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The term “black swan event” is widely used in finance today to describe an unanticipated event that severely impacts the financial markets. The name stems from the discovery of avian black swans by Dutch explorer De Vlamingh while exploring Australia in the late 1600s. Historians credit de Vlamingh with separating the “expected” (i.e., a white swan, which were plentiful) with the “unexpected” (i.e., a black swan, which was a rare sighting).
Writer, professor and former Wall Street trader Nassim Nicholas Taleb popularized the financial theory of “black swan” events in his 2007 book The Black Swan: The Impact of the Highly Improbable. Taleb described the occasional, but highly problematic, arrival of black swans on the investment landscape, and outlined what, in his opinion, economists and investors could do to better understand those events and protect assets when they occur.
Key Points
• Black swan events are extremely rare, unpredictable occurrences with severe consequences that become obvious only in hindsight, a concept popularized by Nassim Nicholas Taleb in his 2007 book.
• Historical black swan events include the Soviet Union’s collapse, 9/11 terrorist attacks, the dot-com bubble burst, and the 2008-2009 financial crisis, each causing catastrophic economic damage.
• Black swan events are identified by three characteristics: extreme rarity with no prior similar events, severe widespread impact on economies and societies, and retrospective recognition of preventability.
• Predicting specific black swan events is virtually impossible due to complex interactions among political, financial, environmental, and social factors that create unpredictable chains of consequences.
• Preparing for black swan events requires portfolio diversification, avoiding panic-driven market timing, maintaining conservative investment strategies, and potentially capitalizing on opportunities during market downturns through dollar-cost averaging.
What Is a Black Swan Event?
According to Taleb, a black swan event is identifiable due to its extreme rarity and to its catastrophic potential damage to life and health, and to economies and markets. Taleb also notes in the book that once a black swan landed and devastated everything in its path, it was obvious in hindsight to recognize the event occurred.
This is how Taleb describes a black swan event in his book: “A black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences,” Taleb wrote in his book. “Black swan events are characterized by their extreme rarity, their severe impact, and the widespread insistence they were obvious in hindsight.”
It can be a difficult concept for investors. Who, after all, throughout the history of the stock market, would leave their finances unprotected from a black swan onslaught if they knew the event was imminent?
By definition, predicting the arrival of a black swan is largely outside the realm of probability. All anyone needs to know, Taleb maintains, is that black swans occur and investors should not be surprised when they do happen.
Taleb outlines three indicators that signal the arrival of a black swan event. Each is meaningful in truly understanding a black swan scenario.
1. Black swan events are outliers. No similar and prior event could predict the arrival of a particular black swan.
2. Black swan events are severe, and typically inflict widespread damage. That damage also has a severe impact on economies, cultures, institutions, and on families and communities.
3. They’re usually recognized in hindsight. When black swans occur and eventually dissipate, recriminations take its place. While the specific black swan event wasn’t predicted, observers say the event could have and should have been prevented.
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Examples of Black Swan Events
It’s become common for politicians and investors to call any negative event a “black swan” event, whether or not it meets Taleb’s definition. However, history has no shortage of true black swan events, which led to large, unpredictable market corrections.
The following events are considered some of the most infamous among economists and historians.
The Soviet Union’s Historic Collapse
Economists consider the collapse of the Soviet Union in 1991 a major black swan. Only 10 years earlier, the Russian empire was considered a major global economic and military threat. A decade later, the Soviet Union was no more, significantly shifting the global geopolitical and economic stage.
The 9/11 Terrorist Attacks
In hindsight, the United States might have seen the attacks on the World Trade Center in New York City and the Pentagon in Washington, D.C. coming. International terrorism had long been a big risk management issue for the U.S. government, but the severity of the attack left the world stunned — and plunged the U.S. into a serious economic decline. Stocks lost $1.4 trillion in value the week after the attacks.
