Black Swan Event: Everything You Need to Know

In his book The Black Swan: The Impact of the Highly Improbable, Nassim Nicholas Taleb made the idea of "black swan" events more prominent (Penguin, 2008). 

The main point of his work is those rare and hard-to-predict events that have huge effects on the world. The effects on markets and investments are significant and should be taken seriously.

What does "Black Swan Event" mean?

The swan is always thought of and seen as a white bird everywhere except in Australia. People never thought that swans could be of any other color. When people found Australia, they learned that swans could also be black. It was hard to believe because it was such a great find.

It comes up with the idea that not everything happens as people expect or imagine. New things and events, such as their environment or plans, will always significantly affect a person.

Taleb, who came up with the term "Black Swan" events, says that there is a chance that a few dramatic events for one person might not be as surprising for another person. Everything depends on what's happening around them and what they expect, which will always determine what kind of surprise it is.

Black swan theory for the stock market

Three things are part of a black swan event in the stock market:

1. Most of the time, financial event is hard to predict.

2. The financial event has a significant effect on many people.

3. Investors try to make sense of what happened by using "hindsight bias," which makes it look like the event could have been seen coming.

   
   

Most of the time, people think of a black swan event as something terrible that happens and catches investors off guard.

Since investors use hindsight to look at what happened in past black swan events, they look for patterns to help them predict what will happen in the future. But a black swan is, by definition, hard to predict.

This makes something called the "black swan paradox" happen. The black swan paradox says that investors can't rule out theories because they haven't seen them before. This is why investors need to think about everything that could happen.

Features of the black swan event 

• These kinds of things happen very rarely and have terrible effects. They are hard to predict, and it's hard to think of such possibilities.

• These events are considered very bad and significantly affect the world economy, so they must be dealt with carefully. To deal with them, you need skills with a lot of potentials.

• Science, logic, and astrology cannot predict these things. It also needs a lot of help with management from the countries' governments.

• These things show that, despite progress in science, technology, research, etc., such things are still possible. Many similar things have occurred and shown the above fact to be true.

• All strategic thinkers and planners know that these things will happen, but they are often wrong about how big they will be. Every time, the size is so big that it causes much trouble for society.

What causes the black swans?

The main idea of Taleb's book, which he wrote, is about "our blindness to randomness, considerable deviations." 

Why do we, scientists or not, hotshots or regular people, tend to see pennies instead of dollars? Why do we keep paying attention to the little things and not the big things that might be important, even though it's clear that they have a significant impact?"

We can see that now, more than a decade after the fact. However, one of the most frustrating things about black swans is that hindsight is 20/20. No one knows what makes a black swan happen.

How can investors get ready for black swans?

For investors, it's probably not a good idea to build a portfolio strategy around the idea that a black swan is coming. But there are a few ways to prepare for volatile, uncertain markets, if not a black swan event, and take a more "defensive" stance.

Desai says one way is to have a portion of your portfolio in U.S. Treasuries. Other ways are to buy index put options (with an account that has been approved) or to put a more significant portion of your portfolio in things that have been called "safe havens," like gold or cash. "

Hence, asset allocation and diversification don't eliminate the risk of investment losses. Good old-fashioned portfolio diversification is also a good idea. Check your asset allocation regularly, and don't put too many of your assets in one stock, sector, or market," he said.

Another best way to look at it is that there will always be risks and possible "black swan" events, but there will also always be chances.

Desai said that when investors run away from a black swan, it's often a good time to try something different. 

"It's hard to predict a black swan. But investors who weren't completely blindsided may be able to add low-priced assets to their portfolios. Thus, they can make money when the market recovers."

Exciting examples of black swan event 

Investors can learn from black swan events by looking at what happened in the past. The dot-com bubble and the housing market crash are two common examples.

1. Dotcom bubble of 2001

A classic example of this black swan event is the dot-com bubble of 2001. In 2001, the Internet was still pretty new, and there weren't many online business apps. Still, technology companies put a lot of money into growth, which drove up the stock prices of these companies. 

In the end, companies started going bankrupt, and prices went down. Many companies shut down all at once, which made stock prices drop even more. As the economy went into recession, investors lost a lot of money.

2. 2008 crash of the housing market

Before 2008, loose standards for home mortgages caused the housing market to grow, and as the number of subprime mortgages increased, prices reached bubble levels. 

Banks and significant funds took advantage of the market by making mortgage-backed securities, leading banks to give out riskier loans. In the end, the housing market crashed, which caused more people to stop paying their mortgages and even more damage to the market. 

The whole financial institution was almost in danger of failing.

How do you predict black swan events?

Black swans are events that can't be predicted. Investors will find it hard to predict the next black swan event. 

Investors can listen to "experts" and their theories about rare events that could have disastrous effects, but history has shown that "experts" in finance aren't very good at predicting anything.

A negative Black Swan is an event where the harmful effects are unlimited, but the sound effects are limited. Positive Black Swans are the opposite of negative Black Swans. 

They are hard to predict events and have a significant impact, but they can only go up and not down.

Strategies for investing in black swan events and managing risk

In his book, Taleb shows how to plan for "black swan" events. Risk management is an important area of focus. Taleb talks about a type of strategy called a "barbell strategy." 

This strategy keeps most of an investor's money in safe investments and moves only a tiny amount into riskier ones. The part of the risky portfolio shouldn't be more than 10% of the whole portfolio.

