Understanding Black Swan Events in the Stock Market: European explorers would have been taken aback when they encountered the first black swan in the 17th century during their conquest of Australia. After all, if you have spent your entire life accustomed to seeing white swans, the sudden appearance of a black swan might indeed come as a shock.

Regardless, the concept of witnessing something rare and entirely different is not limited to swans or birds. The black swan we discuss in the investment world today shares similar surprising characteristics with the actual black swan. In this article, we will explore what black swan events are in the stock market, some examples of past black swan events, and how to handle black swan events when investing.

What is a Black Swan Event?

A black swan in finance is an unpredictable event that exceeds what is generally expected of a situation and may have severe consequences. This theory is essentially a metaphor that describes an unexpected event but can have significant impacts.

The theory was proposed by former Wall Street trader Nassim Nicholas Taleb in 2001 and popularized in his book "The Black Swan," published a year before the 2009 stock market crash. The theory illustrates the limitations of learning from our observations and experiences, much like discovering a black swan in Australia.

Advertisement

A person may have seen millions of white swans in their lifetime, but just one black swan can shatter the belief that all swans are white. Today, let's take a closer look to understand the black swan in finance and how we can prepare for them.

What Makes an Event a Black Swan?

There are no limits to the manifestations of black swan events. The causes of black swans can range from natural disasters, wars, to even viral outbreaks. These events do not always have sudden consequences; they can unfold slowly, like the decline of the Roman Empire. Taleb identified three common characteristics of all black swans:

1. They are extremely rare, with the likelihood of occurrence being unknown.

2. They have catastrophic impacts.

3. In hindsight, they are often rationalized as if they were predictable, which is not the case.3. When it actually happens, when explaining it in retrospect, it seems, in fact, to be predictable.

The impact of Black Swan events is amplified and tends to be catastrophic, primarily because they disrupt our expectations of the universe as an orderly place.

Several different Black Swan events in the stock market of the past

The stock market has experienced multiple Black Swan events in the past. Here are some of the most notorious recent ones.

1. The Harshad Mehta Scam

The exposure of the Harshad · Mehta scam had a staggering impact on the Indian economy, which had just opened up to the world. The amount of fraud reached 40.25 billion rupees, which would amount to 240,000 today. This scam led to a nearly 45% drop in the BSE Sensitive Index. It took almost 18 months to recover from this. You can read more about the Harshad · Mehta scam here!

2. The 2008 Economic Recession

This recession was the largest since the Great Depression. It is estimated that global stock markets lost over $10 trillion. The 2008 financial crisis is one of the most recent Black Swan events, caused by the U.S. mortgage and credit crisis. This also led to the largest bankruptcy of Lehman Brothers. In hindsight, many people correctly said that it was bound to happen, and a few outliers even predicted it.

3. The 9/11 Attacks

The attacks on the World Trade Center's Twin Towers in New York were also a Black Swan event. The attacks led to the closure of the New York Stock Exchange and NASDAQ. It is estimated that losses amounted to $1.4 trillion within a week. The airline industry was the most affected by the attacks.Brief: The April 2020 crude oil price crash to negative values made headlines for its unimaginable negative pricing, serving as an example of a black swan event. You can read more about this event here.

How should investors respond to black swan events?

We often see so-called financial experts making predictions on television. The first step is to ignore these so-called forecasts and predictions. Taleb criticized predictions that could extend up to 30 years, but we fail to realize that we can't even predict next summer because our cumulative prediction errors for political and economic events are so large.

- Steps before a black swan event

1. Diversify investments

Regardless of whether the market is experiencing a bull or bear market, it is best to follow the basic principles of investment and diversification. Investors who only invest in stocks face significant value loss. However, if his investments are spread across stocks, liquid assets, and gold, the loss will be lower. This will help investors survive black swan events.

However, there are also investors who struggle during black swan periods. It is equally important to note that if a person invests simply because he is afraid that a black swan event may occur at any given moment, his returns will be severely affected. What we can do is to hedge our portfolios through diversified investments, so that they can perform in a bull market and reduce losses when a black swan strikes. To this end, investors need to look for assets that may perform poorly in a bull market but provide returns when the market crashes, and then incorporate them into your portfolio.

An example is the Universa Investment Fund managed by Taleb and Mark Spitznagel. The fund benefited greatly during the coronavirus infection. Its return rate was low or at a loss in the 10 years before the pandemic. However, during the pandemic, the fund increased by 3600%. Despite the losses, the fund still rose by 200%. A report also shows that if an investor only invests 3.3% of his portfolio in the Universa Fund and the rest in the S&P 500 tracking fund, the investor's return rate in March will still be 0.4%, even though the benchmark index fell by 12%.

- Steps to be taken during a black swan event

2. Astonishing investmentsWhen investing during an ongoing Black Swan event, it is advisable for investors to stagger their investments over a period of time rather than making one lump-sum investment at once. This is because the duration of a Black Swan event is difficult to predict. Staggered investing will provide investors with the opportunity to take advantage of price declines during a bearish trend.

3. Opt for safer investment options, such as gold

When Black Swan events occur, gold is considered a safe haven. It is best to diversify investments into the gold sector in advance. During the Arab oil embargo from 1971 to 1979, when the world was in turmoil, the price of gold skyrocketed by 2400%. The rise in gold prices during Black Swan events has been repeatedly observed, such as during the 9/11 incident and the 2008 crisis.

4. Seek out companies with sound financial health, not just ideas

Before the Black Swan, when the market was performing well, even companies with poor financial health but great innovative ideas could raise funds and struggle forward. However, after the collapse, these companies may struggle to survive. Therefore, during the "Black Swan" period, it is best to invest in companies with sound financial health, ample cash, high capital returns, low debt ratios, and good management.

Conclusion

Black Swans are often considered to have negative connotations, but the outcomes typically depend on one's perspective. Consider the examples of John Paulson during the 2008 crisis and George Soros in 1992.

Predicting a Black Swan is nearly impossible, as too many events can occur at any given time, and their past predictions require a great deal of skill and luck. However, what we can control is making our investment portfolios as resilient to Black Swans as possible.