Black Swan event is a metaphor used for the events, particular activities, or transactions that cannot be predicted or even expected to happen. This term was tailored by Nassim Nicholas Taleb, a former Wall Street trader, who has also written a well-known book on this topic. These events are extremely rare and have a huge impact on the economy, politics, society, and politics, and are also widely spread. In his book “The black swan: The impact of the highly improbable”, describes the black swan “as an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences.”  

Subsequently, the black swan events need to be handled with great caution. Let’s find out more about them, and also learn about sustainable trading strategies when they occur.

The history of the Black Swan Theory

Taleb introduced the idea of Black Swan events as far back as 2001, but it grabbed attention when he wrote an entire book on the subject in 2007 – just before the world suffered a Black Swan event in the form of the 2008 financial crash.

For a long time, in nature, black swans were believed not to exist. From this comes the metaphor of ‘black swan’ referring to something that is so rare, that barely even exists. Just because only white swans have been seen, people had taken it for granted that all swans were white. In 1697, a team of Dutch explorers would be the first Europeans to encounter black swans, on the Western coast of what today is Australia. Hence, this belief was debunked when the first black swan was found.

This, of course, might have been an interesting surprise for bird scientists, but the intrinsic significance of this story lies in its symbolism. What it symbolizes is the fragility of our knowledge, and how hard it is to predict things with certainty. One black bird was enough to put out of existence a millennia-long belief. This one single observation completely discredited what seemed to be a firm assumption of the existence of white swans only.

The black swan theory suggests what you don’t know could actually be far more important than what you do know. You can use all your knowledge to prepare for what you believe to be every possible outcome, only to be proven wrong by one black swan event.

Another interesting parable for this phenomenon, used by Taleb in his book, is the example of a Thanksgiving turkey. All its life it's been fed, every single day, from the day of birth. Every day it rests assured that this is the general rule of life, and that people are friendly overall and simply looking after its needs. This, understandably, represents a standard way of living for the turkey. However, on the day before Thanksgiving, something completely unpredictable happens. Something that the turkey could not have foreseen. This event will provoke a revision of a belief.
 

Features of Black Swan Events

In order to be considered a black swan event, here are the three characteristics it needs to have:

1. An outlier. It is probably the oddest of all thinkable scenarios, something that lies outside the realm of normal expectations because nothing in the past suggested that it would happen. Nor logic nor science can predict it coming.
2. A severe and extreme impact on society or the world. These events have severe repercussions and a high-level impact on the global economy.
3. To be rationalized in the afterthought. After its occurrence, it is rationalized and deemed predictable. A number of reasons are found to make it explainable and predictable, but always post-occurrence. This is only due to the fact that they become aware only then of the outcomes of the said event.

Examples of Black Swan Events

When it comes to examples, it’s needless to go further than the present tense, since the world is currently going through a black swan event, or better said, a series of such events. There was first the novel of Covid-19, with all the consequences it had on the global scale, and now the war in Ukraine.

Even though there has been some debate going on whether the coronavirus pandemic can actually be classified as a black swan event, because of its existence in China first, which the rest of the world knew about, it does meet all the criteria.

While the threat of a virus was known, the unpreparedness of governments around the world showed how it was considered an outlier event with a low possibility of happening.

It has had extreme consequences, both on public health and the economy. Plus, now that it has happened, it is explainable and everyone is wondering why we weren’t ready for it.

