A black swan event can have a tremendous effect, both positive or negative, on financial markets and on investment portfolios. These are events that occur from time to time, are unpredictable and often come with little or no warning. In this post we will discuss some notable black swan events that have occurred in history, how one can prepare for them, and how they can best be dealt with if or when they occur.
- What is a black swan event?
- Where did the term “black swan” come from?
- Understanding black swan events
- Examples of black swan events
- Grey swans and tail risks
- How to deal with black swan events?
What is a black swan event?
A black swan event is an event that is completely unexpected and cannot be predicted. Unexpected events are generally referred to as black swans when they have significant consequences, though an event with few consequences might also be a black swan event. It may or may not be possible to provide explanations for the occurrence after the fact – but not before. In complex systems, like economies, markets and weather systems, there are often several causes. After such an event, many of the explanations for its occurrence will be overly simplistic.
Where did the term “black swan” come from?
The term ‘black swan’ was coined by Nassim Nicholas Taleb who’s third book covered the subject. Taleb used the term to describe unpredictable and unexpected events that have occurred throughout history. The term was originally used in England as a metaphor for things that didn’t exist – because at the time it was assumed that black swans did not exist. When explorers first went to Australia, they found that a species of black swans did in fact exist, and the metaphor became meaningless. Black Swan Theory is now a widely discussed part of broader event theory.
Understanding black swan events
Taleb said that a black swan event has three attributes:
Firstly, they are outliers that exist outside of what people believe possible. Taleb describes the tendency of humans to assume that the worst-case scenario we have experienced is the worst-case scenario that can occur. He, calls this the Lucretius Problem after the Roman poet Titus Lucretius Carus who said that “the fool believes that the tallest mountain in the world will be equal to the tallest one he has observed.”
Secondly, they have an extreme or significant impact. Their effect can be devastating, or constructive. Wars and stock market crashes are obviously devasting and can have far reaching implications that last for years. Positive black swans like the personal computer and internet have a broad positive effect but can also be disruptive at the same time.
Finally, in an attempt to make an event predictable and explainable, humans will try to rationalise the causes of a black swan event. The rationalisations that are made are often irrelevant because the next black swan will be completely different.
When it comes to stock markets, the main black swan effect is increased volatility. This is not just due to the actual effect, but the psychological effect of something completely unexpected happening on market sentiment.
Examples of black swan events
While natural disasters may not be predictable, they are not usually black swans. We know there will be storms, earthquakes and volcanic eruptions in the future. While we don’t know when they will occur, we can’t say they are unexpected. For a natural disaster to be a black swan it has to be unprecedented in some respect.
Even then, whether or not it qualifies as a black swan event may be debatable as record keeping only dates back a certain amount of time. The 2004 Tsunami in South East Asia is probably the natural disaster most likely to qualify as a black swan, though some would dispute that claim.
Major wars and terrorist events are often black swans. Both World War One and Two were black swans because in the decades leading up to them, war in Europe was thought to be a thing of the past. The attack on Pearl Harbour was also completely unexpected and unprecedented. The 9/11 attack on the Twin Towers in 2001 was unexpected, unprecedented and had far reaching implications on the world. However now that an attack of that magnitude has occurred, most terrorist attacks are not black swans.
The Fukushima nuclear disaster was also a black swan as the nuclear facility was supposed to withstand storms and waves far larger than had ever occurred before. The emergence of the personal computer, internet and mobile phone were unexpected and have changed the world forever. While computers have been around for a long time, the fact that they could become so powerful and have such far reaching implications was never really predicted.
More minor or temporary black swans can also occur in popular culture. New fashion trends are often unexpected and have a large impact on societies. The success of certain books, movies and music can also qualify as black swans.
When it comes to markets and economies, the global financial crisis is the most widely sited example of a black swan event. While there were some predictions of the event, few expected it to have the effect it did on markets and the global economy. The original crisis may have occurred in the United States, but it caused damage to economies all over the world.
Grey swans and tail risks
An important aspect of any black swan event is the fact that it cannot be predicted. Some events however are predictable to a certain extent. A grey swan is an event that can be anticipated to some extent, although the probability is thought to be very low.
If you read “The Big Short” by Michael Lewis (or watch the movie) you will know the Global Financial Crisis in 2008 was not a surprise to everyone. In general, it was still a black swan because hardly anyone could foresee how destructive it would be. This also underscores the fact that whether or not an event is a black swan, depends on an individual’s own expectations and experience. An event that is a black swan to most people may be a grey swan to people with more knowledge of a system.
Tail risk is a type of portfolio risk that exists when the probability of extreme events is underestimated. This can often occur when a complex system has a series of feedback loops. For example, a stock price might be thought to have a very low probability of falling 3 standard deviations below its mean.
However, if it falls 2 standard deviations, the resulting change in sentiment can cause it to continue falling. In other words, the fact that it fell 2 standard deviations increased the probability of it falling 3 standard deviations. The above situation could be an example of a grey swan to people who understand the dynamics of a particular market.
How to deal with black swan events?
As mentioned, black swans cannot be predicted. That means you cannot prepare for any specific black swan event. Investors often make the mistake of preparing for the last bear market, rather than the next one. What you can do however is prepare for the unexpected by positioning a portfolio so that it is not overly exposed to any particular investment or asset class. Broadly speaking, this means a portfolio needs to be diversified.
Effective asset allocation is the best way to ensure that a portfolio can endure over the long term as black swan type events will inevitable occur. Chasing returns in the top performing areas of the market may produce great returns in the short term, but it only takes one catastrophe to wipe out a portfolio that is not diversified. A portfolio can be diversified by asset class, region and investment or product style.
Remember also that not all black swans are negative, and capitalising on certain events can help to offset losses that occur elsewhere in a portfolio. The occasional stock market crash or severe correction should be expected and accounted for in an investment strategy. A bear market can actually be an opportunity and a well-positioned portfolio can capitalise on the volatility and on lower prices. Hedge funds for example, can capitalise on falling prices with short positions, as well as on relative value trades created by volatility.
Buying value stocks with a margin of safety will also help to eliminate likely downside in the event of a black swan hitting the market. Value stocks may have underperformed over the last decade, but that also means they should have less downside.
Holding cash in a portfolio is not generally desirable because cash generates low returns and loses buying power of time. However, holding some cash does allow you to take advantage of low prices after a correction.
Quantitative investing strategies can also be used to better position a portfolio by identifying stocks with more limited downside. Quant strategies are also better placed to avoid and manage tail risks, or even to take advantage of grey swan type events. Innovative solutions, for example the Data Intelligence Fund that is based on A.I. algorithms and big data analysis of millions of capital market-related news in real-time, may also be able to limit risks faster than traditional asset managers due to change of market sentiment in case of black swan events.
Real assets like precious metals and property can also limit the downside when uncertainty hits financial markets. Black swan events cause volatility in the prices of financial assets, but real assets usually appreciate at these times. Finally, owning options or volatility ETFs can also cushion the downside during a correction. Implied volatility rises when uncertainty rises. This causes the value of options and volatility ETFs to rise at these times.
Conclusion: Diversify your investment portfolio to limit your downside
As you can see, trying to predict black swans misses the point. Black swan events cannot be predicted. The way to protect yourself and your wealth from these types of events is to position yourself so that you won’t be wiped out when they do occur. Hedge funds, real assets, quant strategies and options can all be used to protect the downside of a portfolio, and even to profit from bear markets and increased volatility.