In the ancient world, people believed that swans could only be white…
And they believed this so strongly that they would describe something that seemed impossible or wildly unlikely as a ‘black swan’.
The poet Juvenal said, ‘A good person is as rare as a black swan.’
Even Aristotle would use the phrase black swan to describe something that was improbable.
Perhaps you’ve heard this term before…
It was made famous in April of 2007, when a former trader named Nassim Taleb published a book called The Black Swan: The Impact of the Highly Improbable.
In the book, Taleb dives into human psychology…and how we, through our limited experience, often come to trust in patterns that aren’t always reliable.
In other words, we start to believe things are certain…when they really aren’t. What Taleb calls a ‘false premise’.
For example, say I have a pond on my property…and for years, all I catch are brown trout. Every time the bobber goes under and I reel it in, it’s that brown spotted fish wriggling on the hook.
My mate comes over one day and asks what’s in the pond. I tell him that the only darn fish in that hole are those old brown trout.
He casts out and slides into his lawn chair…then the bobber submerges. He reels in and, lo and behold, on the end of the line is a beautiful gleaming rainbow trout, its green and red bands glistening in the sun.
Shocked, I realise that what I believed to be impossible — something completely unexpected — has happened…and my understanding of what lives in my pond now changes.
That would be a ‘black swan event’…an unexpected and improbable event that makes you rethink your whole world view.
The problem with this concept, of course, is that black swans actually exist in Australia.
In my recent trip over, I actually saw one myself near Homebush Bay in Sydney. Here it is:
See it there circled in red?
That’s a black swan.
It’s possible you’ve seen one before too. They exist all over Australia and New Zealand…and here in New Zealand, it’s actually rarer to find a white swan than a black one.
But it took Western society until the 1700s to discover that such a creature existed after thousands of years scoffing at the idea.
The black swan theory
Well what does it mean and why does it matter?
As Taleb recorded in his book, we as humans experience black swan events sometimes in our lives.
When it happens, it often takes us by surprise and has a major effect as a result. Then, with the benefit of hindsight, we tend to over-rationalise the event.
Here are the three facets of the theory according to Taleb:
- ‘The event is a surprise (to the observer).
- ‘The event has a major effect.
- ‘After the first recorded instance of the event, it is rationalized by hindsight, as if it could have been expected; that is, the relevant data were available but unaccounted for in risk mitigation programs. The same is true for the personal perception by individuals.’
His book was well-timed because within only a few short months after publishing, the world experienced a major black swan event — the Great Financial Crisis.
Another event was the hyperinflation crisis in Zimbabwe, where peak inflation hit 79.6 billion percent.
The dot-com bubble was another, the Great Depression, the ’73 oil crisis, and many more…
You’ll notice that the financial sector has a disproportionate number of black swan events throughout history. Taleb attributes this fact to the idea that the financial sector is built on millions of financial models, most of which are defective, inaccurate, limited, or biased.
As a result, there are heaps of ways for a fracture to slip by unnoticed.
Hedge fund Long-Term Capital Management was a prime example of a black swan event. It collapsed in 1998 as a result of the ripple effect triggered by a debt default by the Russian government. The original cause was something so unexpected that none of the company’s computer models could predict it.
What can you do?
Fortunately, there are a few things that you and I can do to manage the risk of black swan events.
The first is to identify areas of vulnerabilities early on…so that you can do what Taleb calls ‘turning the Black Swans white.’ This can be hard. It means casting doubt on the things that you’ve come to trust.
For example, most of us believe that the government will always be in a position to bail out the private sector if things go wrong. They represent an almost bottomless pit of money, right?
But if we were to doubt that assumption for a moment, consider what that black swan event could look like…if the government couldn’t bail anyone out in a crisis. Mass bankruptcy. Economic collapse. Homelessness. Rioting in the streets.
Considering events like that is the best way to get yourself in a good place to handle black swan events when they do occur.
Another key is to appreciate the complexity of black swan events after they happen. There are often so many building blocks that have to come together in just the right way for that event to have happened…but the natural tendency is to over-simplify it in order to make it easier to process.
But the truth is black swan events are rare and unexpected for a reason…and the best way to prepare is to avoid becoming overexposed.
For investors, that could mean implementing the ‘barbell strategy’.
In this strategy, you completely avoid medium-risk investments. Instead, you put 90% of your money into the safest investments possible. Maybe US Treasuries could fit that bill.
And the other 10% you place on extremely speculative bets.
This defensive tactic builds up a strong defense in case of a negative black swan event, while also providing the opportunity to profit off positive black swan events. The rise of the computer, for example, would have delivered windfall returns for speculators early on.
Whether you employ the barbell strategy or not, the fact remains: black swan events can and do occur.
When it happens, try to be as prepared as you can be.
Editor, Money Morning New Zealand