Black Swans: Every Investor’s Worst Nemesis

If you follow the financial markets on a regular basis, you might notice that nothing really noteworthy happens on a vast majority of days.  On a few rare days, the markets will explode in an extremely dramatic move, often many orders of magnitude of the typical moves it makes day to day.  Examples of this include the Crash of 1987, the 2010 Flash Crash, the Nikkei crash of 2011 after the Earthquake, etc.  The daily returns of most assets do not follow a bell curve and these extreme events happen far more frequently than dictated by a Normal Distribution.  Trader and Statistician Nassim Taleb coined the term Black Swans to describe these extreme events, citing the notion that people did not believe black colored swans existed for many centuries until they saw them with their own eyes in Australia.

Black swans are generally so rare that conventional statistics is ineffective in providing probabilities of their occurrence or making predictions in advance.  Usually, they’re declared in hindsight.  In investing, while any particular black swan cannot be reasonably predicted in advance, certain assets and even asset classes have had a history of being prone to black swans.  And with the advent of the Internet in recent decades, black swans have increased in frequency not only due to the instantaneous spread of news but also the ability to sell investments electronically in a matter of seconds.

In order to reasonably tame the negative impact of black swans on your portfolio, here are my 3 rules of thumb:

1. Limit your exposure to any single source of risk.  In other words: diversify.  If you’re 100% invested in a single company, you’ve exposed yourself to black swan risk: no matter how great its prospects are, that company is not guaranteed to stay in business indefinitely or even in the near future.  Nothing, not even knowing the deepest inside secrets, will guarantee that you can make an accurate prediction of its ability to stay in business for the next X months or years.
2. Don’t use leverage.  If you’re not borrowing money to invest, then the most you can lose in the worst case is 100% of the money you’ve invested.  If you’ve invested 10% of your net worth in a particular asset and that asset goes to 0, you’ll only lose 10% of your assets.
3. Don’t worry about what you can’t avoid.  If civilization collapses or a large asteroid slams into the Earth, I doubt your portfolio will remain unscathed no matter how diversified or conservatively invested you are.  But there’s nothing you can do to prevent such an outcome so it’s an utterly useless excuse for not investing.  Besides, you’ve got bigger issues to worry about than losing all of your money if such a scenario pans out.

I’ll assign black swans to 3 different categories below.  (Please note I’ve invented these category names and you probably won’t find them via Google.)

Localized Black Swans

Localized Black Swans are extreme events in the financial markets that only affect a relatively small portion of participants, usually localized to investors of a single company, institution, etc.  When a company goes bankrupt or a bank fails and its investors lose everything they invested in these institutions, the effects are pretty horrible for those affected but they rarely pan out to something significant on a more macro level.  The conventional wisdom of diversifying and not putting all of your eggs in one basket is effective at minimizing the effects of this black swan.

Systematic Black Swans

Sometimes, it’s not a single company or industry that suffered from a black swan but an entire economy or asset class.  The most recent example of this was the 2008 Financial Crisis.  Diversifying among different companies was useless as the contagion spread to many different industries.  Even International diversification, once thought of as the holy grail of diversification, was of little help due to the already globalized and unsegmented nature of markets.  However, not all was lost since US government bonds skyrocketed as their yields plummeted.  The money being pulled out of stocks HAD to go somewhere and it eventually found its way into government bonds.  The only way to minimize the impact of a systematic black swan is to be sufficiently diversified among multiple asset classes.

Colossal or Apocalyptic Black Swans

If society collapses, then it’s no surprise your money and investments will be useless and no clever asset allocation scheme would be able to escape the carnage and no asset class will be immune from decimation.  In this extreme case, the only way to limit your exposure is to live off of the grid, which is not a practical choice for most people.

So What to Do About Black Swans?

Localized black swans are relatively easy to avoid: don’t put everything in one basket.  Systematic black swans will require some higher level investment planning especially in the area of asset allocation.  Colossal black swans are not worth the effort to plan ahead for even though the probabilities of them happening some time in the future is still greater than 0; it’s just that there’s not much you can do, at least without taking drastic action and limiting your day to day lifestyle.  Besides, losing all of your money is the least of your worries when the next supervolcano erupts or nuclear war ensues.