A Black Swan – The Red Beak Scares Me!
As I mentioned last week, I’m a believer that this upcoming decade will be a bull market, with a solid run over time. But I also forewarned that it may not be a perfect line, and it could be mired with a couple Black Swan Events. Black Swan Events are a metaphor for a surprise event that are beyond the realm of normal expectations, and have a major effect on the world – either financial or not. They are the extreme cases, with probabilities so low that they aren’t traditionally computed in standard planning methodology.
The idea of the Black Swan Event has been around for a long time, but was first published by Nassim Nicholas Taleb in his 2004 book, Fooled By Randomness. According to his criteria, to be a Black Swan Event, you must have the following:
- The event has to be a surprise
- The event has to have a major effect (and it doesn’t have to be negative)
- After the event, it is rationalized by hindsight as being able to be predicted and/or mitigated
Beyond the financial markets, he highlights the examples of the creation of the Internet and the September 11 attacks as Black Swan Events. He also reminds readers that banks and other financial institutions don’t usually take Black Swan Events into consideration in their risk models, and so they aren’t prepared to handle them – which we saw in the financial crisis of 2007.
As such, these events can happen again, and here are some of my thoughts on what you need to be aware of.
Black Swan Events to Watch Out For
While Black Swan Events must be a surprise by definition, based on recent history, I think there are several possible events that “experts” have disregarded as not being able to happen, that in reality, could very easily happen in the next decade. Here’s what I think you should watch out for.
High Speed Computer Trading Tanks the Stock Market
We’ve already seen this happen twice:
- The Flash Crash of 2010
- The Knight Capital Debacle of 2012
In the Flash Crash of 2010, the stock market dropped 9%, or about 1,000 points, in a matter of minutes because of a high-frequency computer trading program that went haywire. In 2012, Knight Capital had a similar issue, having a computer algorithm send trades that ended up costing the company over $400 million and manipulating the market for over 140 securities.
As computers become the dominating force on Wall Street (they currently make up about 70% of all trades each day), the potential for errors costing trillions of dollars is becoming more and more likely. And while the government and financial institutions implement “safeguards“, that just gives a false sense of security before the next Flash Crash actually happens.
China or Europe Collapses
The European Union is the second largest economy if you add up the GDPs of all the member states, but China is slated to take that spot very soon, and is the second largest stand-alone economy behind the United States. And both of these areas are facing significant headwinds over the next decade.
Europe has been dealing with debt and stagnant growth for years, and there has been an on/off again relationship with multiple member countries – Greece, Spain, Portugal. If any one of these countries collapses, or the EU breaks up, it could result in a tumultuous market and result in a huge, unexpected, change to the global economy. This could send a shock that would decimate the stock market.
China, on the other hand, is trying to figure out how to grow in a sustainable way. It has been taking in huge sums of money for decades, and is now starting to experience growing pains as its infrastructure, government, and legal framework is being tested by the growth of its economy. If it were to run into a recession, it could be a huge event that would ripple through the global economy, similar to what US recessions have done before.
Natural Disasters Strike
Finally, there are always the potential for more natural disasters. Scientific studies have shown that natural disasters have been increasing in frequency over the last few decades. However, natural disasters by their own regard don’t usually impact the economy negatively – in fact, in many cases, the aftermath boosts the economy because of renewed economy spending. I believe, though, that there will be a combination of issues that mire an upcoming natural disaster that will negatively impact the economy, and be a Black Swan Event. If the way our government handled Hurricane Sandy relief is any indicator, I think future responses to disasters will also be mired in bureaucracy, which will delay the response. Then, if that is compounded with a recession or other event, we could have a severe problem on our hands.
Strategies for Investing around Black Swan Events
Now that I’ve highlighted all the doom and gloom that I can think of, how do you cope? There are two basic investment strategies for handling Black Swan Events.
Barbell Investment Strategy
The Barbell Investment Strategy was actually created by Nassim Taleb as a way to mitigate the effects of the events that he labeled. The idea is that you keep about 90% of your investments in ultra-safe assets, like cash and T-Bills, since nobody can predict the future. Then, with the remaining 10%, you invest in highly speculative investments, like venture capital. That way, no matter what happens, you only stand to lose 10% of your portfolio at any given time.
This approach isn’t suited to most investors, however. It is too conservative, while at the same time too risky with what you do invest.
Do Nothing Strategy
My strategy for these types of events is the “Do Nothing Strategy“. Pretty classy name, huh? It highlights my point that you should probably do nothing and just ride it out. In every Black Swan Event that has occurred, the market has rebounded nicely, and has hit new highs after the event. Black Swan Events are doom and gloom in the short term, but usually end up being blips on the radar in the long term. As such, you have a couple of options:
The name of the game should always be to avoid investing mistakes. Buying high and selling low is always number 1. So don’t sell out just because the market has a flash crash. Your best bet in most circumstances will always be to do nothing and watch your portfolio return to its original glory over time.
