Bracing for Black Swans

Ancient Roman poet Juvenal had no way of knowing the impact of his words when he penned the description, “a rare bird in the lands and very much like a black swan.”

At the time, no one thought black swans existed. They did, of course. It was a simple enough mistake on Juvenal’s part, but one that has since been extrapolated into what we now refer to as Black Swan Theory. 

Introduced in 2001 in Nassem Taleb’s Fooled by Randomness and expanded upon in his follow-up The Black Swan, the idea is pretty simple. You cannot predict and prepare for everything because not everything is knowable. And now and then, the unknowable can be almost indescribably consequential.

These Black Swans can range from a terrorist attack to a major political event and beyond. We cannot predict when they will hit and we cannot know the unique depth of their impact on the markets. What we can know is that Black Swan events do happen now and again, so understanding more about them matters.

Black Swan Theory Basics

Taleb tends to be who everyone quotes when they discuss black swan theory, and it’s not just because he introduced the notion in popular culture. He also explains it quite beautifully, writing:

What we call here a Black Swan (and capitalize it) is an event with the following three attributes.

First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme ‘impact’. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.

I stop and summarize the triplet: rarity, extreme ‘impact’, and retrospective (though not prospective) predictability. 

Taleb’s exploration of these ideas and Black Swans throughout history offers some fascinating insights, but today we focus on the part of the story that makes the world go ’round: money.

In finance, Black Swans may take the shape of a market reaction to an extreme event (like the 9/11 attacks) or a development with an economic domino effect (like Bears Stearns). The scope and durability of Black Swan economic impacts vary dramatically. You could be talking about a few months of consequences or a few years. Or maybe one of these events changes the game forever.

Black Swan Prognostication Pitfalls

Black Swans are kind of hard to deny, if only because of their definition. The minute you start to explain why something was actually predictable is the moment you meet the condition of retrospective predictability. And that same look-back will highlight just how unpredictable it felt to how many people in the moment.

A good example of this comes from some of the mythology that swirls around the 2008 crisis. Analysts love to prop up their bear market calls preceding the crash like they were somehow prescient. The short-sellers that read the tea leaves and placed winning bets get vaunted as simultaneously savvy and villainous. But that’s what we see in hindsight.

If the enormity of the 2008 crash had actually been reasonably, remotely predictable, the mass erasure of wealth worldwide wouldn’t be part of this conversation. Anyone having a good-faith conversation about Black Swan Theory will admit as much. You can bet that anyone claiming they have the power to predict the trigger, timing, and size of the next Black Swan is either delusional or trying to sell you something. 

The More Things Change…

Some argue that Black Swans are less likely today. Information moves faster and more freely. More people have access to markets. The sheer volume of transactions taking place around the world is a thing to behold, to say nothing of the amount of money changing hands at break-neck speeds.

The combination of these factors, they insist, creates a more efficient market. By the time something bad happens, the markets will have already priced it in, mitigating the impact of any potential resulting market volatility.

This position ignores reality. The biggest market players still have access to more, stronger, and faster data. Volume tends to get driven by systems, some of which have already caused mini-market events in the past when they went rogue. If anything, the stakes are higher now, and finding the signal in the noise presents a serious challenge. And the markets cannot respond rationally to a data set it’s never encountered before. 

How the Debt Ceiling Debate Illustrates Black Swan Risk

Back in 2011, the idea of the US defaulting on its debt seemed like the plot of a badly written Sorkin-esque political thriller. The debt ceiling was never designed for use as a weapon. And for all the partisan tension in the air at that point, most measured individuals believed that pragmatism would beat out theatrics.

It did, technically. We did not default. But the fact that we waited until two days before the deadline generated significant market losses and increased borrowing costs for the government by more than $1.3 billion in 2011 alone following a credit downgrade by major agencies. 

And even though the damage was severe, it still arguably shouldn’t get classified as a Black Swan. But that’s not why 2011 matters in conversations about Black Swans. It didn’t take a default for us to see major consequences. It took a deviation from expected behavioral norms. 

This is why, as the US continues their latest rendition of the debt ceiling debate, some skittish investors and analysts are wondering if partisan dysfunction is about to deliver an actual Black Swan event. For the government to actually default on its debt by choice would be unprecedented. Though few argue it could generate an economic catastrophe, our ability to predict the depth of the fallout is limited by our lack of previous experience. That reaction has Black Swan potential, even if we predict that it could be triggered by an actual default.

The Proper Investor Perspective

No one who had skin in the game in 2008 will tell you they had a great time weathering the storm (assuming they did). Black Swans invariably cause serious pain for investors. The amount of pain, however, depended on several factors.

Most people aren’t investing for just the next year or even the next five. This is about a long-term strategy designed to build wealth over time. To this end, the people who experience the most pain as a result of Black Swans are those who can least afford to take that loss: those who are closer to retirement or already reliant on their investments for income. 

Black Swans also uniquely hurt those whose portfolios are not adequately diversified or too aggressively positioned. When your risk exposure is high or overly consolidated, losses under extraordinary circumstances can be astronomical. 

The 2008 Black Swan Exception

Just in case the idea of an unpredictable event carrying untold consequences wasn’t scary enough, let’s talk a little more about 2008. 

One of the reasons the 2008 financial crisis gets talked about like a statistical boogeyman is because it highlighted how quickly institutions can collapse and take our investments down with them. It was because the losses happened everywhere, all at once.

Under most circumstances, certain asset classes perform in generally predictable ways. When things go well, “risk” assets like stocks tend to go up. When things feel dicey, “safe” assets like bonds tend to benefit. These correlation levels form the foundation of Modern Portfolio Theory. Spread your bets across non-correlated assets and limit the odds of getting swept up in a downward motion.

But in 2008, historical correlations went out the window. Everyone lost as money raced away from the markets, fearful of systemic instability and terrified by their rapidly depleting portfolios – no matter how balanced. 

That won’t necessarily be the case during the next Black Swan. But it underscores just how unpredictable a real Black Swan event can be and how important it is to be deliberate with your portfolio management. 

Keep Your Eyes on the Horizon

The only really predictable thing about Black Swans is that most will likely see one at least once in their lifetime. You won’t know when, where, or how big it will turn out. No one can fully prepare for or protect against those moments.

But understanding as much – and the rest of the dynamics, math, and tools in play – means investors can keep things in perspective. Investing is not a race, nothing is guaranteed, and you don’t know what you don’t know. That’s the bottom line. Just ask Juvanel.

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