proposed . . . didn’t proceed through observations confirmed by verification; it proceeded through wild, overarching conjectures, which generalized “beyond the data” but were always controlled and sharpened by falsification [i.e., proof that the theory was wrong]. (p. 90) Gopnik (2002) further explained that it was the conscious, purposeful search for falsification by refutation, by the single decisive experiment (or black swan), that Popper believed allowed science to proceed and objective knowledge to grow. Yet, most of us—in our investment ideas and in our political ideas—do exactly the reverse: We search for the facts that confirm our beliefs (reinforcement bias), not for the facts that would negate them.

The Light Shined by Knight In the markets, few theories are advanced with the search for falsification as the object, and we continue to speak of forecasts and probabilities. But probability is a slippery concept when applied to our financial markets. We use the term “risk” all too casually and the term “uncertainty” all too rarely. The distinction between them was first made by the late University of Chicago economist Frank H. Knight (1885–1972), who spelled it out in his seminal work, Risk, Uncertainty, and Profit (1921). Knight wrote:

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. . . [U]ncertainty must be taken in a sense radically distinct from the familiar notion of risk, from which it has never been properly separated. The term “risk,” as loosely used in everyday speech and in economic discussion, really covers two things which . . . are categorically different. (p. 19) Those two things are risk and uncertainty. In Knight’s view, risk properly used is a measurable quantity in which probabilities and distributions are known (as with the roll of dice). Uncertainty is immeasurable and, therefore, not subject to probabilities. Knight continued: It is a world of change in which we live, and a world of uncertainty. We live only by knowing something about the future; while the problems of life or of conduct at least, arise from the fact that we know so little . . . in business as in other spheres of activity. [We act according to our] opinion, of greater or less foundation and value, neither entire ignorance nor complete information, but partial knowledge. If we are to understand the workings of the economic system, we must examine the meaning and significance of uncertainty. (p. 199) In this view, the susceptibility of opinion or estimate to error must be radically distinguished from probability or chance because in the case of opinion, groups cannot be formed of instances of sufficient homogeneity to make possible a quantitative determination of true probability in which any sort of statistical tabulation provides any value for guidance. Knight concluded: . . . [T]he conception of an objectively measurable probability or chance is simply inapplicable. . . . [T]here is much question as to how far the world is intelligible at all. . . . It is only in the very special and crucial cases that anything like a mathematical study can be made. (various pages in Part III) In a 2004 article, Glyn A. Holton properly pointed out that uncertainty accounts for only one aspect of the idea of risk. The second aspect is exposure. People must have a stake in the outcome; it must matter to them. What Holton means is that although outcomes are inevitably uncertain, we must consider not only the uncertainties or probabilities of our choices but also the consequences that we face if we are wrong. Consequence is illustrated by the famous Blaise Pascal (1623–1662) wager on whether or not God exists. (Pascal concluded that, considering the consequences, the safer bet is that He exists.) As Peter Bernstein explained, “Considering the consequences of being wrong is essential in decision-making under uncertainty” (2007, p. 5).

