Bank stocks and investment turkeys

I recently had a beer with a friend and we started discussing about Temasek, a topic that seems to be losing steam in the press (perhaps intentionally?). I pointed out how Temasek's huge concentration in financial stocks (40% of their portfolio) is a huge concentration of risk, especially since banks are hugely susceptible to "negative Black Swan payoffs" rather than positive Black Swan payoffs.

For the uninitiated, negative Black Swan payoffs are like Taleb's analogy of the turkey being fed steadily by the butcher (i.e. stable returns over an extended period of time) before dying quite abruptly in the abbatoir. The returns look like this (taken from Taleb's article in Edge.org):

To compare this turkey with bank and financial stocks, look at IndyMac's earnings before insolvency:

You really could replace "IndyMac" with just about any big bank that were former stars: UBS, Citibank, RBS, etc. (Aside: I've noticed that some of the banks that took the biggest hits have names and acronyms that end with S-es: UBS, RBS, MS. Perhaps they were thinking with their S-es while trying to follow the trendsetting S: GS.)

On this basis of the payoff structure, I said it's quite inadvisable to put too large a portion of your portfolio in banking stocks. My friend took issue with it, saying "you're saying all banks are bad investments"; what I was really saying was that, if you're going to invest in banks, then you better hedge your bets (e.g. by buying a put option on the S&P Financials index ETF or by portfolio diversification) rather than put most of your eggs in this basket of turkeys.

Personally, I wouldn't go anywhere near a bank in terms of investments, as I don't know when they will be impacted: an ex-girlfriend's grandfather was a long time investor in a Singapore bank, and he got very badly burned in this recent turmoil. The negative payoffs are completely not predictable ex ante. By the same logic, I won't go near an insurance company (except as their client), but this is especially with my working hypothesis on the interaction between global warming and increased human growth and urbanization [Note: my working hypothesis is that the confluence of both factors increases the likelihood of natural disasters happening with greater frequency (global warming), and with ever greater economic impact (human population growth and widespread urbanization). E.g. the huge 1883 eruption of Krakatoa killed an estimated 30,000 people, when the Indonesian archipelago was relatively unpopulated; in contrast the much smaller-scale Asian tsunami killed around 180,000 people through Southeast Asia despite being a relatively minor geological event. I shudder to think what should happen if Lake Toba blows up, or if a super typhoon hits China].

Essentially my view is that buying an insurance stock is akin to writing an option, while being their customer is to long an option. I'm not too keen on being an investment turkey, so I think I'll stick to being a bank and insurance company customer, rather than an owner, for now.

In the meantime, now is probably a very good time to go into stocks of companies that provide reliable services that will definitely be required, the so-called defensive stocks, like utilities, waste management, commodities, pharmaceuticals, etc. It's well worth looking into these, particularly into waste management companies, which is something I've been promising myself to do ever since the Economist published a special report on waste.