Last Updated on 17 November, 2020 by Samuelsson
Read throughout this post if you want to know more about black swan events. You’ll definitely find out more, so continue reading the article!
Planning to trade stocks? If yes, then you have to protect yourself against those unknown factors which could affect the stock price. Ever familiar with black swan events? Well, these are something that could be hard to predict but could offer devastating effects on your stocks.
And of course, since they are unknown occurrences, you still need to know how to protect yourself against them, especially if you are to enter the world of investing. Let’s get to know them more!
Black Swan: Where Did the Term Come from?
It pays to know the origin of the term first. Before 1697, any Western civilization hasn’t observed any black swan. And this gave rise to the notion claiming that such creatures actually didn’t exist. Hereafter, the term then became used to describe instances of impossibility.
In 1967, right after a black swan was finally observed in Western Australia, the said notion was disproved. From that on, black swan describes instances that perceived impossibilities have been disproven then paradigms have been shattered.
Now, What Are Black Swan Events?
Black swan events are those random occurrences which are nearly impossible to predict. Why is that so? Well, that is because they are indeed beyond the expectations of the normal situation.
Nassim Nicholas Taleb pioneered the phrase and was also made popular by this author and finance professor, at the same time one time Wall Street trader. Taleb left the world of investing after the 2008 financial crisis and its terrible effects. The risk analyst and statistician then shifted to writing instead.
In fact, he was able to write two best-selling books that explain the subject and these are The Black Swan and Fooled by Randomness. In these books, he explained why the events are considered impossible to anticipate yet still have catastrophic consequences.
Due to this, investors and traders need to be prepared at all times for the unlikely black swan event as much as possible. Plus, Taleb further explained that the silver lining to these occurrences is that they provide the chance for a broken system to fail.
And Taleb also discussed how this could improve the system against future unforeseen devastating events like these.
Though black swan events are mostly considered to be negative instances, the said concept doesn’t only apply to negative events. There could be two types of black swan events, the positive and the negative. And whether it is positive or negative, it still depends on the individual’s perspective.
Say, for example, a disastrous day in the stock market could be considered as a positive type of black swan even for those investors with aggressive short positions. On the contrary, this could be a negative type for those investors who are heavily invested in the stock market.
What Are the Attributes of Black Swan Events?
There are three defining attributes of a black swan even as outlined by Taleb. And these are the following:
- An event which is unpredictable to the observer.
- The results could be severe and widespread consequences.
- After the occurrence of the said black swan event, individuals would rationalize the event as having been predictably referred to as the hindsight bias.
Black Swan Theory: Explained
Also coined as a theory of black swan events, black swan theory was postulated by Nassim Nicholas Taleb, is used to describe the impact of events which come as a surprise in societal aspects. This kind of event is unprecedented within a particular point in time until it happens.
Black swan theory is a combination of the mathematical as well as philosophical reasoning that explains and describes the randomness of uncertainty. This event has a major effect or could be shocking in nature. The said spurs interest from concerned or affected groups to make some changes to the current practices promoting positive events and avoiding the negative ones.
Also, black swan theory is relatively close to beyond design basis accidents and so they are important once considering the long term safety of those people living near the power plants of different types.
The theory offered well-explained answers to the following three major questions:
Q1: Why do unusual events affect science, history, finance, and technology unreasonably?
A1: These rare events happen with low frequency but they are not treated with high regard in realms wherein hypotheses are proven highly frequent observations.
Q2: Why are these scientific methods not enough when it comes to predicting rare events?
A2: Black swan events could only be predicted effectively and prepared for by philosophical and mathematical reasoning. Since scientific methods show that once events have a low frequency of occurrence they are being disregarded.
Q3: Why are individuals not aware of the sizable role that these rare events play in history?
A3: Unless catastrophic, low-frequency events are given high priority in historical records rarely.
Three Properties of Black Swan Theory
There are three properties of this theory and these are:
- Rarity. This simply means that the event is considered as a surprise.
- Extreme Impact. It refers to the idea that the event offers a major impact.
- Retrospective Predictability. If you try to look back, this kind of event could have been expected to happen.
Where Are Black Swan Events Applied?
- Risk Management
- Decision Making
- Economic System
- Dealing with Complexity
What Are the Strengths of Black Swan Theory?
Here are some of the benefits of the said theory:
- Insight in the veins of the causes of the 2008 crisis.
- Increased awareness of uncertainty in decision making.
- An alternative to the current economic system.
- A new way to deal with uncertainty and risks.
How About Disadvantages of Black Swan Theory?
Of course, this theory offers some limitations as well including:
- Taleb is considered a maverick so Black Swan Thinking could be extreme.