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Mandelbrot on Risk, Ruin, and enced only one 20-sigma occasion—that infamous Reward Black Monday. The odds against such a happening are about 10 to the 50th power. The abstract theories of Popper, Knight, and Pascal Our markets are periodically defined by fraccan be directly applied to the financial markets, tals and power laws (although we never know which is exactly what Benoit Mandelbrot, the bril- when), but fractals and power laws do not apply in liant inventor of fractal geometry, did with Rich- many areas. The classic example is the height of ard Hudson in The (Mis)Behavior of Markets, men; another is the extremes of temperature. A ominously subtitled A Fractal View of Risk, Ruin, third, the flipping of coins, is shown in Figure 2. and Reward (2004). This pattern is the familiar Gaussian (standard freFractal geometry, simply defined, is about pat- quency) distribution curve known as the “bell terns that repeat themselves continually—in nature curve.” Yes, when two dice are rolled 1,000 times, and in geometry—scaling up or scaling down. 7 will come up (roughly) 167 times; 6 or 8, 139 times Sometimes the patterns are defined by a determi- each; 5 or 9, 111 times each; 4 or 10, 83 times; 3 or nation rule; sometimes they form entirely by 11, 56 times; 2 or 12, just 28 times. chance. They often relate to so-called power laws, But other areas in which fractals appear are where growth is not linear but logarithmic. In the surprising. One classic fractal pattern is the average Fibonacci sequence, for example, each successive wealth of U.S. citizens. The figure follows a fairly number is the sum of the two previous numbers— neat Gaussian distribution pattern until we reach that is, 1 – 2 – 3 – 5 – 8 – 13 – 21 – 34 – 55 – 89 – 144, very high figures, at which point the pattern takes and so on. As it happens, each successive number on a fractal look. For example, bring a hedge fund is 1.6 times its predecessor, and after 144, the mul- manager with annual earnings of $200 million into tiplier is 1.618, a ratio that the Greeks called “the a room of 100 people earning an average of $50,000, Golden Mean.” It is a ratio that permeates our and the average jumps to more than $2 million. globe, most notably in nature, art, and architecture. So, looking at past patterns of market repetition Mandelbrot applied this concept to the daily as a sort of Gaussian bell curve, or relying on Monte price movements of the Dow. As Figure 1 shows, Carlo simulations in which past stock market since 1915, the standard deviation (sigma) of the returns are thrown into a giant mixer that produces daily change in the Dow has been 0.89 percent; a million or more permutations and combinations, that is, two-thirds of the fluctuations were within or looking at probabilities in the stock market—all ±0.89 percentage points of the average daily send us on a fool’s errand. We deceive ourselves change of 0.74 percent. Nonetheless, the occasions when we believe that the Gaussian-like returns when the standard deviation has been as high as recorded in the stock market, as shown in Figure 3, 3 or 4 have been frequent; occasions when it has provide the bounds by which we can predict the exceeded 10 have occurred infrequently; and as future. 3 When we settle for those beliefs, we ignore Figure 1 points out, the U.S. market has experi- the potential for future black swans.

Figure 1. Daily Changes in the Dow, 1915–2007

Number of Standard Deviations 25

Black Monday 20

15

10

5

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Black Monday and Black Swans Figure 2. Expected Distribution of 1,000 Rolls of Two Dice Number of Occurrences 180 160 140 120 100 80 60 40 20 0 2 3 4 5 6 7 8 9 10 11 12 Figure 3. Distribution of S&P 500 Index Annual Returns, 1926–2006 Number of Occurrences 18 16 14 12 10 8 6 4 2 0 −30% −20% −10% 0 0 10% 20% 30% 40% More or to to to to to to to to Than More −30% −20% −10% 10% 20% 30% 40% 50% 50% Source: The Vanguard Group.

The fact is that the infrequent but extreme daily happen on so few days, and so unpredictably, sugchanges in the stock market can overwhelm the gests the perils of jumping into and out of the market frequent—but usually humdrum—fluctuations that and the value of simply staying the course. take place each day within normal ranges. For example, since 1950, the S&P 500 Index has risen from a The Wisdom of Keynes level of 17 to a recent level of 1,470. But if we deduct Although returns earned in the stock markets are the returns achieved on only the 40 market days in volatile and unpredictable, the returns earned by the which the S&P 500 had its highest percentage underlying businesses in the aggregate—which colgains—40 out of 14,588 days—the level drops to 288. lectively represent the foundation of aggregate marContrarily, if we eliminate the 40 worst days, the ket capitalization—are (or have been historically) S&P 500 will be sitting at 11,550. That so much can far less volatile and unpredictable. Put another way,

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investors are more volatile than investments. Economic reality governs the long-term returns earned by our businesses, and black swans in business are unlikely. But emotions and perceptions—the tides of hope, greed, and fear among the participants in the financial system—govern the short-term returns generated in the markets. These emotional factors magnify or minimize the central core of economic reality, and in such an environment, a black swan may appear at any time. More than 70 years ago, the great British economist John Maynard Keynes (1883–1946) recognized the critical distinction between the rational and the irrational in the stock market. In his remarkable The General Theory of Employment, Interest and Money (1936), Keynes focused on the two forces that tug at stock prices. The first he called enterprise—the rational exercise of “forecasting the prospective yield of an asset over its entire life.” (Quotations in this section are from Chapter 12.) The second was speculation—the irrational exercise of “forecasting the psychology of the market.” Together, these two factors explain what he called “the state of longterm expectation” for an investment. From his vantage point in London, Keynes observed that: In one of the greatest investment markets in the world, namely, New York, the influence of speculation . . . is enormous. . . . It is rare . . . for an American to invest . . . ‘for income’; and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that . . . the American is attaching his hopes . . . to a favourable change in the conventional basis of valuation, i.e. that he is . . . a speculator. In the U.S. stock market today, the same situation prevails—even more strongly. Keynes’ observation that speculation was overwhelming enterprise was based on the thendominant ownership of stock by individuals who were largely ignorant of business operations or valuations, which led to excessive, even absurd, short-term market fluctuations based on events of an ephemeral and insignificant character. Shortterm fluctuations in the earnings of existing investments, he argued (correctly), would lead to unreasoning waves of optimistic and pessimistic sentiment—fertile ground for the appearance of a black swan. Although competition between professionals possessing judgment and knowledge beyond that of the average private investor should correct the vagaries caused by ignorant individuals, Keynes added, the energies and skill of the professional investor would come to be largely concerned with

