Black Swan theory explained: what is a Black Swan event?

What is a Black Swan event?

‘A black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black swan events are characterised by their extreme rarity, their severe impact, and the widespread insistence they were obvious in hindsight,’ writes Nassim Nicholas Taleb, a former Wall Street trader, in his book The Black Swan: The Impact of the Highly Improbable.

There are no limitations in the way a Black Swan event can manifest itself. It could be anything from a natural disaster to a war, a financial crash or the outbreak of a virus. But they do share three characteristics according to Taleb, who formulated the theory about how extreme and surprise events can play an outsized role in life.

The first is that Black Swan events are outliers – something that lies outside the realm of normal expectations because nothing in the past can credibly suggest it will happen.

The second is that the event has a severe and extreme impact on society or the world.

The third is that a Black Swan event is predictable after the event has occurred. While the event is not expected beforehand, it becomes explainable in hindsight and the world asks why we weren’t prepared.

Black Swan events can also be used to describe highly probable events that don’t happen.

Black Swan events are rare by nature but it is still highly likely that something similar has happened before. The coronavirus crisis is a Black Swan event, but it isn’t the first time humans have had to deal with a worldwide health pandemic when you consider the likes of Spanish Flu or other outbreaks.

A natural disaster is always shocking, but they have happened before whether it be an earthquake, tsunami or a volcanic eruption. A financial crash always comes out of nowhere and catches most people by surprise despite the number that have happened in the past. Notably, these events are not regarded as impossible but very unlikely based on historic evidence.

It is also worth highlighting the role of perspective in Black Swan events. For example, a terrorist attack will be classed as a Black Swan event to most people, but not by the perpetrators. This also means that Black Swan events are not always perceived as negative by everyone.

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 dedicated 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.

The term ‘Black Swan’ refers to the story that Westerners believed all swans were white simply because that was all they had ever seen, until that belief was rubbished when Australia was discovered and the first black swan was found.

‘The sighting of the first black swan might have been an interesting surprise for a few ornithologists, but that is not where the significance of the story lies. It illustrates a severe limitation to our learning from observations or experience and the fragility of our knowledge. One single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans. All you need is one single black bird,’ Taleb writes.

The Black Swan theory suggests what you don’t know is far more important than what you do know. You can use all your knowledge to prepare for what you believe to be every eventuality, only to be proven wrong by one Black Swan event.

Examples of Black Swan events

There have been a number of Black Swan events throughout history and they can take very different forms. Both World Wars, the fall of the Soviet Union, the rise of Islamic fundamentalists, 9/11, the impact of the spread of the Internet, and the 1987 and 2008 financial crises are all examples of Black Swan events.

But we are living through a Black Swan event right now. There has been some debate over whether the coronavirus pandemic is a Black Swan event, but it does meet the criteria. While the threat of a virus was known, the unpreparedness of governments around the world shows it was considered an outlier event and that there was a low possibility it could happen.

It has also had dire 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.

Taleb argues that most scientific or technological breakthroughs are the result of Black Swans. Most discoveries are not necessarily planned, but discovered by accident or as a result of a Black Swan event happening.

For example, X-rays and microwave ovens are both thought to have been discovered by accident. Similarly, while many companies are scrambling to find a vaccine for coronavirus, the effective treatments found so far were all initially developed for other reasons, such as the antiviral drug Remdesivir.

The idea is that most discoveries are made through a process of aggressive trial and error rather than extensive design and planning, and this is why new technology or scientific discoveries are usually so surprising and unexpected.

What do Black Swan events mean for traders and investors?

So, 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. Taleb said ‘we produce 30-year projections of social security deficits and oil prices without realising that we cannot even predict these for next summer’ because ‘our cumulative prediction errors for political and economical events are so monstrous’.

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 rather than treatment when it comes to cataclysmic events.

The problem it has in engaging many investors and traders is that preventative tactics rarely offer the same rewards as treatments. For example, a company that invented a vaccine for a virus that is seen as a threat but hasn’t yet caused any illness or death in humans will be regarded as unnecessary and wouldn’t draw any applause, but a company that finds one to stop a pandemic will be showered in rewards.

Similarly, if an investor is consistently bearish in fear that a Black Swan event could occur, then their returns will significantly underperform until it happens.

Still, as the number and extremity of Black Swan events increases as the world becomes more complicated, Black Swan investing is gaining momentum. Unsurprisingly, attention to it rises when a Black Swan event occurs, so the coronavirus will propel it back into the spotlight as investors look at ways to reduce risk, hedge their bets and diversify their portfolios to protect themselves from the unknown.

For example, this could involve siphoning a proportion of your portfolio to safe haven assets like gold even when the market is undergoing a long bull run and gold prices are not generating any returns – at least until the markets crash again – or hedging your positions. You are likely to underperform the market during the bull run, but will fare much better when the market crashes. Or, when examining different stocks, consider the threats and risks that aren’t listed in the company’s principle risks and how it would perform under different scenarios.

Black Swan investing is about looking for stocks or other financial instruments that could deliver huge returns if markets plunge. The strategy only works once a crash occurs, so it can entail incurring losses over an extended period of time before cashing-in when a sudden crash happens because of a Black Swan event.

Take Universa Investments as an example. Run by Mark Spitznagel and Taleb, the Black Swan fund ‘formalised and institutionalised the idea of tail risk hedging’ and has benefited hugely since the coronavirus outbreak plunged markets into turmoil. It is reported that the fund has risen over 3600% during the crisis – but notes that its performance over the preceding 10 years was uninspiring and loss-making as markets continued their bull run.

However, the strategy seems to pay off in the long term, considering the fund is thought to still be up over 200% in the last 10 years, largely thanks to the last few months alone. A separate report suggests an investor could have deployed just 3.3% of their portfolio in Universa and the rest of it an S&P 500 tracker fund and they would have seen a 0.4% return in March 2020 – a month when the benchmark index plunged 12%.

Black Swan investing is not for the faint-hearted or the impatient. As Spitznagel once said, it is like trying to learn the piano for 10 years and struggling to play ‘chopsticks’ all in the hope that one day you will wake up and be able to play Rembrandt.