- Use in complex and chaotic conditions.
- A decision theory based on the anti-fragility still works in progress.
- The theory isn’t yet mainstream.
Any Assumptions About the Theory?
Well, here are some conditions related to the theory:
- Black Swans couldn’t be predicted since they are rare.
- Underestimation of luck in like but overestimation of skills.
- Overestimation of knowledge yet underestimation of uncertainty and randomness.
Examples of Black Swan Events
Based on the Black Swan Theory, here are some examples of black swan events:
Asian Financial Crisis
Happened in 1997, this financial crisis came at the end of the staggering growths of the so-called “Asian Tigers” which include South Korea, Philippines, Singapore, Indonesia, Thailand, and Malaysia. There was a great loss of over 70% in the stock markets and currencies of the said countries due to the popping of asset bubbles.
There was also a great influx of Foreign Direct Investment which sent the real estate prices at its highest and that was due to the growth in the export-oriented economies of the regions. With this investment inflow, the Corporations and Governments started to accumulate large public debt from banks along with ambitious infrastructure projects and bold spending plans too.
Even the U.S Federal Reserve tightening cycle had no help to the case of the export currencies of these countries that were attached to the Dollar.
Thailand had an unsustainable property market that proved as the tipping point as it collapsed after the default of the Somprasong Land and bankruptcy of the Finance One early in 1997. Its official currency, Thai Bhat, also floated and devalued massively along with the ensuing instability. Other currencies then followed suit as the taint spread to the neighbouring economies.
So, the IMF stepped in to aid with the crisis having short term loans of around $110 billion to South Korea, Indonesia, and Thailand. However, there were stringent conditions of reduced public spending, higher taxes, higher interest rates and privatization of state-owned businesses to cool off the overheated economies.
Eventually, these measures lifted the said region out of the mess by 1999 as Asia gained back the growth momentum as well.
Crash of 9/11
Indeed, this was a topic of hot debate which crashes of 2000 and 2008 could have been avoided or at least mitigated their effects. However, there could be events like terrorist attacks on New York City, that no one foresaw or could have predicted, so the market reaction to such event was pretty predictable considering the markets were reeling from another black swan event a year ago.
And because there were no fundamental factors coming from the market side, simply look at the numbers from the U.S stock market on September 17, 2001, as it finally opened after its longest closure since 1933.
The said closure was made to avoid panic selling and market chaos. There was a huge sell-off in the Airline as well as in insurance stocks for obvious reasons. This catastrophic week ended with S&P down -11.6% and Dow posting -14%. In one week, a market cap of almost $1.4 trillion was also wiped out from the books.
Indeed, it turned out to be another downtrend in a major correction that finally ended a year later in October 2002.
Fukushima Nuclear Disaster
This event caused a massive loss of life at the same time a major financial headache particularly in Japan and the neighboring region. On March 11, 2011, the 8.9 magnitude earthquake resulting in 100 ft. A tsunami hit the Northeast Shoreline of the island nation causing the death of almost 28,000 people.
And this natural disaster indeed devastated the economy of Japan in more ways than one. In fact, the stock markets all over the world recorded sharp losses right after the incident. The towering waves of the said Tsunami smashed the Fukushima nuclear power plant leading to radioactive leaks that took almost months to stop.
In addition, out of 50 nuclear reactors, 11 were shut down after the disaster, therefore, reducing the electric generation capacity of the country by almost 40%. There was a need for Japan to import oil in order to replace the generation capacity that caused a bigger burden on a highly-indebted economy.
Another misfortune was the closure of some of the key ports for a country that was heavily dependent on exports. Indeed, its timing was just so unfortunate since Japan was only beginning to come out of two decades of deflationary pressures and also stagnating growths.
Black Monday China
This day was coined after the Shanghai stocks have plummeted -8.5% on news of an economic slowdown in the second largest economy of the world, however, there were some other factors which contributed to the said fall.
The same with the American situation in 2008, the Chinese companies were permitted to borrow cheaply from the banks that encouraged them to take undue risks in the stock market. So, as expected, the rate of borrowing soon surpassed the rate at which the invested companies could grow leading such a major drawdown.
But on top of that, weak economic data bothered the government up to a point wherein it decided to weaken the parity of yuan against the Dollar. Traditionally, China has been using the peg in order to manage the fiscal policy because its economy is so heavily export-oriented. Nevertheless, the plan has backfired as the stock index of China lost 30% of its value within three weeks flashing a sell-off in some other financial markets.
Finally, there is the never-ending saga of Brexit, known as a joint economic partnership that has turned to a messy divorce along with a resolution not in sight. It was considered to be a rocky relationship from the signing of the Maastricht Treaty year 1992 that turned European countries in a single monetary union. And this involved huge transfers of power to the new European Union.