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forecasting what the general public will do in the market. He thus described the market as a “. . . battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years.” In my 1951 senior thesis on the mutual fund industry, I had the temerity to disagree with Keynes’ conclusions. 4 Rather than professional investors succumbing to the speculative psychology of ignorant market participants, I argued, investment pros would focus on enterprise. In what I predicted would become a far larger mutual fund industry than at that time, portfolio managers would “supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic, a demand that is based essentially on the [intrinsic] performance of the corporation rather than the public appraisal reflected in the price of its shares” (emphasis added). I was accurate about the growth of the industry, but alas, the sophisticated and analytical focus on enterprise that I expected from the professional investors failed to materialize. Rather, the emphasis on speculation by mutual funds actually increased. Call the score Keynes 1, Bogle 0. Interestingly, Keynes was well aware of the fallibility of forecasting stock returns. He noted, “It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain.” And he added (shades of Knight!), “By ‘very uncertain’ I do not mean the same thing as ‘very improbable.’” Keynes made no attempt to quantify the relationship between enterprise and speculation in shaping stock market returns, but decades later, it occurred to me to do exactly that.

Quantifying Keynes’ Distinction By the late 1980s, based on my own experience and research on the financial markets, I began to measure what Keynes called “enterprise,” which I called “economics,” and what Keynes termed “speculation,” which I called “emotions.” Economics was represented by investment return—the initial dividend yield on stocks plus the subsequent annual rate of earnings growth. Emotions I defined as speculative return—the change in the price investors are willing to pay for each dollar of earnings (essentially, the return generated by changes in the valuation or discount rate that investors place on future corporate earnings). Simply adding speculative return to investment return—a crude but simple step—produces the total return generated by the stock market.

©2008, CFA Institute

The investment return on stocks has proven to be remarkably susceptible to the application of reasonable expectations. The initial dividend yield—a crucial but underrated factor in shaping stock returns—is a known factor. The secular rate of earnings growth, although hardly certain, is relatively stable. Corporate earnings in the United States have grown with remarkable consistency at about the rate of the U.S. GDP. There have been no black swans in long-term investment returns. Even the sharp drop in corporate earnings during the Great Depression was but a 2-sigma event, within the 95 percent probability range. Speculative return has proven to be, well, speculative. It has alternated from positive to negative over the decades. 5 But in the long run, even speculative return has produced no black swans. In fact, when P/E multiples were low by historical standards (say, below 10 times earnings), they were likely to rise over time. And when they were high (say, above 20 times), they were likely to decline (although in neither case did we know when the change was coming). Certainty about the future never exists, nor are probabilities always borne out, but applying reasonable expectations to investment return and speculative return and then combining them has proved to be a sensible and effective approach to projecting the total return on stocks over the decades. The point is this: Over the very long run, it is the economics of investing—enterprise—that has determined total return. The evanescent emotions that surround investing—speculation—so important over the short run, have ultimately proven to be virtually meaningless. For example, the 9.6 percent average annual return on U.S. stocks over the past century was composed of 9.5 percentage points of investment return (an average dividend yield of 4.5 percent plus an average annual earnings growth of 5 percent) and only 0.1 percentage point of speculative return, arising from an inevitably period-dependent increase in P/E. Despite the black swans of stock market history, ownership of U.S. business for investors who have stayed the course has been a remarkably successful strategy.

