As a freshman accounting major I was required to take two science courses. Since I placed out of chemistry, I was able to choose whatever I wanted for my second course. I chose Astronomy, one of the two smart course choices I made during my undergraduate career. (The other was Sports in American Life.) I loved that Astronomy course. It had just enough physics that I could still follow what the professor meant, but not enough to make it evident that my high school physics teacher was more interested in the girls P.E. coach than in teaching physics. In fact, I enjoyed it so much that I signed up for a second astronomy course simply because I had room for an elective.
The second course bore no resemblance to Astronomy as I had come to know it in the first course. The enticing title of the course, “Black Holes and Stellar Masses,” quickly devolved into the droning of an incredibly boring professor on topics indecipherable to man (or at least to accountants). For some unknown reason, if you look at my undergraduate transcript, the course is listed as “Astronomy Bizarre.” How apropos. What began as a wondrous exploration of the mysteries of deep space became an obsession about how much mass could collapse upon itself.
I used to teach at a university that had a live lion in a habitat on campus. Please note that I said “a lion”, as in only one, meaning that this lion was unhappy most of the time. (The current lion is much happier, because they expanded the habitat and gave him a female companion.) It is interesting and unique to have a lion on campus, the kind of thing that you like to tell friends about who live on less savage campuses (no offense, Reveille). I actually stayed in the President’s Home on campus during one visit before I started teaching there. I awoke at 6 a.m. to a jungle roar.
I did not understand lions, because it was not really my job. But it was possible that this creature that I did not understand could significantly affect my life. I can remember thinking to myself, what exactly is the plan if the lion gets out? If I am going to lunch, and I look up to find myself face-to-face with a lion, what is my next step? There may well be a documented plan, but I guarantee you that no faculty member on that campus knew what it was. And those who did were unlikely to carry it out in the heat of the moment.
This brings me, logically, to the 1000 point intraday drop in the Dow last week. As I write, people are still speculating as to what triggered the selling spree that caused Procter and Gamble to plunge 36% and consulting firm Accenture to temporarily trade at a penny. Watching the market the other day and listening to people describe their emotions and decisions reminded me of a bunch of professors trying to decide what to do now that Leo is out of the cage. The popular term for unexpected events in the market is “Black Swans”, after Nassim Taleb’s book, Black Swan: The Impact of the Highly Improbable, which claims that these devastating “unlikely events are far more likely than most investors believe,” according to Tuesday’s Wall Street Journal. In fact, a hedge fund advised by Taleb made a $7.5 million options bet that the market would fall, and this transaction may have started a string of transactions that caused the Dow’s dramatic drop.
Things eventually turned, with some people taking advantage of the situation and some transactions being unwound after the fact. But this black swan was a “loose lion” moment for many people in the market, something they had not experienced before. The markets have chosen efficiency over accuracy, and with electronic high-frequency trading firms providing the bulk of the trades and much of the market liquidity, rapid adjustments of this sort are likely to happen again. Of course, safeguards will be put into place. Leo’s habitat will be redesigned to make escape much more difficult.
But today people are wondering—can one influential trade linked to a bunch of trading robots cause a market disaster? How do I hedge the risk of this type of event happening? The black swans of today are the black holes of my yesterday, collapsing all mass within reach on top of themselves. And as happy as Leo is on a normal day in his habitat, what do we do if he gets out?
I was pleased to see this blog on last Thursday’s fiasco. I work in a wealth advising firm and have been following the whole ordeal rather closely. I am surprised; however, that you made no mention of the decision made by the officials of the NYSE and Nasdaq market regarding the cancellation of trades that met the 60% threshold. It would seem the aggressors taking risks and buying securities as the market was collapsing were denied the return, which in my opinion was proportional with the risks being taken (lets not forget the European credit situation the contradicting opinions of outcomes).
I am aware of the opposing view and the people that lost drastic amounts based on a system “failure”. However, anyone that invests knows they are taking risks of losing, and that loss has endless potential. My opinion is that Thursday was a display of how amazingly efficient our systems are. With that efficiency, like being able to buy/sell shares and view instant real time prices of securities on an iphone in class, comes new risks.
I’m waiting for the moment it is announced who put in the wrong number of 0’s on a proctor trade causing widespread panic. I think it’s fair to say that is grounds for an “instigating a riot” citation by your local police.
Scott, your point is well taken. And I am clearly not as efficient as the markets, since I spent four paragraphs talking about black holes and a campus lion, and I can only make the blog so long. There was also an interesting WSJ article this week about two traders, one whose trade was unwound, the other’s which wasn’t, and I don’t want to just duplicate what the WSJ has to say about things. The market incorporates information rapidly, including mistakes. There is no (or not much) “Did you really mean _________ ?” in the markets. I still am not fully convinced what caused the drop. But if you’re going to drive on the Autobahn or in Montana with no speed limit, you’d better have good drivers. And you’d better not stop to change a tire.