Throughout the history of the world, there have been bouts of improbable events that shook the world and left great damage in their wake. These events, though rare, have lasting effects. Such events are known as black swan events.
The term ‘black swan event’ was first used by former Wallstreet trader, Nassim Nicholas Taleb in 2001. He, later, went on to write a complete book about this concept – The Black Swan: The Impact Of The Highly Improbable in the year 2008. Black swan events can cause catastrophic damage to an economy. Since they cannot be predicted, economies can only prepare for them by building robust systems. Let’s look at black swan events in more detail and understand their mechanism.
Attributes of Black Swan Events
As per Taleb’s theory, an event is categorized as a black swan event if it has all of the following characteristics:
- It was unpredictable and rare in nature,
- It had severe and widespread consequences, and
- The event seems to be obvious in hindsight.
Since the inception of the term ‘black swan event’, it has been widely used in the field of finance to refer to a large-scale, extremely negative event. In retrospect, people might think that there were obvious red signals, but they are, by their very nature, unpredictable. Such signals or predictions are dismissed to be utterly far-fetched or become lost in the noise of the range of possible outcomes of a situation.
While looking back at these events, we can easily see that there were warning signs all along – giving an indication that something catastrophic was about to happen. But people at the time are usually blindsided. It is important to note that there is a mountain of difference between a black swan event and a crisis. Not all crises are black swan events. Neither are all black swan events, a crisis.
Examples of Black Swan Events in History
A fairly recent example of a black swan event can be the 2008 financial crisis which was triggered by the collapse of the Lehman Brothers. This led to the bursting of the housing bubble prevalent in the US markets at the time, and over $10 trillion of wealth vanished from the global markets. Economies across the world took a hit, and once the bubble burst, it could be seen that there were obvious signs that there was something inherently wrong with the way the US financial system was working up until that time. Banks had been handing loans left and right to borrowers. The availability of cheap and easy credit led to the housing boom. Add into this equation the ‘irrationally exuberant’ outlook of people all over, and you’ve got a recipe for disaster. There were red flags fluttering all the while the real estate climbed to new heights – but at the time, it was difficult to comprehend that it would bring the financial system to its knees.
This same attitude preceded the 2000 dot-com crash. The dot-com bubble, fuelled by an internet boom, was built over the foundation of internet companies with no business plan. Consequently, the crash led to NASDAQ losing 78% of its value.
Some more instances of black swan events can be the 1997 Asian Financial Crisis, the 9/11 Attacks, and World War 1.
Implications on Investing
A black swan event in the stock market is usually an event that is characterized by a market crash exceeding 6 standard deviations. This makes the probability of such an event to be extremely rare.
Stocks and other investment alternatives are affected by all types of events, good or bad. However, the extent of the effect is impossible to ascertain. For instance, the 2008 financial crisis was not a surprise to everyone. But it was still categorized as a black swan event because no one had any idea exactly how destructive it would be.
Alternatively, even if we can correctly forecast some market variables, other events like a natural disaster or a war can easily override these factors.
Planning for Black Swan Events
When disaster strikes, it is usually impossible to ascertain its impact and for how long it will last. But still, investors can take precautions so as to minimize their losses. So let’s look at some ways investors can make changes to their strategies to account for possible crises.
1. Watching Market Indicators
Investors can periodically look at a few market indicators to gauge any signs of escalating concerns amongst market professionals. Treasury yields are one such indicator. Another indicator can be the Volatility Index (VIX), also known as the fear index. VIX is a real-time market index that represents the market’s expectations of volatility in the next 30 days.
Also, it has been found that all black swan events are preceded by ‘pre-shocks’ in index values. This might be as a result of proactive investors and risk-averse investors pulling out their money from the markets. However, this indicator is not sufficient to determine whether a crisis will be of black swan scale, as such drops have been seen during other scares as well, which lasted for only a short period of time.
Another indicator is the CBOE SKEW Index. The SKEW Index is also referred to as the black swan index. It measures the probability of outlier events of two to three standard deviations. The typical range of SKEW is 100 to 150, but it can also move below and beyond these numbers. A SKEW value of 100 indicates a ‘normal’ market, i.e., the market expectations of a black swan occurrence are low. The higher the value of the index, the higher is the risk of a possible outlier event.
Portfolio Diversification
A black swan event, by its very definition, is an event that is unpredictable. It is impossible to forecast, let alone predict its various implications. More than often, investors make the mistake of preparing for the ‘last’ bear market, rather than the next one. In any case, the best way to prepare for a possible market downtrend is by not overly exposing your portfolio to a particular investment or asset class. That is, what needs to be done is portfolio diversification.
A bear market may prove to be an opportunity and a well-positioned portfolio can capitalize on the market volatility. Hedge funds, for example, capitalize on falling prices with short positions, as well as on relative value trades created by volatility.
Another measure can be to buy value stocks with a safety margin. Such stocks help to eliminate the possible downtrend arising from a black swan event hitting the market.
Moreover, holding cash in a portfolio is usually not advisable as cash generates low returns and loses buying power as a result of the time value of money. But holding some cash may allow investors to take advantage of low prices after a market correction. Investors should also expose their portfolio to commodities like precious metals, and property. Black swan events lead to a decrease in the prices of financial instruments, however, real assets usually appreciate during such times.
Finally, owning options or volatility ETFs can also act as a cushion during a correction. Implied volatility rises when uncertainty in the market increases. This causes the value of options and volatility ETFs to rise during these times.
The Bottom Line
Black swan events are a part of life, and they may happen whether we like it or not. We can only prepare ourselves for such unprecedented events by taking a proactive approach, so as to avoid predictable crises, so as to have more resources to deal with the catastrophic impact of black swan events. The future continues to be a mystery, and one can only plan for it. Predicting future events is next to impossible, so the best strategy is to take a conservative investment approach.