Minsky Adds a Crucial Ingredient I envisioned that the simple insights presented would provide a framework for understanding stock market returns. But I failed to consider the extent to which speculation in the financial economy (emotions) might influence changes in the business economy (enterprise). When I learned of the work of the great U.S. economist Hyman Min-

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sky (1919–1996), who dedicated much of his career to what he described as the “financial instability hypothesis,” I recognized that an additional key element of “risk”—here, clearly “uncertainty”— had to be considered. 6 In 1974, Minsky observed the fundamental link between finance and economics with these words: “The financial system swings between robustness and fragility, and these swings are an integral part of the process that generates business cycles.” The prevailing financial structure, under this concept, then, becomes a central determinant of the behavior of the capitalist economy. Minsky added: Financial markets will not only respond to profit-driven demands of business leaders and individual investors but also as a result of the profit-seeking entrepreneurialism of financial firms. Nowhere are evolution, change, and Schumpeterian entrepreneurship more evident than in banking and finance, and nowhere is the drive for profits more clearly the factor making for change. 7 Long before the recent wave of complex financial products, Minsky observed that the financial system is particularly prone to innovation. He noted the symbiotic relationship between finance and industrial development, in which “financial evolution plays a crucial role in the dynamic patterns of the economy.” When money-manager capitalism became a reality during the 1980s and institutional investors became the largest repositories of savings in the country, they began to exert their influence on financial markets and the conduct of business enterprises. This change in the structure of capitalism has been dramatic. A half-century-plus ago, individuals owned 92 percent of U.S. stocks and institutions owned but 8 percent. Currently, individuals own 26 percent and institutions, 74 percent. In this new environment, the raison d’être for money managers (and the basis by which they were held accountable) became the maximization of the value of the investments made by their clients—measured over periods as short as years or even quarters. As institutional managers turned increasingly to speculation (versus investment, just as Keynes had predicted), business executives became increasingly attuned to short-term profits and the stock market valuations of their companies. The growing role of institutional investors fostered continued evolution of the financial system by providing a ready pool of buyers of securitized loans, structured finance products, and myriad other exotic innovations whose complex risks are shaking the financial markets today.

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Minsky’s key concept was that the financial increase of more than 20 times. 8 The costs that the economy, focused on speculation, should not be con- nation incurs in its financial economy must, by sidered separate and distinct from the productive definition, be subtracted from the value created by economy, focused on enterprise. His expectation— its productive businesses. and fear—like that of Keynes, was that speculation We can measure the dominance of the financial would come to overwhelm enterprise. Were Min- economy over our productive economy in many sky and Keynes right? Recent history seems to con- ways. In 1975, as shown in Figure 4, the stock firm their fears, as rampant speculation in the market had an aggregate capitalization of $800 bilmarkets has added a new element of uncertainty into lion, about 50 percent of the $1.6 trillion value of the our economy. goods and services that the United States as a Indeed, my view of the secular changes in the nation produces each year, measured by GDP. But economy (which is similar to Minsky’s view) is that while GDP was rising 8 times over between 1975 over the past two centuries, the United States has and 2007, stock valuations were rising nearly 20 moved from an agricultural economy to a manu- times over. Today, the $15.7 trillion aggregate value facturing economy, to a service economy, and to of U.S. stocks is actually equal to about 120 percent what is now predominantly a financial economy— of the country’s $13 trillion GDP. and a global one at that. The United States, it seems Moreover, comparing the capitalization of the to me, is now on the way to becoming a country U.S. stock market with U.S. GDP greatly underwhere no business actually makes anything. We states the rise in speculation, for new financial merely trade pieces of paper, swap stocks and “products” have themselves overwhelmed stock bonds back and forth with one another, and pay the market valuations. In 1957, the market value of financial croupiers a veritable fortune. stocks in the S&P 500 was $220 billion and futures Furthermore, the creation of ever more com- and options markets on the index did not even plex financial derivatives that entail huge and exist. 9 By 1982, the value of the S&P 500 had soared unfathomable uncertainties and risks adds sub- to $1.2 trillion and the then-recently-created S&P stantially to those intermediation costs. Led by 500 futures and options outstanding totaled $438 Wall Street investment bankers and brokers and billion, about one-third the value of the index itself. mutual funds, followed by hedge funds, pension By the close of 2006, with the S&P 500 valued at $12 fund managers, financial advisers, and all the other trillion, futures and options contracts on the index participants in our financial system, these costs had soared to $20 trillion—an “expectations marhave soared to staggering proportions. Aggregate ket” valued at almost double the value of the “real annual costs incurred by market participants have market.” On this basis, stock market participants risen from an estimated $2.5 billion as recently as have a $32 billion stake in the S&P 500, equal to an 1988 to something like $528 billion in 2007, an astonishing 250 percent of GDP.

