How to Deal with Stochastic Events

Last week, investors throughout much of the world either went to sleep with or woke up to the headlines about the drone strike on an Iranian commander.  This was clearly an important story from a geopolitical perspective, but events of this nature require a clear focus from traders and investors when assessing their impact upon one’s portfolio.

Significant events that occur seemingly out of the blue are often referred to as stochastic events.  It is useful to think of them as “unknown unknowns.”  This differentiates them from the multitude of “known unknowns” that drive the markets daily.  The latter category includes items like earnings, sales, dividends, interest rates and the like.  All market participants know that these items influence prices of individual stocks and the broad market, and many of them are well-telegraphed.  Companies typically announce their earnings release dates well in advance and the Federal Reserve publishes a calendar of its significant events.  In the interim, traders and analysts digest a wide range of news items to help them prepare for these developments and price financial instruments accordingly.

Stochastic events, or “unknown unknowns”, seem impossible to plan for – but that is only partially true.  The most recent event was a closely guarded secret, but investors should have expected that there was a reasonable possibility for some sort of crisis that could impact oil producing nations in the Middle East.  One could not have hedged the risks surrounding this specific incident, but smart risk managers would have game plans ready for events of this nature. 

Traders and investors should continually consider how a wide range of low probability, high impact outcomes might affect their positions.  Advance planning would help one to avoid catastrophic portfolio risk and offer a path for seeking opportunities during a chaotic period.  It is extraordinarily difficult and expensive to hedge amidst a nervous market, and it is very difficult to strategize more quickly than those who have done so beforehand.

Last week’s incident fell under the category of potential oil shock, since it directly affected relations among leading oil producers.  The price of crude oil jumped accordingly, along with classic safe havens like US Treasuries, gold and the yen. That they moved so quickly it’s a testament to the preparation that the fastest traders have done in order to respond to news of this type and magnitude.  Other risk assets fell, as markets tend to utilize a broad “risk on/risk off” paradigm.

As with many moves of this type there was an early overreaction, as we saw oil fall from its highs and equity indices rally from their lows.  This is a testament to avoiding panicky situations at all costs.  On Friday morning someone was selling S&P Index futures down nearly 50 points, and he had to regret that sale as those futures halved their losses shortly thereafter.  It is imperative not to succumb to panic, and even more imperative not to put yourself in situations that require you to act during those moments.

There are many more nuances to this topic, and I expect to be discussing them in writing and on video in the coming days.  But the most important takeaways from unexpected geopolitical events are to be prepared in advance for low probability/high outcome events and not to panic when they do occur.