There are a number of black swan events from the past. Here are some common examples from the past few decades:

• The financial crisis in 2008.  Before the COVID-19 outbreak, the most notable example (in recent years) of a black swan event was the great global recession of 2008. It was precipitated by the sudden, severe crash of what had previously been a booming housing market eventually causing a sharp decline in economic activity during the late 2000s. This is considered the most significant downturn since the Great Depression. The term applies to both the US recession, officially lasting from December 2007 to June 2009, and the ensuing global recession in 2009. The economic slump began when the U.S. housing market went from boom to bust, and large amounts of mortgage-backed securities (MBS) and derivatives lost significant value.
• Dotcom bubble in 2001. This event has similarities to the 2008 financial crisis. The US was enjoying a rapid economic growth and increases in private wealth before the economy catastrophically collapsed. The Internet was still new in terms of commercial use, with few online commercial applications being used. However, technology companies were investing heavily in growth, and the stock prices of these companies became inflated. Various investment funds were investing in technology companies with inflated valuations and no market traction. When these companies folded, the funds were hit hard, and the downside risk was passed on to the investors. The digital frontier was new so it was nearly impossible to predict the collapse. 

Despite the association with events with significantly negative impacts, black swan events are not necessarily all crises, per se. Examples of black swan events also include the rise of the Internet and the personal computer, which both satisfy the criteria to fall under the black swan category, but have an immensely positive influence on things.

Black Swan trading strategies and risk management

Now that we’ve understood that black swan events are totally unpredictable, the goal is not to learn how to predict it, since this would be impossible, but how to be as prepared for it, if it comes.

Obviously, asset prices are most often negatively affected by a black swan event. Investors and traders must simply assume that they will occur sometimes. Because of the assumption that a catastrophic event can and will occur, investors should allocate their portfolios in such a way to prepare for the worst of scenarios.

Traditionally, investors who are exposed to a black swan event in the market will likely see account values plummet. The market may see a lot of panic selling, driving prices down even further. One major area of focus is risk management.

Typically, when one area of the market does well, other areas tend to underperform. Diversification is one strategy that can help limit the exposure of investments to a black swan event. By having a diversified portfolio, investors can take advantage of the growth in various market conditions.

Another strategy that an investor can take to mitigate the effects of a black swan event is a barbell strategy. This strategy keeps the majority of an investor's assets in ultra-safe vehicles and moves a small percentage into speculative investments. The risky part of the portfolio shouldn’t exceed 10% of the whole portfolio. The barbell strategy avoids putting money in moderate-risk investments. It is primarily a risk-averse portfolio with only a small amount of speculation.

The idea is that most of the money is protected during a market panic, and the high-risk ventures have the opportunity to soar.

One more way to protect the capital allocated is to look for stable, blue chip companies. Blue-chip is a name given to stocks of well-established companies, with a reputation for financial stability, reliability, and quality. These stocks have market capitalizations running into billions of dollars and are usually the market leaders in their sectors.

Blue-chip stocks provide a sense of security and “survive” and recover during market meltdowns. It is also important to remember that a falling stock price doesn’t mean that the company is going out of business.

What do Black Swan Events mean for traders and investors?

How does somebody prepare for the unknown? The theory is not about trying to predict future Black Swan events but acknowledging that they will occur and making sure you are prepared to react to whatever happens.

This means disregarding most predictions and forecasts, especially ones that are over the long term.

Investing under the principles of black swans is bearish by nature, and leans on the fact that the world needs to focus more on prevention than treatment when it comes to cataclysmic events.

With this in mind, prudent traders should always look at ways to reduce risk, hedge their bets and diversify their portfolios to protect themselves from the unknown.

Sources Consulted:

1. CFI Team. Examples of Black Swan Events https://corporatefinanceinstitute.com/resources/knowledge/finance/examples-of-black-swan-events/ (2020)
2.  Gordon, S. Black Swan https://www.investopedia.com/terms/b/blackswan.asp (2022)
3. Thakur M. Black Swan Event https://www.wallstreetmojo.com/black-swan-event/#h-attributes-of-a-black-swan-event (2020)
4.  Warner J.What is a Black Swan Event? https://www.ig.com/en/news-and-trade-ideas/black-swan-theory-explained--what-is-a-black-swan-event--200703 (2020)
5. Leonard K. What is a Black Swan Event? https://seekingalpha.com/article/4489012-black-swan-event (2022)