What Is A Black Swan Event?

Black Swan Meaning

The meaning of a black swan event has a historical origin. It was widely thought that only white swans existed. It wasn’t until 1697 when a Dutch explorer found black swans in Australia that the assumption changed. The event was unexpected and profoundly changed zoology theories.

More recently, the term has been attributed to very rare economic or financial market events. In 2007, a mathematician and former trader named Nassim Nicholas Taleb used the term as the title of his book to describe rare and profoundly impactful events that happened in society. He explained that not only were the events unpredictable and rare, but that people had simplistic explanations about the events after the fact – as if the events were predictable.

Stock Market Black Swan Theory

A black swan event in financial markets conventionally has three characteristics:

The event is mostly unpredictable.
The event has a widespread impact.
Investors rationalize the event in what is called hindsight bias which makes it seem as if the event was easily predictable.
The black swan event is usually an event that negatively impacts the stock market, because investors are caught off guard.

Because investors use hindsight to examine what happened in previous black swan events, they look for a black swan pattern to help predict future events. However, by definition, a black swan event is hard to predict.

This unpredictability leads to what is called the black swan paradox. The black swan paradox says that investors cannot rule out theories just because they haven’t seen them before. This is why investors need to factor in all possible outcomes.

Effect of a Black Swan Event

Asset prices are most often negatively affected by a black swan event. Because black swan events can’t be predicted, investors must simply assume that they will occur. Because of the assumption that catastrophic events will sometimes occur, investors may choose to arrange their portfolios to prepare for the worst of scenarios.

Investors who hold a lot of risky assets in their portfolio may see account valued plummet once they are exposed to a black swan event in the market. Panic selling may drive deeper losses, potentially more than warranted.

Tip: Diversification is one strategy that can help limit the exposure of investments to a black swan event.

Black Swan Event Examples

Investors can look at previous events to learn from black swan events. Some common examples include the dotcom bubble and the housing market crash.

2001 Dotcom Bubble

The 2001 dotcom bubble is a classic example of a black swan event. The internet was still new in 2001, with few online commercial applications being used. Yet technology companies were investing heavily into growth, and the stock prices of these companies became inflated as excitement over the internet economy grew to euphoric levels. Eventually, growth and business results underdelivered, and stock prices began to drop. Risk capital was removed from the stock markets, and in fact many firms shut down in rapid succession, including famed companies such as Nortel. Investors were hit hard as the economy entered into a recession.

2008 Housing Market Crash

In the years leading up to 2008, loose standards for home mortgages drove a soaring housing market, eventually leading to bubble-level prices as subprime mortgage issuance increased. Banks and large funds capitalized on the market, creating mortgage-backed securities which, in turn, made banks make riskier loans. Eventually, the housing market collapsed, leading many homeowners to default on their mortgages, causing catastrophic harm to the market and some local communities. The whole financial system nearly collapsed.

Predicting Black Swan Events

By definition, black swan events are unpredictable. This means that investors will have a hard time finding the next black swan event before it happens. Everyday investors can monitor “experts” and pick up on various theories about potential outlier events. Of course, may of these theories never play out in the real-world, and it’s a lofty challenge to separate doom theories with low probabilities from those that may actually have a chance of occurring.

Black Swan Investing Strategies & Risk Management

Taleb’s book “The Black Swan” outlines strategies to prepare for black swan events. One major area of focus is risk management. Taleb discusses what’s called a barbell strategy. This strategy keeps the majority of an investor’s assets in ultra-safe vehicles and moves a small percentage into speculative investments. Per Taleb, that risky portion shouldn’t exceed 10% of a portfolio.

The idea is that most of the money is protected during a market panic, and the high-risk ventures have the opportunity to soar.

Another strategy that an investor can take to mitigate the effects of a black swan event is to diversify. Typically, when one area of the market does well, other areas tend to underperform. By having a diversified portfolio, investors can take advantage of the growth in various market conditions.

Tip: The barbell strategy avoids putting money in moderate-risk investments. It is primarily a risk-averse portfolio with only a small amount of speculation.

Bottom Line

Luckily, black swan events are rare. However, when they happen, they lead to catastrophic declines in market prices. Investors should expect the worst as a possibility and plan their portfolios accordingly.