What Is Black Swan Event? Should Investors Consider The Possibility Of Such An Event While Making Investing Decisions?
By: Rupesh Oli
What is Black Swan Event?
Black Swan Event refers to an outlier that possesses extreme and far-reaching consequences for investors as it is outside the realm of regular expectations justifying the fact that nothing in the past carries the tendency to predict its possible occurrence in the future. It is perceived as the harshest negative event possessing the capability to destroy the portfolio of any sort of investor by a considerable margin. People often rationalize black swan events as being predictable (the hindsight bias), although they tend to do so only after the occurrence of such events.
Black swan event might be perceived by the majority as an event reflecting negative connotation, however, it all depends upon the perception of individuals whether they want to perceive it as a positive or negative. It is because most of the investors might leverage by earning a hefty amount by shorting, hence, bearing of losses and severe consequences might not always be the case. Further, it is an event with a very low possibility of occurrence yet possesses significant catastrophic impacts on the economy and financial market. Such events typically manifest themselves as extreme price variations in the financial market. There does not exist any sort of limitation in the way black swan events manifest themselves as it could be a financial crash, war, natural disaster, or even an outbreak of the virus.
Who Coined the Term “Black Swan”?
The term was coined by Nassim Nicholas Taleb – retired New York University professor, former derivatives trader, and writer – in 2001 and the term got even more popular through his book ‘Black Swan: The Impact of Highly Probable’ that came a year before the financial crash of 2009. Taleb took into account the term to refer to unpredictable and unexpected events that took place throughout history. It is the term further originally used in England as a metaphor of things that never existed as it was assumed that black swan too didn’t exist till then. However, the explorers when they went to Australia for the very first time found the species of a black swan to actually exist, until then people only assumed white swans to have existed. As a matter of fact, the metaphor became meaningless and now black swan event is one of the widely used phrases in the financial world.
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Reason Behind the Occurrence of Black Swan Event
Taking into consideration the fact that black swan events are virtually impossible to predict, one could not provide the concrete reason behind its occurrence making it one of the complicated questions to be answered. There might be various factors responsible for the black swan event whether it be the political, environmental, financial, or social factors; however, to pinpoint one of the factors and argue it to be the one solely responsible for the event to occur, it’s whimsical.
What Does a Black Swan Event Signify Traders and Investors?
You are to be prepared for the unknown as the black swan event is not about predicting its future occurrence, but about the acknowledgment that such an event can occur and you as an investor or trader stay prepared to react to whatever unfolds in the future. Disregarding the predictions and forecasts – the ones over the long haul – would help you stay to the ground of reality in investing. Taleb argued, ‘It is the fact that we cannot predict the probable events for next summer, even though we produce the 30-year projection for social security deficits and the oil prices’ denoting ‘our cumulative prediction errors for the political and economic events to be so monstrous’. The world needs to stay prepared by adopting prevention rather than the treatment of catastrophic events. Investors, if they become aware of the fact that the black swan event could possibly ensue, they look at the ways to reduce their investment risk, perform hedging and diversify their portfolios to face the unknown.
5 Enthralling Black Swan Events that led to Stock Market Turbulence
The major black swan events that created turbulence in stock market are: (randomly ranked)
1. Global Financial Crisis (2008)
The financial crisis of 2008 was the most severe one to hit the US stock market since the Great Depression of 1929. It is one of the widely studied and researched financial crises in the world in recent times. We, of course, possess in-depth insights regarding how and why it took place, how it spread across and how the regulators fell short to maintain a steady financial system. It is also referred to as the Great Recession of 2008. The housing market bubble is the one that led to the severe financial crisis with its acute impact reaching all parts of the world. After the bubble burst, the commercial banks that took excessive risks with the mortgage-backed securities fell in value dramatically.
As per the Financial Services Modernization Act of 1999, banks used the customers’ deposits to invest in financial derivatives; mortgage-backed securities were one of those derivatives and banks were lending such securities to the homeowners with questionable credit ratings. The housing market started to lose value for the first time in decades since the start of 2006. Still, banks were not taking it seriously. However, the bankruptcy of Lehman Brothers in September 2008 sent serious shockwaves throughout the global markets. It was then too late to handle, and the world was to pass through the phase of its severe consequences.
2. The 1929 Great Depression
The 1929-1933 Great Depression is one of the most devastating black swan events in history. Economists often refer to this event to describe how intense a financial crisis can be and hit the world economy severely. It started with the stock market crash of October 29, 1929, also coined as Black Tuesday in the financial world. GDP – worldwide – fell by approx. 15%, international trade declined by 50% and unemployment skyrocketed to 23% in the US along with the reduction of personal income drastically. If you compare the 1929 Great Depression with the 2008 Great Recession (refer to the first event), the Global GDP fell only by less than 1% in 2008 whereas it was a whopping 15% in 1929. This fact is alone to justify the severity of the 1929 Great Depression. While some of the countries started recovering by the mid-30s, other countries still dealt with its negative impact till the beginning of the second world war. Still, the actual reason behind the Great Depression is not unveiled, economists believed that the sudden market crash led to a reduction in investor confidence ultimately lowering consumption and investment spending. The gold standard – the country’s currency value directly linked with gold – too is perceived to be the cause and blamed by some of the economists to be responsible for the primary transmission mechanism of the Great Depression.
