Investing & the Price of Complacency

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.]


  1. This is an extremely important and fundemental point. Question is: how does one make money?

  2. Well, extreme events are sort of by definition unlikely. So any attempt to trade them or even price them is going to suffer from a lack of feedback, as well as a long wait to collect on any strategy.

  3. This is not historically unprecedented, and is actually a fairly common investment phenomena.
    When the great San Francisco earthquake hit in April 18, 1906, it took the markets a few weeks to register the costs and economic impact. By May, the markets had fallen 10%. But the full impact was not well understood until the following year, leading to the Panic of 1907, and the Dow took a nearly 50% hit during that period. (History buffs will recall the Panic and its aftermath were the impetus for the creation of the Federal Reserve System).
    Consider a more recent example: The 1973 OPEC oil embargo. For several weeks, markets all but ignored the issue, as U.S. stock markets traded sideways. Investors eventually recognized the enormity of what the embargo meant to the U.S., and stocks sold off.
    Even more recently, the market’s rallied a week or so past Katrina, despite the obvious devastation to the nation’s busiest port and largest region of natural gas supply.
    The key to each of these events was the gradual comprehension by investors of the enormity of what occurred. Investors are emotional creatures who often react to visceral evidence, rather than relying on contemplative analysis. It turns out that Denial is a surprisingly common trait amongst investors . . .