Figure 4. U.S. Stock Market Capitalization as a Share of GDP, 1945–2006

Capitalization as Percent of GDP 200

150

100

50

Source: U.S. Federal Reserve Board and U.S. Department of Commerce.

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Even more striking is the truly staggering seen by the original lenders. It is common sense that increase in financial transactions of all types, a under such conditions the lenders pay far less attenglobal phenomenon whose implications are far tion to loan quality than if they were keeping the from clear. Although the world’s GDP is about $60 loans. Nor is it surprising that the creators of these trillion, the aggregate nominal value of global mortgage-backed bonds have no incentive to help financial derivatives is said to be $600 trillion, fully mortgagees in distress work through their financial 10 times as large as all of the net goods and services difficulties and retain their homes. produced by our entire world. Among the riskiest Given Wall Street’s ever-pressing need to have of these derivatives are credit-default swaps, which something, anything, to sell in the way of “new alone total $45 trillion, an amazing ninefold product,” it is hardly surprising that these collaterincrease in the last three years. These swaps are five alized debt obligations (CDOs) became more and times the size of the U.S. national debt and three more complex over time, with risk more and more times U.S. GDP. 10 deeply concealed. U.S. SEC-registered rating agenIf Minsky’s nightmare has not yet materialized cies placed their imprimatur on hundreds of new in full, surely the value of speculation in the U.S. issues of CDOs that were created entirely out of financial system has come to dominate the nation’s subprime mortgages. (These agencies, as I underproductive economy. Keynes’ warning of 70 years ago seems almost prescient: stand it, were paid some $400,000 per rating.) A typical example is provided in Figure 5. The [T]he position is serious when enterprise column on the left shows what might be underlying becomes the bubble on a whirlpool of specula- the CDO—subprime mortgages that would likely tion. . . . When the capital development of a country becomes a by-product of the activities be considered as rated B, C, or even D in quality. of a casino, the job [of capitalism] is likely to be Transformed by the CDO, however, 75 percent of ill-done. (from Chapter 12) the value of the bonds were in tranches (series) rated AAA, another 15 percent were rated at least Risk and Ruin—A Reprise A, and 5 percent were rated BBB. Only the remainJust as the volume of financial transactions has ing 5 percent carried a rating of B. One might call soared, so has their mind-numbing complexity. The this magical conversion of low quality into high most recent example is, of course, the boom in quality a new version of the old alchemy—turning mortgage-backed debt obligations, part of the secu- lead into gold. This financial alchemy represented lar move toward the “securitization” of assets of all the same false promise, an illusion. Financial lead, kinds. Once held largely by community banks for it turns out, is still lead. By early 2007, when mortlocal citizens (the Jimmy Stewart movie It’s a Won- gage defaults began to snowball, the financial crisis derful Life comes quickly to mind), mortgages have in mortgages was upon us, at a great (and growing) been disintermediated by lenders pooling their cost to U.S. citizens and society. This crisis is a loans and sending them off to Wall Street for con- classic example of the impact of the financial econversion into “packaged products” never again to be omy on the real economy.

Figure 5. The New Alchemy

100% 75% B/C/D? AAA

15% A 5% BBB 5% B Underlying Investments Bonds Issued

Source: Bogle Financial Markets Research Center.