The idea is that most of the money will be safe during a market panic. Thus, the high-risk investments will have a chance to soar.

Diversification is another thing an investor can do to lessen the effects of a black swan event. When one part of the market does well, other parts usually worsen. 

When investors have a diversified portfolio, they can take advantage of the growth in a variety of market conditions.

What steps do you need to take during the black swan event?

1. Spreading out your investments

Whether the stock market is rising up or down, it's best to stick to the basics of investing and spread your money around. Investors who only buy stocks risk losing a lot of money. 

But the losses will be minor if his investments are spread out among stocks, cash, and gold. This will help a person who invests deal with the Black Swan.

But some investors do well when a black swan happens. Also, it's important to remember that a person's returns would be meager if they only invested out of fear that a black swan event could happen at any time. 

We could protect our portfolios by making them more diverse so they do well when the market is going up and lose less when a "black swan" happens. 

For this, investors should look for assets likely to underperform when the market is going up but will make money when the market goes down.

For example, Taleb and Mark Spitznagel were managing the Universal Investments fund. During the coronavirus, this fund has gotten a lot of help. Before the pandemic, it hence made little or no money for ten years. 

During the time of the pandemic, on the other hand, the fund had grown by 3,600%. Even though there were losses, the fund is still up 300%. 

One report also shows that if an investor only put 3.3% of his portfolio in the Universal fund and the rest in the S&P500 tracker fund, he would have still made 0.4% in March, even though the benchmark index had dropped by 12%.

2. Staggering investments

During a black swan event that is still going on, investors should spread out their investments over time instead of putting in a large sum all at once. 

This is because it's hard to tell how long a black swan event will last. If they spread out their investments, investors can take advantage of falling prices during bearish trends.

3. Take shelter in safer investment options like gold

When a "black hawk" event happens, gold is a safe place to put your money. Gold is an excellent way to spread out your investments. 

Between 1971 and 1979, when the Arab oil embargo shook the world, gold prices went up 2,400 percent. Many black swan events, like 9/11, the financial crisis of 2008, and COVID-19, have caused gold prices to rise.

4. Don't look for ideas. Instead, look for companies that are already making money.

Before black swans, when the market was doing well, companies with bad finances but great ideas could raise money and do well. But after a crash, it's hard for these companies to even stay in business. 

So, when a black swan happens, investing in financially stable companies with a lot of cash, a good return on capital employed (ROCE), low debt, and good management is best.

Is the COVID-19 pandemic a "black swan"?

Many people have said the pandemic was a "black swan" event. But the sorting would also depend on where it was.

For a country like China, the virus is most likely a black swan since the country was caught off guard when it first started spreading in December. On the other hand, India could have seen it coming because it hurt them only a few months later.

Nassim Nicholas Taleb told Bloomberg in an interview last week, "It was not a black swan. The bird was white. People who talk about coronavirus and say "it's a black swan" really bother me. 

"There's no reason for businesses and businesses not to be ready for that.”And governments have no reason not to be ready for something like this," Taleb said.

How to identify a "black swan" event?

You can figure out if an economic event is a black swan by seeing if it meets the three criteria for a black swan:

1. Look at the effects

The first thing that makes an event a "black swan" is its considerable effect. This effect goes far beyond expected economic effects. If an economic event had a small effect, like a short-term change in stock prices or currency inflation, it's probably not a black swan. 

Most economists say that if the event causes a loss of value worth trillions of dollars, it is probably a black swan event.

2. Figure out if typical ways of making predictions can be accessible to predict it

The second thing that makes a black swan event unique is that it is impossible to predict, even with tools like modeling. 

Economists can't figure out how likely a black swan event will happen because they don't happen often enough for there to be enough data to explain why they do. After a black swan event, economists might try to predict black swan events by building new models. 

Because there isn't much data, these prediction models are based more on statistical odds than on facts about what caused the black swan event.

So, if the models used to predict that event are based on known relationships where one event causes another, then that event is not a black swan event. If the models are based on how likely something will happen, it is likely a black swan event.

3. Look at how the public reacted.

The third thing that makes an event a "black swan" is the historians and economists. They try to explain it away as if it could have been seen coming. This is what is known as "hindsight bias." 

One way to determine if the "hindsight bias" was affected by the public's response is to look at when the prediction models for that event were made. If models for that event didn't come out until after it happened, it might be a black swan.

Related questions: FAQs

1. Can a "black swan" be a good thing?

A negative Black Swan is an event where the harmful effects are unlimited, but the sound effects are limited. Positive Black Swans are the opposite of negative Black Swans. They are hard to predict events and have a significant impact, but they can only go up and not down.

2. How many times have black swans happened?

Black Swan has information about more than 40,000 events once duplicates have been found and merged.

3. Are black swans rare?

A black swan is an infrequent event that can have bad results. It can't be known ahead of time, but after the fact, many people say it should have been clear.

4. What does that mean if someone sends you a "black swan"?

The phrase "black swan" is a metaphor for something no one saw coming. But it has enormous effects.

Bottom line

Black swan events are tough to predict, full of surprises, and bring new things. But unfortunately, no one can fully understand it or know for sure if an event is a black swan or not. 

It will always depend on how the observer sees it, what they know about it, and how much of a surprise it is. But the only strange thing about it is that it might or might not happen.