3. The Dot Com Bust (2000)
The rapid rise in the US stock equity valuations for the Internet-based companies led to the Dot Com Bubble of 2000 with NASDAQ Composite Index rising 582% from January 1995 to March 2000. In the end, all bubbles have to burst at a certain point in time and the same incident happened with these companies as they reached an extreme level of valuation becoming significantly overvalued. In such a process, many entities declared themselves bankrupt while some of them faced a liquidity crisis resulting in a plummet of NASDAQ 75% from March 2000 to October 2002. The majority of companies possessed no viable business model however they were able to attract interest from the venture capital firms as they fell under the high-growth tech industry then perceived to be the remarkable emerging sector. As a result, huge investment and capital were flowing to the tech companies in abundance as it was being done with insufficient company analysis, industry analysis and the market trend analysis that led to massive overvaluation of these companies.
Robust and stable tech companies such as Alphabet and Apple Inc. surpassed the crisis and turned out to be the effective investment option whereas the so-called tech companies lacking robust fundamentals led to the bitter taste of Dot Com Bust due to the unrealistic expectations of investors.
4. Asian Market Real Estate Crisis (1997)
The prominent East Asian and the South Asian emerging economies felt a sudden shock when the real estate bubble burst set off with Thailand. Backing strong internal growth and foreign investment, the property price in Thailand reached absurd levels. When the bubble burst, it inevitably caused the property price crash wiping out 70% of the wealth in Thailand’s stock market. Due to the interconnection with Southeast Asian Economies, a similar level of supply-demand shock in property prices was felt in the economies of countries like Indonesia, Singapore, South Korea, and Malaysia. The fact that South-East Asia accumulated a huge pile of foreign debt made the crisis even worse. The foreign debt-to-GDP ratios in the Asian Economies rose from 100% to 167% during the period of 1993-1996 with becoming even worse reaching beyond the 180% during the crisis. Currency markets were hit the most. The Thai belt fell by 40% reaching as low as 41 bahts per USD from 24.5 baht per USD. Likewise, Indonesian rupiah was hit the most, leading to a fall of 83.2% to as low as 14,150 rupiahs per USD from 2380 rupias per USD.
5. The 9/11 Terrorist Attack
The 9/11 Terrorist Attack can be considered as one of those black swan events where war and conflict led to the demolition shaking the stock market. The horrific terrorist attack blew up the center of finance of the modern world –New York City. New York’s most recognizable business monument being destroyed, and thousands of lives being lost within a few hours stunned the world as the US being the world’s most powerful nation was struck on its own soil by a terrorist organization. The panic was felt across the world, however, the majority of the impact facing the US. Impact on the US denotes worldwide turmoil. The S & P 500 index fell by double digits within a week wiping out more than a trillion dollars of investor’s wealth. It is to be noted down that this crisis was an outcome of investors’ fear and panic, not because of the system faults inherent to the system. However, it is unrealistic to believe that it could have been predicted. Such crises are often challenging to predict due to their seemingly random occurrence. If any indicator is to fit for such an event, it would be observing the political and military trend on a global scale.
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Coping with Black Swan Event
To cope with the upcoming black swan which might be knocking right next to your door in upcoming years, you should not overexpose your portfolio to a particular investment of asset class, instead, you ought to follow the principle of diversification. Effective asset allocation will make sure that you can endure over the long haul considering the fact that black swan events can inevitably occur. Chasing the top-performing stock or relying on a single sector to put forth all your investment capital might deliver you with a stunning return over the short haul, however, it is sure that your portfolio will be wiped out if catastrophes like black swan hunt out your portfolio that lacks the diversification. Inclusion of the value stocks with a margin of safety and real assets like precious metal and property can work as one of the best approaches towards hedging in such circumstances. If, negating all the ways I mentioned above, what you can do is, select the company with sound financials and strong fundamentals. If done so, you are investing your time to hunt out for the company that can be relied on over in such harrowing events as well.
Is Prediction of Black Swan Events Even Possible?
History has proven that even the so-called financial experts have failed to predict black swan events with certainty. Investors will have a hard time predicting the next possible black swan event, if not, almost impossible.
Is COVID-19 a Black Swan Event?
The majority argued COVID 19 to be the biggest black swan event of the 21st century jolting the world economy in decades. The crisis has not only impacted certain parts of the world, however, trounced the economy in every part of the world. Eight of the ten biggest single day drops in the value of the S&P 500 have been recorded in the year 2020 itself because of the pandemic.
However, Nassim Nicholas Taleb in an interview with Bloomberg stated COVID 19 to be the white swan rather than the black swan. He further added by stating that companies should not make excuses for not staying prepared. In addition, there are definitely no excuses for the government not to be prepared for such events.
The Bottom Line
Investors – definitely – should consider the possibility of black swan events while making the investing decisions as such events can wipe out your hard-earned money within a matter of days whether it be your 1929 Great Depression, 2008 Great Recession, or 9/11 terrorist attacks. Investors must focus on creating a portfolio that can even tackle such black swan conditions through strategies like hedging and diversification. However, no matter how worse the market crash would be, the market recovers ultimately. Nonetheless, the time it takes to recover from such a crash is colossal which every investor should be concerned about.
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