Most swans are white. A black swan is a rare sight, especially in the United States. The rare nature of its existence is why rare events that majorly impact the financial markets are called black swans. The black swan is a metaphor describing unexpected and unpredictable disruptive events that have a significant, often catastrophic, impact on financial markets, economies and even day-to-day life.
In this article, we'll take a deep dive into understanding what is a black swan event. We'll review some prior black swans and the lessons learned from them. We'll also cover ways to mitigate some of the damage and how to survive them.
By the end of this article, you'll gain more insights into black swan events to make more informed decisions regarding your portfolio and finances during the next one.
What is a black swan event?
As an investor or trader, you will recognize black swan events. They are so wide-reaching and catastrophic that they make mainstream headlines worldwide. Black swan events have systemic risks. Systemic risk has the potential for a failure of the entire financial system.
It can impact everyone in society in one way or another. Black swan events are long-reaching, with the potential for financial markets to collapse, sending volatility sky-high. The elusive aspect of a black swan event is their unpredictability under normal circumstances with the element of certainty in hindsight. In other words, it makes complete sense how and why it occurred when examining them after the fact. The cliché "Hindsight is 20/20" applies to black swan events.
Most black swan events, as they pertain to markets, are unfavorable and bearish. From the internet bubble of 2000 to the 9/11 terrorist attacks on the United States, the 2007 real estate bubble, the financial meltdown, and the 2020 COVID-19 pandemic are examples of significant historical black swan events. Negative black swan events tend to gain the most panic-driven headlines.
However, black swan events can be positive. From the invention of the transistor to the discovery of penicillin, the human genome project and the development of the internet are all positive black swan events. More recently, the explosive adoption and growth of artificial intelligence (AI) thanks to applications like ChatGPT can be considered a recent positive black swan event.
The origin of the term “black swan”
A black swan is a rare creature to find in the wild. The same principle applies to black swan events. The term black swan is a metaphor originally coined by statistician and author Nassim Nicholas Talab in his 2007 book "The Black Swan: The Impact of the Highly Improbable."
The timing was uncanny as the book released at the dawn of the next black swan event: the subprime mortgage triggered the real estate bubble and financial meltdown. History has shown that black swan events are akin to the spark that lights a fuse in a warehouse already soaked in kerosene. In other words, the stress fractures were already building for a long time and finally waiting for the proverbial tipping point to collapse.
Characteristics of black swan events
Black swan events share many of the same characteristics. Nassim Taleb states that black swan events share three key characteristics:
- Black swan events are rare and unpredictable.
- Black swan events have rare and extreme impacts.
- Black swan events have retrospective predictability as they seem inevitable after the fact.
Black swan events have extreme impacts, resulting in a fast deceleration of the stock market and financial asset values as evidenced by the internet bubble, housing crash, financial meltdown and the COVID pandemic. The paradox of black swan events is that they make perfect sense of how and why they happened retrospectively. This retrospective predictability helps to make changes that reduce the chances of a similar black swan event. These changes can come from legislative or regulatory to operational changes within enterprises and organizations. Since black swan events are unpredictable, they rarely ever repeat themselves. As they say, "Fool me once, shame on you. Fool me twice, shame on me."
Nassim Nicholas Taleb and black swan theory
Nassim Taleb composed the black swan theory using the three characteristics to identify black swan events. Taleb explains what's a black swan. He says they are more common than most people think, but people ignore the signs to focus on more predictable events rather than low-probability events.
Often, they hide in plain sight. For example, the internet bubble accelerated on outrageous valuations and illogical assumptions like a game of musical chairs. Eventually, the music had to stop. In the meantime, the ridiculousness was in plain sight the whole time.
The same applies to the subprime meltdown with the advent of no income, no job or assets (NINJA) loans and the surplus of easy home ownership through interest-only loans. Stories of cocktail waitresses owning multiple rental properties were widespread due to the ease of obtaining mortgages. Consumers were not interested in entertaining the theory of the black swan in 2007 or understanding the black swan meaning.
Financial markets and black swan events
Black swan events have historically ushered in economic recessions and bear markets that define the meaning of a black swan event. The market black swan has systemic risk, which makes the impact even more catastrophic as fear takes over in the financial markets. Counterparties walk away, and the whole financial system is often at risk of complete breakdown is the black swan effect.
Recent black swan events
Let’s take a deep dive into recent black swans.
The COVID-19 pandemic of 2020 was the most recent black swan event. The onset of the virus was straight out of a zombie horror movie, as videos showed hospital emergency rooms packed to the hilt. The growing number of deaths attributed to COVID and the unprecedented abrupt halt to the global economy was truly unpredictable. Social distancing accompanied by mandatory lockdowns and stay-at-home mandates worldwide caused productivity to collapse. Factories were taken offline, and the global supply chain was completely tatters.
Stockpiling of household items like toilet paper and Lysol created massive shortages. The migration to online and digital transformation accelerated years ahead of time. The lockdowns spawned the acceleration of remote work and the elastic office as Zoom Video Communications Inc. (NYSE: ZM) stock spiked to the moon literally. Zoom video became a household name as it was the only way to engage professionally and socially during lockdowns. Athleisure companies saw brisk business as workers stayed in shelters and communicated through Zoom calls.