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Given the nature of the modern financial sys- Figure 6 shows that today’s projected equity pretem, few giant investment banks had the courage mium of only 2 percent would be 60 percent below to jump off the mortgage-backed bandwagon (and the century-long average of 5 percent. Such a spread even fewer had the guts not to jump on). Issuance assumes (1) that bonds, based on the current yield of such bonds in the United States in the past five on investment-grade issues, should return about 5 years totaled $2 trillion (including both prime and percent annually over the coming decade and (2) subprime mortgages), which probably generated that stocks, based on today’s dividend yield of about an estimated $80 billion of revenues to Wall 2 percent and prospective nominal earnings growth Street—its investment bankers, its brokers, its rat- of about 6 percent (with a shading for the slightly ing agencies, its attorneys, and its securities proces- lower P/E that I expect a decade hence), could sors. I conclude that, like Oscar Wilde, the only return about 7 percent annually. On the other hand, thing the banks could not resist was temptation. risk is already being repriced in the bond market. As Even the biggest and most savvy firms reveled at Figure 7 shows, the spread of rates on high-yield the party, with its rocking music and joyous danc- bonds over intermediate-term U.S. Treasury bonds, ing. Charles Prince, former chairman of giant Citi- which tumbled from 10 percent in 2002 to 3 percent group, said of the situation, “As long as the music in mid-2007, has leapt to about 6 percent amid the is playing, you’ve got to get up and dance. We’re growing unpleasantness in the mortgage market. still dancing” (Nakamoto and Wighton 2007). Our markets seem to be ignoring the warning But as 2007 ended, Citigroup’s write-down in issued by former U.S. Federal Reserve Board chairthe value of its CDOs (and other deteriorating cred- man Alan Greenspan in 2005: “History has not its) would total an astonishing $22.1 billion. For dealt kindly with the aftermath of protracted periMerrill Lynch, the write-down was even larger, ods of low risk premiums.” 12 When participants in $24.1 billion. UBS has written down $18.4 billion. the financial services field ignore the lessons of And HSBC has so far written down $10.7 billion. 11 history, yet another set of financial uncertainties Following a long era of cheap credit, easy credit with potential black swans is created. availability, and borrowers with high confidence and low collateral, the price is beginning to be Other Risks paid—even as the U.S. economy faces a plethora of The risks in our financial sector are hardly the only other risks created by the financial system. risks investors face. Some huge, seemingly unacknowledged, risks characterize U.S. society. ConHigh Risks, Low Risk Premiums? sider: the Social Security and Medicare payments If systemic risks are increasing, how can risk premi- committed to by our national government; the string ums on stocks in the U.S. market be less than one- of huge (and, in fact, understated) deficits in the U.S. half the historical average? On the one hand, federal budget (see Gokhale and Smetters 2007); our

Figure 6. U.S. Equity Risk Premium for Trailing 10-Year Periods, 1909–2006

Percent 20 Premium 15

10

Average 5

0

−5

−10 09 21 33 45 57 69 81 93 05 Source: Bogle Financial Markets Research Center.

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Figure 7. Yield Spread between High-Yield U.S. Corporate Bonds and Intermediate-Term T-Bonds, January 1987–June 2007

Percent 15

Spread

10

Average 5

enormous expenditures (soon to reach $1 trillion) on end them. The stock market, indeed, seems to be the wars in Iraq and Afghanistan; terrorism; the saying that it expects the Republic not only to mudthreat of global warming and the cost of dealing with dle through but to surmount the troubles. I can only it; unfettered global competition, our trade deficit, hope that the market is right. and the decline in the value of the U.S. dollar. Whatever the case, some surprising event out Other risks are more subtle in nature: a political there, far beyond our expectations, will surely system dominated by money and vested interests; come to pass, an event that will carry an extreme a Congress and an administration seemingly impact, and one for which, once it happens, we’ll focused entirely on the short term, with an attitude quickly concoct an explanation as to why it was so of “the long-term consequences be damned”; the predictable after all. That event, if—perhaps I vast chasm between the wealthiest among us and should say when—it comes, will be just one more those at the bottom of the economic ladder (the top black swan. 1 percent of our citizenry holds more than a third of our total wealth, whereas some 20 percent of New Afterword York City residents earn less than $8,300 per year); our self-centered, “bottom-line” society focused on This essay is based largely on a speech delivered to money over achievement, charisma over character, the Risk Management Association on 11 October and the ephemeral over the eternal; and finally, the 2007. In early February 2008, the extreme volatility paucity of leaders who are willing to, well, lead— in the stock market continued at high levels, the to defy the conventional wisdom of the day and to contagion in the CDO markets had continued to stand up for what is right and noble and true. spread, and the stock market (the S&P 500) had So, the risks are high; the uncertainties rife. Yet, declined by another 14 percent. Together, these probperhaps we’ll muddle through. After all, through- lems in the financial economy seemed to be spreadout our 230-year history, the United States has ing to the productive economy, with an emerging always done exactly that. Perhaps, too, our society consensus that a business slowdown, if not a recesand our economy will continue to reflect the resil- sion, lies ahead. The plethora of risks that I described ience that they have demonstrated in the past, often in the article are beginning to manifest themselves, against all odds. And perhaps we’ll come to our although a black swan has yet to appear. collective senses and develop the courage to take arms against this sea of troubles and by opposing, This article qualifies for 0.5 CE credit.

