What is a Black Swan event?

What is a black swan event?

A black swan event is something that happens without anyone expecting it and that has huge consequences. These events are characterized by their rarity and the sheer force of their impact. As far as the markets are concerned, negative black swan events can wreak havoc via their negative impact on both investments and markets. Apart from that, not even the best economic forecasting models have so far been able to accurately predict a black swam event. Experts who rely on standard forecasting models not only fail to predict black swan events, they might actually worsen their economic impact by promising false security. This article covers some of the previous black swan events, their impacts and how the future effects of black swan events could be cushioned for investors.

When and how did the term Black Swan event originate?

It might come as a surprise that the term black swan event is actually relatively new. The term was coined in 2007 by Nassim Taleb. He was previously a Wall Street trader but later became a writer and finance professor.

Taleb subsequently used the 2008 financial crisis to illustrate his views on black swan events. He argued that if we allowed an already broken system to fail, then in the future it will be strengthened to make it better equipped to deal with catastrophic events. Taleb also expressed the view that a system that is artificially kept alive by insulating it from risk will eventually become even less fit to deal with rare, catastrophic disasters. He went on to describe a black swan event as one that:

  • Happens so seldom that we can not assign a probability to is
  • When it does happen, has a massive impact, and
  • Afterwards explained by ‘experts’ as if it were quite predictable.

Of course, these very same experts have never been able to predict an actual black swan event.

Taleb also believes that for exceptionally rare events our usual tools of prediction and probability won’t work. This is because they depend on past sample sizes and a large population. Both of these are not available when it comes to events this rare.

Taleb highlights that using statistical extrapolation based on our observations of events that took place in the past will not make us able to better predict black swan events. These observations and analysis might actually increase our vulnerability.

Examples of previous Black Swan events

There is a growing debate over which historical events qualify to be called black swans. The following examples are, however, accepted by most observers as having met all the criteria of such an event:

The case of LTCM

Until 1998, LTCM (Long-Term Capital Management) was a successful hedge fund. In that year, however, it was suddenly and unexpectedly wiped out by a single event. The Russian government defaulted on its debt. The ripple effect of this was so unexpected and so severe that even LTCM’s most sophisticated statistical models could not predict it.

The dotcom bubble of 2001

This event, which had quite a few similarities to the LTCM disaster, was the first black swan of the 21st century. Before the economy suddenly and unexpectedly collapsed, the United States was experiencing strong growth in private wealth and fast economic growth.

The Internet was young and growing quickly and many dotcom companies sprang up overnight. A lot of them didn’t have any market traction and their valuations were hugely inflated. Yet investment funds were investing in them on a large scale.

When these companies started collapsing it hit the funds very hard. The brunt of the collapse was eventually passed on to individual investors. Looking back today, we might think that all of them should have known better. Yet the Internet was something totally new and its frontiers were unknown. Would we really have done better given the same set of circumstances?

The 2008 financial crisis

The financial crisis that rocked the world in 2008 and the subsequent collapse of the American housing market is a more recent example of a black swan event. The ripple effects of the collapse travelled far beyond the borders of the US. It also had a catastrophic impact on the global economy. Just like Taleb predicted, there are many ‘experts’ who say we could have seen the storm coming if we knew where to look.

Hyperinflation in Zimbabwe

In 2008 Zimbabwe experienced the most extreme case of hyperinflation the world has seen so far in the 21st century. Zimbabwe’s inflation rate peaked at just below 80 billion per cent. An inflation rate that high can destroy a country’s economy, yet nobody predicted it.

Covid-19

A few economists have argued that the 2020 Covid-19 outbreak is the biggest black swan event in recent history. Covid-19 was an unexpected event. Covid-19 has had a disastrous impact on the global economy. It remains debatable whether we could have predicted it, even with the most advanced forecasting models.

There are, however, others who argue that we should have known better. History tells us that epidemics, infectious diseases and pandemics have in the past killed more people than anything else. More than wars, and more than natural disasters. More people were killed by the flu outbreak in 1918 than during the whole of World War I.

Can there be good Black Swan events?

Although so far we’ve mostly focused on the negative aspects of black swan events, Taleb actually distinguishes between bad black swan events and good black swan events.

  • A negative or bad black swan is one where the upside is limited while the downside is unlimited.
  • A positive black swan is when the downside is limited while the upside is uncapped.

Taleb encourages investors to invest in those areas where they are most likely to be exposed to positive black swan events. Let us look at a few examples he mentions in his book.