With that, Britain opted out from a single currency as well as the social chapter. In 1997, Britain finally subscribed to the social chapter yet decided to maintain their very own currency.
European Union tried solving the economic problems by a new treaty that the UK ended up vetoing after demanding exemptions year 2011. UK’s exit from the EU was considered a mess and was so turbulent like the relationship itself.
So in 2016, as a knee jerk reaction to the said Brexit vote, the global markets fell sharply with both the Euro and Pound declining significantly too. Gold was considered as a traditional hedge against risk also rose 6%.
Consequently, the transition plan negotiated between the EU and the British PM was recently voted down in the UK Parliament through a huge margin taking certain things back to square one. The deadline would be on March 29, 2019, yet the continued uncertainty together with political manoeuvring is going to hurt the economic interests of those negotiating parties in the long term.
These are just some of the most popular examples of Black Swan events that you should at least know to better understand what black swan event really is.
How to Manage Black Swan Events?
Knowing what black swan events are, and their effects, of course, you might be looking for things on how you are going to manage these kinds of occurrences. In doing so, take note that these cruises offer a unique opportunity to get things in order.
Nevertheless, most businesses are into making a bad and rash decision since everything is almost moving quickly. And they wouldn’t identify how bad those decisions were only until things are beginning to go downhill. What’s next? Well, except for a lot of things to clean up!
So, to help you to easily manage with black swan events, consider the following strategies:
Weed the Garden
Well, you don’t need to do this literally! You should begin by removing those unnecessary costs like overhead expenses as they could get out of hand with revenue. However, they tend not to decline as fast as possible when the sales drop off.
You have to analyze the cost structure in order to convert more cost to variable versus fixed. And this will ensure that costs would stay consistent with the volume.
Another thing to do is to fix any hiring mistakes. Since you have a commitment to continue the business for your employees, you should remove the people who don’t fit at all and don’t add value as well.
And also, try analyzing your products and services. Try comparing their profitability. You must also remove those which are either unprofitable or not that profitable like the other products. You can reallocate the resources to the services and products which perform better.
In times of uncertainty, it would be critical to consider to reduce leverage. Debt to equity ratio that is greater than 3:1 was then considered high a few decades ago. But today, a risky investment could be a debt to equity ratio that is greater than 4.1.
Due to the speed and the availability of information that is becoming more accessible, the comfort level with risk of the companies as well increases. Nevertheless, this could also increase the number of problems once negative surprises or black swan happens.
Do More with Less
There will be an assurance that your company would always benefit out from improving productivity. But, it might be different for every kind of business. There could be a formula that you may use to identify the way on how to improve the operations. Just simply divide the Throughput and Resource and you’ll definitely get Productivity.
Once you discover the resources and the throughput for your business, you could discover how to use less resource as well as generate greater throughput. This would improve productivity leading to profitability too. With not as many sales, it would be a great time to evaluate the operations.
Reacting too slowly could be one of the biggest mistakes of a certain company and that should be avoided. In a world of business, you might want to react to new opportunities and of course, make a decision quickly. And that is the same thing with threats. You should address those threats as fast as possible and don’t delay on reacting.
Ever heard about the boiling frog analogy? Well, a chef isn’t just throwing a frog into boiling water. This frog will jump out immediately because it is hot. So, to fool the frog, put it in cool water and slowly turn up the heat. Indeed, this incremental increase in temperature might be hard to notice once inside the water. You shouldn’t be like this frog!
Black Swan isn’t fundamentally about predicting black swan event, rather, it is about concentrating on guarding against its unpredicted effects. Within an organization, particularly risk managers, it would help gain confidence if you know you have a plan for it to take advantage of any black swan events that might happen in the future.
In most cases, people would come up with a preparation plan for upcoming disasters yet they do this when it is over. You have to analyze the situation, and then think of how we could avoid negative results or you should at least assess the risk of losses.
Once you think a black swan is about to make you panic, you have to assess your attitudes towards the risks. By fully understanding that you can have an idea on what type of investment is perfect to hold a long term plan.
Among the options for long-term investment are stocks, assets and more. Though they are a lot riskier, they as well come with high rewards. This could be your time to consider what the company could do better once the sales are falling.
So, these are some of the strategies that you could best consider in order to manage black swan events.
To conclude, the Black Swan events are indeed becoming more frequent rather than being rare. In fact, it has become one of the factors for a major risk, not just for investors within financial markets but for all as well. So, it says that at least you are knowledgeable about this inevitable and unforeseen matter!
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