There is a thought-provoking article up on Bloomberg talking about investors’ inability to properly price geopolitical risk. Among other things, it points to the VIX this year, which is almost ten percent below its average, despite the increasing tensions in energy flashpoints all over the world.
The piece concludes with this useful reminder:
The world has been here before. Despite obvious signs that all was not well, financial markets were “pretty much priced for perfection” in the months leading up to World War I, said [one observer].
Even so, noted Harvard historian Niall Ferguson in the February 2006 issue of The Economic History Review, for decades prior there had been speculation about the potential financial consequences of a war between European powers.
Still, it wasn’t until more than three weeks after the assassination of Austrian Archduke Franz Ferdinand on June 28, 1914, that the Times newspaper in London made the first mention of the possibility that a European political crisis could be a source of financial instability. Less than two weeks later World War I erupted, and European financial markets closed for the year.
“To investors, the First World War truly came as a bolt from the blue,” wrote Ferguson.
Complacency’s price proved steep. British government-bond prices fell 44 percent between 1914 and 1920. French bonds lost 40 percent. Russia defaulted on its debts, while the value of German and Austrian bonds was dissipated in hyperinflation.
The lesson, according to [an observer]: “This might simply tell us that markets don’t price worst-case outcomes until such time as they actually happen.”
Remarkable, is it not? Three week after the events that precipitated World War I, the markets still hadn’t priced it in. As ever, markets simply don’t price extreme values or lower likelihood events very well, and never have.
Some people have tried to make money from the market’s mispricing of extreme events, most notably Nicholas Taleb, with his “black swan” option strategy. While that is apparently still in operation, Taleb tells me that he is
longer actively doing the trading, having wearied of that side of the
business and left it to others in whom he has an economic interest.
[Correction: In an earlier version of this post I said that Taleb's investors had lost patience with the strategy and moved on. It was Taleb himself who moved on.]