Black Swan Event

An event or occurrence that is extremely difficult to predict

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What is a Black Swan Event?

Black Swan Event

A black swan event, a phrase commonly used in the world of finance, is an extremely negative event or occurrence that is impossibly difficult to predict. In other words, black swan events are events that are unexpected and unknowable. The term was popularized by former Wall Street trader Nassim Nicholas Taleb, who wrote about the concept in his 2001 book Fooled by Randomness.

However, the origins of the term “Black Swan” come from a Latin expression used to describe something as being a rare event, nearly impossible. When the term was first used as far back as the 2nd century, it was believed that all swans were white, and black swans were presumed not to exist as none had ever been observed.

In 1500s London, a black swan was used to denote something impossible. However, when black swans (Cygnus atratus) were later observed in Australia by a Dutch Explorer in the late 1600s, this turned the belief that all swans were only white onto its head.

In more recent times, the metaphor has been used to describe something that challenges the foundation of any system of thought. In other words, the entire premise that swans could only be white was undone as soon as a single black swan was observed.

Hence, we should not rule out the existence of a black swan just because we have only seen white swans before.

Characteristics of Black Swan Events

Black swan events are rare and unexpected events with severe consequences with the potential to cause a change in a formerly held belief or system of beliefs. In his book, Taleb notes the three defining attributes of a black swan event:

  1. An event that is unpredictable.
  2. A black swan event results in severe and widespread consequences.
  3. After the occurrence of a black swan event, people will rationalize the event as having been predictable (known as hindsight bias).

Taleb also notes that black swan events are not limited to financial markets or stock markets.

Black Swan Event Good or Bad?

Although black swan events seem to come with a negative connotation, the concept does not only apply to negative events. Whether the event is positive or negative depends on the perspective of each party involved.

For example, Taleb argues that a black swan event for a deer that gets shot is not one for the hunter who shoots the animal. A disastrous day in the stock market may be seen as a positive event for an investor with aggressive short positions but a negative event for an investor who has heavily bought into the market.

Unpredictable events might even produce positive possible outcomes for all parties. One example might be the extreme impact that the rise of personal computing, as well as the creation of the internet, has had in improving many aspects of everyday life — how people work, how people connect and communicate, and how financial transactions are handled, just to name a few outcomes.

The sweeping changes created by the computer and internet are so vast and have become so rooted in our everyday lives that it truly requires an effort to think back to how different things were before they happened.

Real-life Examples

Throughout history, there have been several notable black swan events. Here are a few prominent ones from the finance world with catastrophic consequences:

“Black Monday”

The 1987 crash on stocks represents a black swan event in financial markets. On Monday, October 19, 1987, the Dow Jones Industrial shares dropped 22.6% — the biggest single-day loss in history. Many experts cited warning signs of an impending crash; however, nobody knows the exact cause of that stock market panic.

The “Dotcom” Crash

During the rapid growth of the internet in the 1980s and 1990s, many internet companies were launched. The market was caught up in a frenzy until 2000 to 2002, when many of these overvalued companies failed, wiping out nearly a trillion dollars’ worth of stock value. The NASDAQ stock market lost 78% of its value in the dotcom crash.

9/11 Attacks

The attack on the Twin Towers of New York’s World Trade Center prompted the closure of the NYSE and NASDAQ on the morning of September 11, 2001. Stocks plummeted during the first trading week after 9/11 — $1.4 trillion in stock market value was lost within a week.

The 2008 Global Financial Crisis

The global financial crisis in 2008 started with the collapse of Bear Stearns, creating a domino effect that caused Lehman Brothers to file for bankruptcy — the largest bankruptcy filing in US history. Other companies also followed, including AIG, Countrywide Financial, and IndyMac. In total, over $10 trillion was eventually wiped out in the global stock market.

Brexit

In June 2016, news of the British referendum’s decision to leave the European Union caught many by surprise. It caused the British pound to drop sharply to a 31-year low against the US dollar. The Brexit vote wiped out nearly $2 trillion of value in global markets.

The Coronavirus Pandemic

The coronavirus pandemic of 2020 is a classic black swan event. It came totally out of the blue, with severe consequences worldwide that virtually shut down entire economies across the globe and led to massive changes in people’s lifestyles.

In addition to its widespread consequences and huge loss of life, the global pandemic was also a black swan for the financial markets — stocks on the New York Stock Exchange (NYSE) tumbled by one-third within the first few weeks of the recognition of the pandemic.

Why Businesses Don’t Like Black Swan Events

While black swan events can be either positive or negative, businesses tend to view any black swan event as negative.

Why? Because the success of businesses relies heavily on predictability, while black swan events are unpredictable.

Being able to forecast supply and demand in the marketplace for goods and services is vital to the survival of companies.

For example, the creation of streaming video services has all but completely erased the video rental business, such as Blockbuster, within a span of just a few years.

Can Investors Prepare for a Black Swan Event?

By definition, black swan events can’t possibly be planned for. Such events are random outliers that are low probability but produce high-impact outcomes.

Still, there are ways that investors can prepare for a black swan event, each with their own benefits and drawbacks. Here are five methods that can prepare your portfolio for black swan events:

  • Put options: Investors may purchase put options as a hedge against a possible fall in the price of a security.
  • Volatility derivatives: Purchasing volatility derivatives like the Chicago Board Options Exchange’s CBOE Volatility Index, or VIX, that benefit from market uncertainty.
  • Treasury notes, bonds, or other “risk-free” assets.
  • Portfolio diversification: Taleb calls this strategy “antifragile,” or something that gains from disorder.
  • Personal diversification: Diversify from risks that you are already exposed to. For example, if you work for a bank, try to reduce your investment portfolio away from bank stocks or bonds.

Other Resources

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