In this article, we provide examples of black swan events as they relate to the financial industry. The financial markets are the context in which black swan events are most commonly referred to.
In the investing world, a black swan event is an extremely negative event or happening that is unexpected, which results in a decisively negative impact on the markets and is often hard to fully conceptualize in terms of scope.
The term “black swan event” quickly grew in use and popularity after Nassim Nicholas Taleb, a prolific Wall Street trader, wrote about the black swan theory in his book, “Fooled by Randomness,” which was published in 2001.
In relation to the financial markets, a black swan event is supremely negative, leaving widespread destruction and notoriously uncertain outcomes.
In order to be characterized as a black swan event, the event must: (a) have drastically negative, widespread effects; (b) be marked with a level of uncertainty; and (c) lead to the exhibition of “hindsight bias,” being proven “predictable” based solely on information learned in hindsight.
The current COVID-19 pandemic is a characteristically perfect example of a black swan event.
Classifying Black Swan Events
In order for an event to be considered a black swan, Taleb listed three elements (or attributes) that the event must possess. Every black swan event must:
Have the potential to exhibit drastic, wide-reaching consequences;
Have a nature of unpredictability; and
Typically be accompanied by “hindsight bias,” meaning that once the event has passed, many individuals tend to rationalize that the event was actually predictable (due only to the fact that they are now aware of what the outcomes from the said event are).
Living in a Black Swan Event
The world is currently living in, and after, one of the best examples of a black swan event. The novel coronavirus – more commonly referred to as COVID-19 – meets all the criteria Taleb outlined for a black swan event. It certainly meets the “unexpected” requirement, as the pandemic arose suddenly, and it quickly became apparent that no country was prepared to deal with it. Every day, we learn a little more about the catastrophic effects caused by the global pandemic. Thus far:
Stock markets around the world are down almost 30% since their highest values in mid-February; and
The number of first-time unemployment filings – as of the end of April – surpassed 30 million in just six weeks, meaning nearly 20% of the United States’ workforce is without work.
In addition, companies forced to lay off or furlough workers are finding it difficult to stay afloat. Many small businesses are facing bankruptcy and may not have the resources to reopen once the government gives them the green light.
Perhaps the most terrifying feature of the COVID-19 pandemic is the sheer uncertainty that still surrounds it. The nationwide shutdown has wreaked havoc on personal and corporate finances – something the government is attempting to counteract with trillions of dollars in stimulus financing. But just how bad will it eventually be? What will the death toll rise to? Just how big will the pile of economic wreckage be when the dust finally begins to settle?
The Great Recession
Before the COVID-19 outbreak, the most notable example (in recent years) of a black swan event was the Global Financial Crisis of 2008, precipitated by the sudden, severe crash of what had previously been a booming housing market.
The trouble started after years of steady growth following the dot-com bubble at the turn of the century. Employment rates were high, and inflation rates were low. Lending institutions – and the country as a whole – fell into a pattern of financial complacency. Interest rates fell more than 4% from 2001 to 2008, and there was plenty of “easy money” available to both individuals and businesses.
Primarily as a result of the federal government’s urging, U.S. lenders significantly relaxed their standards regarding qualifying for mortgages. Individuals with poor or non-existent credit were approved for mortgages on homes that were, frankly, way outside of their ability to pay.
The subprime mortgages quickly became a big, fat balloon just waiting to burst. As payment dates passed and mortgages began going into default by the bucketful, lending giants such as Lehman Brothers began to buckle and collapse.
The U.S. government was forced to approve the Troubled Asset Relief Program (TARP) – an initiative that cost nearly $1 trillion – to bail out major banks and establish liquidity to prop up the country’s economy. In an attempt to prevent a similar situation from reoccurring, governments worldwide massively increased regulations for financial institutions, placing stricter guidelines on which types of (and how much) debt they could take on.