Movies

In the movie and television industries, you can produce a film once and then go on to scale it to a massive, worldwide audience via the Internet. If the movie becomes a hit you can make virtually unlimited amounts of money. Conversely, unsuccessful films have limited losses and are fixed to budgets.

Publishing

The same applies to publishing a book. For example, the cost of a book is limited and known beforehand. The potential rewards if it becomes a hit are nearly unlimited.

Scientific Research

In scientific research an unexpected breakthrough in some or other field will always have a positive and nearly unlimited upside. Let’s say, for example, a research firm accidentally discovers a cure for Covid-19 while looking for a cure for a totally unrelated disease. It will nearly certainly become a massive black swan event with the positive impact far outweighing the cost.

How can black swan events impact the markets?

Investment markets such as the stock market are routinely affected by a multitude of different events. Crashes like the 1987 stock market collapse, Black Monday, and the dotcom bubble mentioned earlier are all examples of totally unforeseen events that had major impacts on markets. We all know that wars, unusually severe droughts, and floods can have equally catastrophic impacts on global markets.

When it comes to investments and black swan events, one has to keep in mind that what happens in one market doesn’t necessarily stay in that market. The different sectors of the economy are interdependent. If such an event causes the housing market to collapse, the resulting job losses and lack of investor confidence will often spill over to various other sectors.

How can investor cope with black swan events?

As we already mentioned, the sheer unpredictability of these events is what makes them so dangerous (negative black swan events) or potentially lucrative (positive black swan events). Since most of our statistical models still use the incidence and severity of past events in an attempt to predict the future, they are not very useful to predict black swans.

So what can an individual investor do to try and protect his or her portfolio against negative black swan events and to benefit from the opportunities posed by positive black swan events?

Diversify

The number one rule here is to diversify as much as possible. Never invest all your available funds in a single company, sector or geographical region unless you have very high conviction. Even if you have good reasons to believe that company, sector, or region is on the brink of massive growth. It’s not sensible to buy stocks solely based on region such as the US, UK, Asian, or European stocks either. All of the stocks of particular region will likely be negatively impacted due to the occurrence of a black swan event.

Create diversified portfolios

If you have a relatively high appetite for risk, keep that appetite in check. For example, you could do this by investing 90% of your available funds in a balanced, diversified portfolio. You could then risk the other 10% in a separate high risk portfolio where you go after more speculative stocks. In this way, you will protect your money against negative black swan events, while still leaving the door open to the odd positive black swan.

Use technical indicators wisely

An indicator like the PE (Price/Earnings) ratio can be very useful to compare two stocks or industries. Never forget though that all indicators have their limitations. The PE ratio, for example, has an unfavorable lag. PE is at its highest when earnings have already dropped significantly. The reason for this is that prices typically don’t fall as fast as earnings. If you relied solely on this ratio, you could find yourself investing in a stock or an industry just before a massive price drop.

Face the reality that a Black Swan could happen

Any investment will be riddled with some level of uncertainty. Compile your investment portfolio in such a way that achieve the following:

  • You can benefit from a positive black swan event.
  • The likelihood that a negative black swan event will wipe out everything you own is as low as possible.

Use statistical analysis and modelling to help you make sound investment decisions when possible. However, accept that the future is, and will probably always be, uncertain.

Negative black swan events create opportunities

The average investor is usually over-cautious that he or she buys high and sells low, in the process making massive losses. Waiting until the stock market is at its highest in 10 years before starting to invest is not a recipe for success. You might get lucky and it could move to its highest point in 20 years from there. It’s more likely that a sharp drop is imminent.

Some of the top investors in the world got rich by investing in solid, well-run companies when their stock prices had hit rock bottom because of a black swan event. In other words, they followed the golden rule to ‘buy low and sell high’. Although this might have become somewhat of a cliché over time, it remains a much better option than to ‘buy high and sell low’.

Wrap up

The popular assumption is that the right timing and having ‘inside’ knowledge are the only ways to become successful as an investor. The truth is, however, that time in the market is often of more importance than timing. In other words, just being invested will ensure that you are able to benefit from the good times. Yes, there will be bad times, and sometimes there will be black swans. More often than not there are genuinely more opportunities than negative events.

Also, don’t become a victim of analysis paralysis. Information is important, but accepting risk and minimizing it is a better long-term investment strategy than following a hit-and-run approach where you are perpetually in and out of the market, trying to cash in on the next ‘sure thing’.