Understanding what are Black Swan Events in Stock Market: European explorers would have been more than taken aback when they first encountered the first black swan in the 17th century during their conquest in Australia. After all, if you’re habituated on seeing white swans all your life and suddenly a swan of black colour appears, you might also be astonished.
Anyways, this concept of seeing something rare and totally different is not only limited to swans or birds. The black swan we are discussing today in the world of investing holds the similar astonishing features of a real black swan. In this article, we’ll discuss what are black swan events in the stock market, examples of a few past black swan events and how can you handle black swan events while investing. Let’s get started.
What are Black Swan Events?
A Black Swan in finance is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. This theory is basically a metaphor that describes an event that comes as a surprise, but can have a major effect.
The theory was put forward by former Wall Street trader, Nassim Nicholas Taleb in 2001 which was later popularized through his book ‘Black Swan’, which came out a year before the crash of 2009. The theory illustrates the limitations of learning from our observations and experience just as when a black swan was discovered in Australia.
One may have seen millions of white swans throughout his life but it would take only one black swan to shatter his belief that all swans are white. Today we take a closer look in order to understand black swans in the finance world and how we can prepare for them.
What makes an event a Black Swan?
There are no limitations to ways in which a Black Swan event can manifest itself. The causes of black swan may be a natural disaster, wars, or even an outbreak of a virus. These events do not always have to have sudden consequences but instead can be slow like the fall of the Roman Empire. Taleb identifies three common characteristics between all Black Swans
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- They are so rare that the possibility that they might occur is unknown.
- They have a catastrophic impact
- When it does occur and when it is explained in hindsight the event actually seems predictable.
The effects of black swan events are magnified and tend to be catastrophic primarily because they confound our expectations that a universe is an orderly place.
A Few Different Black Swan Events in Stock Market in Past
The stock market has experienced multiple black swan events in the past. Here are some of the most infamous Black Swans in the recent past.
1. Harshad Mehta Scam
The Harshad Mehta Scam, when exposed, had staggering effects on the Indian economy that had just opened up to the world. The scam amounted to Rs. 4025 crores which today would amount to Rs. 24000 crores. The scam resulted in the BSE Sensex falling by almost 45%. It took almost 18 months to recover post this. You can read more about Harshad Mehta Scam here!
2. 2008 Recession
This recession was one of the biggest since the great depression. It is estimated that over $10 trillion was wiped out in the global equity markets. The financial crisis of 2008 is one of the most recent Black Swan events, caused due to the US mortgage and credit crisis. It also caused the largest bankruptcy in Lehman Brothers. In hindsight, many rightly say that it was bound to happen and a few outliers even predicted it.
3. The 9/11 Attacks
The Attacks on the twin towers of New York World Trade Centre too is a Black Swan. The attacks led to the closure of the NYSE and NASDAQ. Estimates state that up to 1.4 trillion was lost within a week. The airline industry was the worst impacted due to the attack.
Quick Note: The event of Crude Oil Prices diving into negative in April 2020 that broke into the news for its extraordinarily inconceivable negative price dump, was also an example of Black Swan events. You can read more about this event here.
Is the COVID-19 Pandemic a Black Swan Event?
The pandemic has been argued to be a black swan event by many sources. But the classification would also depend on the region.
For a country like China, the virus is most definitely a black swan as they were caught by surprise when the virus first broke out in December. Other countries like India, however, could have seen it coming as they were adversely affected only months later.
In an interview with Bloomberg last week Nassim Nicholas Taleb said, “It was not a black swan. It was a white swan. I’m so irritated people would say it is a black swan,” while referring to coronavirus. “There is no excuse for companies and corporations not to be prepared for that. And there’s definitely no excuse for governments not to be prepared for something like this,” Taleb added.
How can Investors handle a black swan event?
We regularly come across predictions given by the so-called finance gurus on television etc. The very first step would be to ignore these so-called predictions and forecasts. Taleb criticizes prediction that may even extend up to 30 years bu what we don’t realize is that we cannot even predict the next summer because our cumulative prediction errors for political and economical events are so monstrous.
– Steps Prior to the Black Swant Event
1. Diversifying Investments
Regardless of whether the market is undergoing a bull or bear run, it is best to also follow the basics of investing and diversify. Investors who only invest in equities face tremendous value damage. But instead, if his investments are spread across equities, liquid assets, and gold then the damages will be lower. This will help an investor survive the Black Swan.
However, there are investors who strive during a black swan. It is also important to note that if a person invests solely with the fear that a black swan event may occur at any given moment his returns would severely be impacted. What we could do is hedge our portfolios by means of diversification so that they perform in a bullish run and reduce losses when a black swan hits. For this investors have a look for assets that are likely to underperform during the bull run but provide returns when the market crashes and then include them in your portfolio.
One example would be the Universa Investments fund run by Taleb and Mark Spitznagel. This fund has benefitted hugely during the coronavirus. Its returns for 10 years prior to the pandemic were low or loss-making. During the pandemic, however, the fund had risen by 3600%. Despite the losses made the fund is still up 200%. One report also shows that if an investor had only invested 3.3% of his portfolio in the Universa fund and the remaining in the S&P500 tracker fund, the investor would still see returns of 0.4% in March despite the benchmark index falling 12%.
– Steps to take during a black swan event
2. Staggering Investments
While investing during an ongoing black swan event it is best that the investors stagger their investments over a period of time instead of investing lump sums in one go. This is because the duration of a black swan event is difficult to predict. Staggered investments will provide investors the opportunity to take advantage of falling prices during bearish trends.
3. Take Shelter in Safer Investment Options like Gold
Gold is considered a safe-haven when a black hawk event occurs. It is best to diversify investments beforehand into gold. During the Arab oil embargo between 1971 and 1979, when the world was rocked, the prices of gold skyrocketed 2400%. The increase in gold prices during black swan events has repeated time and again for eg. 9/11, the 2008 crisis, and again during COVID-19.
4. Only look for companies that are already financially sound instead of ideas
Prior to black swans when the market is doing good even companies with weak financials but great innovative ideas are able to raise funds and strive. But after a crash, these companies find it hard to even survive. Hence during a black swan, it is best to invest in financially sound companies that are cash-rich, have good ROCE, low debt, and good management.
Black Swans are generally considered to result in negative connotations but the result generally depends on the perspective of the individual. Take the example of John Paulson during the 2008 crisis or George Soros in 1992.
Predicting a black swan can be next to impossible as there are just too many events that can happen at any given time and their prediction in the past took a lot of skill and luck. However, what we can control is making our portfolios as Black Swan Proof as possible.
That’s all for this article on Black Swan Events in stock market. I hope it was useful to you. If you have any queries related to black swan events, feel free to comment below. I’ll be happy to help. Take care and happy investing!
Aron, Bachelors in Commerce from Mangalore University, entered the world of Equity research to explore his interests in financial markets. Outside of work, you can catch him binging on a show, supporting RCB, and dreaming of visiting Kasol soon. He also believes that eating kid’s ice-cream is the best way to teach them taxes.