A Black Swan Event

Can be bad news for stock markets!

A black swan event is one which is unpredictable and which can cause havoc on stock markets.

The name derives from the fact that swans were once only thought to be white in color, since no one, other than Australian aborigines, had ever seen a black one - or one of any other color for that matter. So originally, these events were considered to be impossible.

However, when black swans were seen on a river (since named the Swan River) in Western Australia by a Dutch explorer, the meaning of the term changed to one which suggested that the event was highly improbable or unpredictable.

Black Swans are relatively common in Australia and are widely distributed. Like black swan events, not too much is known about Australian Black Swans.

Relevance to the Stock Market

Depending on how you wish to define this type of event, one could think of it relating to the stock market as a whole, or to an individual stock.

In relation to the total stock market, the global financial crisis, at its commencement, might be thought of as an unpredictable event.

In relation to individual stocks, I could think of a number of unpredictable events that have affected some of my stock holdings in the past. For example ...

  • a severe drought affecting an agricultural stock may be thought of as an unpredictable event
  • actions caused by a rogue trader who loses a billion dollars and causes the collapse of his bank may suffice
  • or the unpredictable decisions of government regulators might do the trick.
In some ways, unpredictable events are what makes stock investing adrenalin raising for some and bad news for others.

A Black Swan Book

Nassim Nicholas Taleb in his 2004 book Fooled By Randomness discussed black swan events related to financial contexts.

He extended the idea to events outside of financial markets in his 2007 book, The Black Swan. The book has since been revised in 2010.

Taleb has asserted that this type of event has the following three attributes ...

  • it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility
  • it carries an extreme impact
  • in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.
Taleb explains that this type of event depends on the observer.

What may be a black swan surprise for a turkey is not a black swan surprise to its butcher. Hence the objective should be to avoid being the turkey by identifying areas of vulnerability in order to turn the Black Swans white.

One Way to Get Protection

Horizons Universa Canadian Black Swan Exchange Traded Funds (ETFs) are the first ETFs to be launched that pair a tail risk hedge (protection from large stock market movements) with an equity index investment.

The Black Swan ETFs are index ETFs with a hedging component that are designed to provide protection from the kinds of significant declines associated with unpredictable events that are not welcomed by investors.

Basically, the ETFs promise to minimize the effect of any so-called Black Swan events that could suddenly shift the direction of the markets. Horizons quantifies Black Swan events as any market declines of 20% or more.

To Conclude

Are there other ways the average investor can protect themselves from these events?

From a value investing perspective, requiring a margin of safety when choosing which stocks to invest in would provide some protection.

Also constructing a diversified portfolio of stocks consisting of 20 to 30 holdings that have a high return on capital and low price earnings ratio would minimize the damage if the event was related to a particular stock.

Joel Greenblatt's magic formula investing strategy would do this to some degree as it relies on longer term averaging of stock performance.

Adopting a longer term approach using capital that you do not need for other purposes in the short to medium term would also provide further protection, since you would not have to sell into a depressed stock market which has been affected from one of these events.

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