The economic black swan|ManualTrader

The economic black swan

2227 ManualTrader

Black swan events are highly improbable, difficult to predict incidents that end up having drastic consequences. These events have such magnitude that they can bring down economies, societies and people. Of course, the Covid-19 pandemic may be the first example that springs to mind. But you may be surprised to know that the coronavirus outbreak is not classed as a black swan event. 

Why? Well, the man who coined the black swan theory in 2007, Nassim Nicholas Taleb, said there were three key ingredients that contributed to such an event: it is so rare that no one could have even anticipated it, its effects are catastrophic, and it is regarded as predictable in hindsight.

Black swan event examples

Ironically, Taleb wrote his book about the black swan theory a year before an event that illustrated his point perfectly: the 2008 financial crisis. It was a downturn so big that Lehman Brothers made the largest bankruptcy filing in history – with 25,000 people losing their jobs and $46bn of the institution’s market value vanishing. The impact was also felt across the global equity markets, with $10trn wiped out. If you want black swan theory explained, this recession ticks all of the boxes: no one could have anticipated Lehman Brothers collapsing, the economic ramifications were massive, and experts now argue that the warning signs were in place before disaster struck. 

Black swan events can also be political – and results such as Trump’s victory in the 2016 presidential election, not to mention the UK voting to leave the European Union that same year – could be interpreted as falling nicely into the black swan theory. Even personal matters, such as losing a loved one in a freak accident, apply.

It is also worth bearing in mind that the black swan theory isn’t confined to negative events. JK Rowling, who wrote her Harry Potter series in cafés while on welfare and suffered countless rejections from publishers, had her own black swan event when her wizarding world captured the imagination of millions of people, and she now has an estimated net worth of £820m ($1.12bn).

The man who invented the black swan theory

Lebanese scholar and former Wall Street trader Nassim Nicholas Taleb released his book – The Black Swan: The Impact of the Highly Improbable (Penguin) – in April 2007. The author argued that the best way to mitigate a black swan event is not to try and predict it, but rather to build resilient systems that can reduce their likelihood even further. For example, stress tests are now a common occurrence in the banking world – simulations that see whether a financial institution could survive another crisis like in 2008 – but some central banks, like the Bank of England, only began these exercises several years after the recession took place.

Consequences for the markets

In this respect, the consequences of one of these black swans are one of the risks that has to be faced when operating in the financial markets. Therefore, although these are events with a low probability of occurring, it would be a serious mistake to ignore them. And even though it is difficult to protect oneself against a black swan completely (because it cannot be foreseen), it is important to have a diversified and structured portfolio with different asset types so that they can act as counterweights in the event of having to respond to varying economic or financial circumstances.

And that is because, although history seems to be a sequence of unavoidable events, it is full of black swan events that have changed the course of history. The First World War, Hitler's rise to power, the crash of 1929 or 1987, the attacks on the Twin Towers, the fall of the Lehman Brothers, Brexit and the current Covid-19 pandemic are all examples of this type of earthquake, which could not be foreseen and which had significant consequences. In other words, black swans, whose occurrence, as the world has become more complex and globalised, is more common and to which investors are beginning to become accustomed.

How to use the black swan theory

From an investment standpoint, there are several ways to capitalise on black swan events and prevent portfolios from suffering catastrophic losses when they occur. These tips include:Seize the opportunities they provide.

If the stock market crashes and share prices tumble because of an unpredictable event, this could be a good time to invest in resilient companies. When a recovery eventually happens, investors can sell high because they bought low.

Embrace diversification.

Those who suffer the worst consequences from a black swan event are people who had all of their eggs in one basket. By splitting capital across multiple investments with varying levels of risk, mitigating the impact of an unexpected downturn becomes possible.

What is the next black swan event?

Sadly, nobody can know that until it happens. 

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