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Black Swan Events: Definition & Theories

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The term ‘black swan’ originates from Latin in the form of an expression “a rare bird on Earth, like a black swan.” For a long time in Europe, people believed that swans other than white did not exist. However, in the 17th century, a population of black swans was discovered in Western Australia, but the expression is still used to describe something unlikely. So, what a black swan event is? 

The article covers the following subjects:

Definition

The term ‘black swan’ is used to describe economic, political and social accidents that are inevitable and impossible to predict. This is exactly what Nassim Nicholas Taleb, a former Wall Street trader and the author of the black swan theory, calls them. 

At the same time, the author understands that the concept of “black swan” applies not only to negative events. Among the positive changes of the same rank, he named major scientific discoveries, the emergence of personal computers and the Internet.

What is Black Swan theory?

In 2007, a year before the onset of the global economic crisis, the American trader of Lebanese origin Nassim Nicholas Taleb published the book “The Black Swan: The Impact of the Highly Improbable.” He used the term “black swan event” to refer to large-scale accidents that affect all areas of life.

From the author’s point of view, the black swan event always meets three criteria:

  1. It should be unexpected for the observer.

  2. Its effect should be large-scale.

  3. As time passes, people will find prerequisites for it — as if it could be expected.

In fact, almost all abrupt changes can be classified as black swan events. You can open any history class book to see such events, for example, read the description of the Great French Revolution. First of all, the reader will be greeted by a paragraph with prerequisites that were revealed after the fact of the revolution itself.

Black swan events change our beliefs

In 2007, along with the release of his book, Taleb wrote an article for The New York Times, where he explained the influence of “black swans” on our basic understanding of the world:

“A single observation can disprove a general belief based on thousands of years of observation of millions of white swans. All you need is a single (and, as they say, rather ugly) black bird.”

In other words, such events fundamentally turn our picture of the world upside down, proving that everything is based on a rather unreliable and even illusory construction. Human nature makes us build predictions based on previous historical events. A completely new occasion might be impossible to predict when there’s no experience to foresee it.

This thesis gives rise to distrust of any expert assessments and forecasts that are based on well-known principles and formulas. According to Taleb, investment strategies are no more trustworthy than astrology. The very first “black swan event” can bring down the market or, conversely, lead to an explosive growth of certain assets, and no one will be able to prepare for this. The author of ‘Black Swans’ explains:

“We forecast oil demand for 30 years ahead, not realizing that we cannot know what it will be like next summer. The cumulative errors in political and economic forecasts are so monstrous that when I look at their lists, I want to pinch myself to make sure I am awake.”

As confirmation of his theses, Taleb cites the past events of September 11, 2001, in New York. Back then, no one objectively assessed all the possible risks, simply because such a turn of events seemed the most incredible. 

Taleb extends the theory of “black swans” to famous personalities who were not appreciated during their lifetimes — such as Edgar Allan Poe or Arthur Rimbaud. In his opinion, if we had abandoned the usual logical attitudes, we would have had time to recognize their talent, which was ahead of its time.

Examples of Past Black Swan Events

Here are the major historical events tagged as ‘black swans’.

The 1997 Asian Financial Crisis

If we talk about financial markets, several events in recent history can be attributed to black swans. The 1997–1998 Asian crisis caused a drop in the exchange rates of the national currencies of many Southeast Asian countries, bank failures and a general stagnation of the Asian economy in the late 1990s.

In the middle of the last decade of the 20th century, the countries of the region, including Thailand, the Philippines, Malaysia, Indonesia, and South Korea, experienced a period of rapid economic growth. This growth was largely financed by foreign lending, spurred by the liberal monetary policy of the US Federal Reserve and favorable lending terms in local currencies. As a result, the economies of Asian countries were heavily over-credited which triggered large deviations and a collapse.

The “Dotcom” Crash

The “Dotcom bubble” was observed between 1995 and 2001. The bubble was formed as a result of the surge in stocks of Internet companies (mostly American), as well as the emergence of a large number of new Internet companies. The shares of companies promising to integrate Internet tech skyrocketed in value. However, many new business models turned out to be ineffective, which triggered a wave of bankruptcies. At the turn of the nineties and two thousand, due to speculation and unjustified optimism, investors lost about $ 5 trillion. 

9/11 Attacks

A black swan in the stock market is not the only example. September 11, 2001, appeared to be one of the most tragic days. Terrorists hijacked civilian planes with passengers on board and sent them to the twin towers of the World Trade Center in New York. It was a catastrophic loss: more than 2,900 people died in the attack. Shortly thereafter, the United States launched a massive anti-terror campaign. However, after the tragedy, some people started declaring that the events of September 11 could have been predicted in advance.

The 2008 Global Financial Crisis

As mentioned above, this event happened a year after the publication of Taleb’s book, where he used the term.

The global economic crisis started with the US financial crisis in 2007-2008. The S&P 500 index, which includes the 500 largest companies in the country, fell by 38.49% in 2008. The economic downturn was so severe that the Lehman Brothers investment bank filed the largest bankruptcy procedure in history — 25 thousand people lost their jobs, and the company — $46 billion in market value. The impact of the crisis also affected the world stock markets, which then lost about $10 trillion. Of course, after the crisis, experts began to argue that the prerequisites and reasons could be seen long before the collapse.

