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 at the time and also today) with the “unexpected” (i.e., a black swan, which was as rare a sighting in the 1600s as it is now).
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.
“A black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences,” Taleb writes in his book. “Black swan events are characterized by their extreme rarity, their severe impact, and the widespread insistence they were obvious in hindsight.”
Taleb describes the occasional — but highly problematic — arrival of black swans on the investment landscape, and outlines what economists and investors could do to better understand those events and protect assets when they occur.
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 that once a black swan landed and devastated everything in its path, it was obvious in hindsight to recognize the event occurred and should have been expected.
It can be a difficult concept for investors. Who, after all, 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 they inflict widespread damage. That damage also has a severe impact on economies, cultures, institutions, and on families and communities.
3. They’re usually seen in the rear view mirror. 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.
Black Swan Event Examples
It’s become common for politicians and investors to call any negative event a “black swan” event, whether or not it meets Tasam’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 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. Stock 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. Economists say that $10 billion in asset value disintegrated during the crisis, which created a bear market.
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 do that:
• Be pragmatic. Investors are better off knowing unanticipated bogeymen do exist and can 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.
• Don’t get bogged down by long-term forecasts. Don’t rely solely on expert predictions or far-off investment outlooks, since unexpected events, including black swans can happen at any time and it’s normal for markets to fluctuate. Instead, consider building a more conservative element into your investment portfolio, one that relies more on protecting your assets, so you’re not tempted to make rash moves during a black swan event. Have a candid conversation with your financial advisor about how proper diversification can 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.
• Look for opportunities. Putting money into the markets during a black swan event can be difficult, but investing in a down market can yield positive returns over the long-term. Rather than trying to time the market, consider using a dollar-cost averaging strategy, in which you make 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 mitigate potential damage, and be ready to take full advantage of the inevitable market upturn once the black swan flies away. Continuing to invest during a recession can pay off in the long run.
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Photo credit: iStock/by Martin Nancekievill
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