The Dot-com Bubble
In the late 1990s, investors were indulging in irrational exuberance and nowhere was that more clear than with the nation’s stock market — particularly with white-hot technology stocks. With an army of Internet stocks in the IPO pipeline, overvalued tech stocks plummeted, taking the entire stock market down in the process. The damage was staggering, with the Nasdaq Index losing 78% of its value between March 2000 and October 2002.
The 2008-2009 Financial Crisis
After a series of high-risk derivative bets by major banks, mounting losses in the U.S. mortgage market, and the collapse of Lehman Brothers, the U.S. economy teetered on the edge of disaster — a scenario it would take almost a decade to correct. The unemployment rate doubled to more than 10%, domestic product declined 4.3%, and at its worst point, the S&P 500 plummeted 57%, creating a bear market.
It’s worth noting that although some people have referred to the Covid-19 pandemic as a black swan event, Taleb does not consider it to be one since he feels there was enough historical precedence to foresee it.
Why Do Black Swan Events Happen?
Since black swan events are virtually impossible to predict, there is no concrete answer as to why they happen. The world is complicated, with many different factors — political, financial, environmental, and social, among others — impacting one another and setting off chains of events that could potentially become black swan events in scope and magnitude.
Can You Predict a Black Swan Event?
By its very definition, it’s nearly impossible to predict a specific black swan event. This makes it hard to prepare for black swans as you would for other investment risks.
Instead, investors may want to focus on making sure they’re prepared, generally, for the unknown. Here’s how to help do that:
• Try to develop a pragmatic mindset. Investors are better off knowing unanticipated negative events do exist and could arrive on their doorstep at any time. Keep in mind the possibility of black swans and consider building an expectation of stock volatility into your overall portfolio-management strategy.
• Try to avoid getting bogged down by long-term forecasts. Relying solely on expert predictions or far-off investment outlooks can be overwhelming, since unexpected events, including black swans can happen at any time and it’s normal for markets to fluctuate. Instead, some investors consider building a more conservative element into their investment portfolio, one that relies more on protecting assets, helping curb a potential desire to make rash moves during a black swan event. Have a candid conversation with your financial advisor, or educate yourself if you don’t have a financial advisor, about how proper diversification may help build a portfolio that balances the need for performance with the need for protection.
• Don’t panic when a black swan event happens. As tempting as it might be to try to get out of a market during a black swan event and get back in when it fades away, resist the urge to engage in market timing.
• Many investors try looking for opportunities. Putting money into the markets during a black swan event can be difficult and potentially risky, but investing in a down market may yield positive returns over the long-term.
Rather than trying to time the market, some investors may consider using a dollar-cost averaging strategy, when making regular purchases — even during a black swan event.
The Takeaway
For long-term investors, the prudent stance on black swan events is to acknowledge their existence, build some protection into your investment portfolio to help mitigate potential damage, and be ready to take full advantage of a market upturn once the black swan flies away.
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FAQ
What is a black swan event in recent years?
One of the most recent black swan events was the 2008-2009 financial crisis known as the Great Recession. That’s when a series of high-risk derivative bets by major banks, mounting losses in the U.S. mortgage market, and the collapse of Lehman Brothers, the biggest U.S. bankruptcy ever, pushed the U.S. economy to the edge of disaster.
What was the biggest black swan event?
The Great Depression of 1929 was probably the most infamous black swan event. It started with the U.S. stock market crash in October 1929 and led to a worldwide drop in stock prices. The U.S. economy shrank by 36% between 1929 and 1933, many banks failed, and the U.S. unemployment rate skyrocketed to more than 25%. It was the longest and most severe economic recession in modern history.
What are the attributes that identify a black swan event?
According to Nassim Nicholas Taleb, who popularized the black swan theory, the attributes that identify a black swan event are: 1) black swan events are rare and no similar or prior event could predict them, 2) black swan events are severe and inflict widespread damage, and 3) after the fact, observers say the black swan event could have and should have been prevented.
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