Brexit

After long preparations, Great Britain exited the European Union in January 2020. This event impacted stock rate and market volatility, but its consequences are still unfolding. Experts say, after Brexit, human rights in the United Kingdom will be severely tested, not least by government hostility to many aspects of human rights protection, the decline of democratic institutions, a climate of intolerance and human rights rejection by many media outlets. Economic decline is only one of many occurrences that people face.

Is Covid-19 a Black Swan?

This opinion is very common. For example, during the Ideas Lab conference in Brussels, experts said that the coronavirus demonstrated the fragility of the global world and the inability of states to act effectively. As a result, we found ourselves isolated and divided by borders, the economy plunged into chaos, and the WHO issued belated and contradictory recommendations. 

As befits a real “black swan”, the pandemic over the past years was unexpected for the world community (except for the predictions of Bill Gates, to which no one listened) and led to global consequences.

More modern examples of the black swan in the economy include the events of early 2020 when the COVID-19 global pandemic broke out in the world. On March 12, Black Thursday happened – on that day, the scale of the fall in the markets could be called catastrophic. 

The S&P 500 lost 9.5% on the day, the worst daily fall in the index since October 19, 1987. Indicators of other world markets also went to their peak. The recovery of American indices to the level of January 2020 occurred only by November.

Why Do Black Swans Happen?

Black swan events might be caused by a natural course of history, but their difference from “white swans” is that they are unpredictable events. Why? Because people pay no attention to the things that precede the catastrophe. 

Here are the main mistakes that prevent us from predicting the appearance of “black swans” in time:

  • Bubble effect. People tend to trust more information and opinions that are prevalent in their environment or among those whom they consider being an authority. In this case, everything that contradicts this is ignored.

  • Overuse of mathematical methods in real life. For example, game theory is often used to predict the likelihood of winning a lottery or card. In practice, everything is much more complicated, and even those factors that we do not know should be taken into account.

  • Application of retrospective analysis: when one tries to predict future events based on the past. The main mistake here is to assume that we know enough to make predictions and that everything will develop according to the same scenario. The experience of the First World War did not help to prevent the Second.

So if you’re on the lookout for black swan signs, here’s the bad news: you aren’t likely to pay attention to the things that will trigger accidents in the future. There are too many possibilities that we actually ignore.

How Can Investors Prepare for Black Swans?

The black swan can influence almost all areas, and sometimes it happens instantly. So how do you protect yourself?

In his book, Taleb wrote that the best way to soften the influence of the black swan is not to try to predict it. According to the author, instead, it is necessary to understand its inevitability and develop stable and sustainable plans that will help reduce the likelihood of such an event. Or smooth over its consequences.

For example, banks run stress tests – simulations that are designed to test whether a financial institution will survive another crisis. This practice became common in organizations just after 2008. Some central banks also took an example from them – for example, the Bank of England, a few years after the crisis, began to arrange its own stress tests.

But, as Taleb noted, not only professional organizations but also private traders can prepare for catastrophic events.

The black swan in trading, as in other areas, comes suddenly and without warning. Therefore, you should always try to secure your portfolio as much as possible from adversity. There are several guidelines:

Accept the idea that the next black swan is bound to come

When you study the history of market movements, it becomes clear that bad events are happening all the time. Therefore, accidents should not come as a surprise, but rather a normal cycle of life.

Take advantage of the opportunities that black swans provide

When the stock market drops and stock prices decline due to such an event, it is worth considering investing in sustainable companies. Ultimately, they will be able to get out of the crisis, and the value of assets will rise again.

Diversify your portfolio

This advice is relevant for absolutely all investors. Remember that if you have only one asset in your portfolio, you will be very seriously affected by a black swan event. To secure your investments, be sure to distribute them among different instruments.

Black Swan investment tips

Here are the key takeaways from historical stock market statistics:

  1. “Black swans” in their influence on the markets do not fundamentally differ from other crisis phenomena.

  2. Recovery times are closely related to the duration of the recession but rarely exceed one year.

  3. The trend of broad market indices in the long term is always upward.

When choosing in favor of individual securities, an investor can often make mistakes. Take the current crisis. Markets recovered quickly, and some sectors such as IT, especially cloud-related stocks, are booming. But there are exceptions to this general trend. For example, Dropbox — one of the symbols of cloud computing and remote work — has not grown exponentially, but continues to trade below the price of its IPO in early 2018. You can protect yourself from such failures if you invest in broad markets, and not in individual securities.

By trading ETFs, investors can not only save their investments from “black swans” and other economic problems but also earn. The market downtrend is perceived by many as an opportunity, so they buy in.

Are there any other black swans coming?

What “black swans” are waiting for us in the near future?

Back in 2017, in an interview with RBC, Taleb predicted the most likely events that will become the new “black swans” are:

Epidemics. In 2020, in an interview with RBC Pro, Taleb said that the high mortality rate from COVID-19 was a direct consequence of the fact that many underestimated the epidemic even when the threat became quite obvious. In his opinion, the end of quarantine does not mean that we can return to normal life: the consequences will remain with us for a long time.

Neoluddism (‘resistance to robotization’). It’s called by analogy with the movement of the Luddites, who existed in the early 19th century and broke weaving machines, fearing to lose their jobs. According to Taleb, this trend will be especially noticeable in Islamic states.

Conclusion

Life is full of unexpected twists and turns, some of which have an extreme impact on the whole world. The black swan theory states ‘hope for the best, prepare for the worst’, and it’s the best attitude you may have. How to protect yourself? If you trade with LiteFinance, make sure you diversify your portfolio and use analytical instruments to predict the movements of your assets.

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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