The rollout of stimulus checks and government-subsidized relief programs like the paycheck protection program (PPP) helped to keep some businesses afloat. The race for a vaccine resulted in a global scramble by the largest pharmaceutical companies in the world to develop vaccines in record time.
The stock market crashed 35.5% in a month from February 20 to March 20, 2020/ The S&P 500 index represented by the SPDR S&P 500 ETF Trust (NYSEARCA: SPY) fell from a high of $338.64 on February 20, 2020. The Dow Jones Industrial Average (DJIA) fell 1,300 points on Black March 9, 2020. The SPY eventually fell to a low of $218.26 on March 20, 2020. Oil prices collapsed due to the lack of cars on the road because of the stay-at-home and lockdown mandates. The economy came to a screeching halt in an unprecedented manner that the world had never seen before. Prior black swan events can help prepare for future black swan events.
Preparing for black swan events
While black swan events can be unpredictable, it is possible to prepare for them. Past black swan events have been learning opportunities that regulators and organizations have used to create new fail-safes and programs moving forward.
Circuit breakers were created by the U.S. Securities and Exchange Commission (SEC) and implemented by the stock exchanges after the Black Monday stock market crash black swan event in October 1987. They have been adjusted and refined to better react to each new black swan event's meaning.
The sub-prime crisis of 2007 ushered in tighter lending standards and eliminated no income, job or assets (NINJA) loans. The financial meltdown stemming from the Lehman Brothers insolvency led to tougher annual bank stress tests implemented by the Federal Reserve. It also spawned new legislation from Congress impacting brokerages, consumer banks and investment banks under the Dodd-Frank Wall Street Reform and Consumer Protection Act, Dodd-Frank for short.
Here are some ways to prepare financially for black swan events.
- Create a financial backup plan. Have a plan to help minimize the impact of a black swan event. Plan how to pay your bills if you lose your job or get furloughed. Start funding an emergency savings account if you haven't created one yet. Plan for the worst-case scenario based on historical black swans like the financial meltdown and the COVID-19 pandemic.
- Diversify and hedge your investment portfolio. A systemic event can take down all financial investments. However, diversify your investment portfolio into multiple asset classes ranging from negatively correlated stocks, fixed income, dividend stocks and money markets to gold to even Bitcoin. You can readjust your allocations, raising investment in consumer staples stocks while trimming weightings in consumer discretionary stocks. The COVID-19 pandemic saw grocery store stocks and membership warehouses spike. You can review this with your financial advisor ahead of time. Make appropriate retirement plans and IRA accounts changes to absorb impending volatility better.
- Keep cash on hand and in reserve. Keeping cash around is wise if you can't reach your bank or ATM. Again, it's about planning for the worst. During the pandemic, the lockdown mandates prevented people from entering bank branches. Cash is still king in case digital payment systems and networks go down.
- Stay within the FDIC limits per bank. Make sure you limit your bank accounts to under $250,000 under FDIC insurance, which protects you in case your bank goes under or experiences economic contagion, like during the 2008 financial crisis.
- Have non-perishable food and hygiene products stored. The COVID-19 pandemic showed how basic household and hygiene items can experience a shortage crisis. Preparing ahead of time means stocking up on non-perishable canned food items. Surplus and camping stores can help you stock up on military meals-ready-to-eat (MREs). Many companies prepare pre-made emergency meal kits that can be stored just in case stores shut down or the electric grid goes down. Investing in power generators and solar energy panels may also be wise to be self-sufficient if the electricity grid experiences extended outages in your area.
- Keep medicine, bottled water and first aid kits stocked. Black swan events can be physically dangerous, such as the 9/11 terrorist attacks in New York City. Always be ready for any health risks or injuries that may occur directly or indirectly from a black swan event.
Can you predict black swan events?
By its nature, you can't predict black swan events. They can only be identified and confirmed in hindsight. The advent of artificial intelligence (AI) and machine learning algorithms can predict them down the road.
However, sophisticated data analytics may help forecast potential black swan events, which enables financial institutions to help mitigate some of the impacts by preparing ahead of time. In hindsight, the subprime crisis may have been predictable. However, the nature of Wall Street and bankers may have enabled it to occur as financial institutions are obligated to enhance shareholder value by consistently beating earnings estimates.
Machine learning algorithms may be able to forecast and warn about black swan events early enough in the future. AI models could develop after training and analyzing enormous data sets to identify patterns. However, knowing that a black swan event may unfold and taking action preventing a black swan event are two completely different things. The paradox of black swan events is that they are unexpected and unpredictable by nature.
Don’t predict, react
Predicting a black swan event is like predicting a sub-zero temperature day in Florida in July. It's unpredictable because the likelihood of such a freezing day in the heart of summer in Florida is extremely low.
However, if that day does ever happen, what would you do? Simple, turn on the heat. It's easier to react than to predict. If you are an agile trader, you may even consider short-selling during a black swan event, but check the short interest to avoid the potential for a short squeeze.
Traders and investors must accept and practice in the financial markets. Don’t waste time trying to predict; have the discipline and assertiveness to react when a black swan event occurs.
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