What are your thoughts on these Black Swan Events? Do you think they’re likely to occur? What else do you think can happen?
About Robert
I like this view. In fall of 2011 we had a minor black swan event (black cygnet?) when the market dipped in response to the debt ceiling being reached and Congress taking their usual sweet time to sort it out. Once they did, the market recovered nicely. I was out of the country at the time and before I left, I put in a number of orders at ridiculously low prices “just in case” because I knew I wouldn’t have internet access. Lo and behold, by the time I got back, every single one of the buys was executed and I was sitting on a nice gain. I put that down to pure luck, because I had no idea the market would react like that, but in hindsight that turned out to be a blackish swannish thing.
At the end of last year I got out of the market because I thought many people would sell off to lock in their gains before higher tax rates take effect. That turned out not to be as beneficial, although my little portfolio got a nice 3% jump since I got back in around the new year.
Maybe the next debt ceiling situation might create well, let’s call it a black cygnet. Not a full grown swan, just a little baby.
The big black swan, though, the elephant in the room, is a revolution in China. We forget that they are a dictatorship. For the most part a benign one, to be sure, but a dictatorship nonetheless. I have some exposure to that market, because I believe there are some Chinese stocks which are WAY undervalued (for other reasons, well documented elsewhere). But we should never forget that all revolutions (French, Russian and Cuban are the obvious ones that come to mind) came unannounced and totally wiped out the previous regime and its investments. The current censorship issue in China is just a reminder that under the surface there is a growing steam pressure building.
I don’t think the EU will crash. There are too many sound economies underpinning it.
But hey, I’ve been wrong before.
Great post Robert! I was working the day of the Flash Crash, and it was just absolutely nutty how investors were just going nuts looking to jump ship. Then you have Knight Capital and the FB IPO issue and it gets investors nervous. I can understand the fear, but really, they’re blips that do correct themselves over a generally a short time. Like you said, they can correct quite well in fact. I think we’ll probably see more of the same tech issues over time but I could be wrong.
I am in the do nothing camp as doing the opposite would just result in losing money on both sides of the equation. If anything, I keep some cash on the sides with the hope of being able to take advantage of some quick dips. That is assuming & hoping that Nasdaq wopuld not come in and cancel the order later. 
Interesting question. Frankly, I think the response depends a little on what the black swan event is . I also think the Chinese political instability question is one that could be a darkhorse, but having said that they have been managing the transfers of power between successive regimes so well, and growth has generally been so strong that people havent had a strong enough reason to want change.
I think if the Chines economy collapses, then all bets are off. The Chinese economy of late has been prone to such wild swings with property bubbles, and deflation of those bubbles that you suspect at some point they will be unable to orchestrate a soft landing.
The bigger black swan in my view if what happens if lenders to the US economy stalk baulking at accepting US bonds. China has more than $1T of US bonds I believe. I wander what would happen if they start to question the feasibility of recovery and look to aggressively sell down. At that point all bets are off.
I think that the best approaches to black swan are normally to either invest more aggressively or do nothing. The flash crash and other events are just mere blips which correct themselves, which I view as opportunity.
If its something more fundamental like LIBOR rates dramatically increasing like in 2008, or the debt scenario I mentioned above, thats when I tend to get a little more cautious and err on the do nothing side, as these are real problems that affect the underlying economy.
Nice post. There are are far too many people who make a couple of mistakes: 1) selling on the way down, in a panic; 2) not expecting some big dips in stock performance, and instead expecting linear growth. Best to be more informed and less impulsive.
With respect to disasters and markets, the Nikkei plummeted in the immediate aftermath of the tsunami in Japan a few years ago. While of course a tragedy and sad event, there were probably people who made money buying on the immediate drop, because the market did recover within a few weeks – back to old levels.
With super nervous clients, we used to place stop losses on a portion of the portfolio and ride it out with the rest. I would never sell everything AND I’m always fearful of selling on the way down, because then I have to try and find a brilliant way to get back in (and sadly, that’s guesswork). At the very least, we’d buy it back at a lower price to avoid a portion of the fall (this buoyed us a little in 2002).
Great post. Sweet charts.
This is great, I’ve never heard of a black swan event before. As I was reading, I was thinking, “Huh, so uh,..I shoudl probably just do nothing and let things bounce back, right?” And there it was at the end, one good strategy is to just freaking do nothing, lol. Which is nice, because that’s the easiest thing to do.
Really seems like black swans happen ALL the time doesn’t it?
I wonder what will be next….