March/April 2008 www.cfapubs.org 39

Financial Analysts Journal

Notes

1. From its September 1929 high of 381 to its July 1932 low of 41, the Dow dropped by an astonishing 90 percent. 2. Before the discovery in the 17th century of Australia, where black swans are common, Europeans thought that all swans were white; to imagine swans of any other color was completely unreasonable. 3. The average annual return on stocks during the 1926–2006 period was 10.4 percent. Curiously, in only 2 years of those 80 years did the returns realized fall between 9 percent and 11 percent. The “average” year, then, rarely occurred. 4. This thesis, written for Princeton University, was entitled “The Economic Role of the Investment Company” and was published in Bogle (2001). 5. For a discussion of the stock market’s historical returns, including each decade’s investment return, speculative return, and total return, see pp. 15–18 of Bogle (2007). 6. In this section, I have liberally quoted and paraphrased investment adviser Frank K. Martin (2006). Martin’s quotes from Hyman Minsky come from Minsky’s 1974 article “The Modeling of Financial Instability: An Introduction,” in Modeling and Simulation.

References

Bernstein, Peter L. 2007. “In Defense of the Greenspan Put and a Call on Pascal’s Wager.” Economics and Portfolio Strategy (15 December): www.peterlbernsteininc.com/. Bogle, John C. 2001. “The Economic Role of the Investment Company.” Princeton University thesis in John Bogle on Investing: The First 50 Years. Columbus, OH: McGraw-Hill. ———. 2007. The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns. Hoboken, NJ: John Wiley & Sons. Gokhale, Jagadeesh, and Kent Smetters. 2007. “Do the Markets Care about the $2.4 Trillion U.S. Deficit?” Financial Analysts Journal, vol. 63, no. 2 (March/April):37–47. Gopnik, Adam. 2002. “The Porcupine: A Pilgrimage to Popper.” New Yorker, vol. 78, no. 7 (1 April):88–93. Holton, Glyn A. 2004. “Defining Risk.” Financial Analysts Journal, vol. 60, no. 6 (November/December):19–25. Keynes, John Maynard. 1936. The General Theory of Employment, Interest and Money. London: Macmillan, Cambridge University Press, for the Royal Economic Society. (Currently available from Prometheus Books and at http://cepa.newschool.edu/het/ texts/keynes/gtcont.htm.)

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7. Joseph Schumpeter (1883–1950) characterized capitalism with the famous phrase “creative destruction,” in which the old ways of doing things are endogenously destroyed and replaced by new ways. 8. These data are Bogle Financial Markets Research Center estimates based on data from the Securities Industry and Financial Markets Association, Lipper Analytical Services, and Empirical Research Associates. I recognize the fragility of these data and continue to urge a thorough and independent economic analysis of the costs and benefits of our financial system. 9. Data in this paragraph are from the McGraw-Hill Companies symposium held 20 June 2007 to recognize the 50th anniversary of the S&P 500. 10. These figures come from Seides (2007). 11. These write-down amounts are from the New York Times (1 February 2008, p. C6). 12. Spoken at a symposium entitled “The Greenspan Era: Lessons for the Future” in Jackson Hole, Wyoming, 26 August 2005.

Knight, Frank H. 1921. Risk, Uncertainty, and Profit. Boston: Houghton Mifflin (www.econlib.org/LIBRARY/Knight/ knRUP.html). Mandelbrot, Benoit, and Richard L. Hudson. 2004. The (Mis)Behavior of Markets: A Fractal View of Risk, Ruin, and Reward. Cambridge, MA: Basic Books. Martin, Frank K. 2006. Martin Capital Management Annual Report (http://mcmadvisors.com/downloads/2006_Annual_Report_ 8_5_x_11_copy_for_website.pdf). Nakamoto, Michiyo, and David Wighton. 2007. “Citigroup Chief Stays Bullish on Buy-Outs.” Financial Times Limited (9 July): www.ft.com/cms/s/0/80e2987a-2e50-11dc-821c-0000779fd2ac. html?nclick_check=1. Seides, Ted. 2007. “The Next Dominos: Junk Bond and Counterparty Risk.” Economics and Portfolio Strategy (1 December): www.peterlbernsteininc.com/. Taleb, Nassim Nicholas. 2007. The Black Swan: The Impact of the Highly Improbable. New York: Random House.

©2008, CFA Institute