What event is most likely to cause a financial crisis in Asia in the months ahead? a) collapse of the Chinese real estate market, b) a major drop in the value of the Chinese yuan, c) a Japanese debt crash, d) war over South China Sea islands, or e) none of the above.
If you’re familiar with the Black Swan theory, you would have answered “e) none of the above.” And you’d probably be right.
A “Black Swan” event is an event that is nearly impossible to predict, and which has a massive impact on markets. The term was created by the statistician and author Nassim Taleb, who wrote a book by that name in 2007.
Taleb notes that most of the methods used to predict what will happen in markets rely on what’s happened in the past. But since the past doesn’t foretell the future – especially for something as unpredictable as the stock market – this approach underestimates the chances of something that’s never happened before happening.
Often, it’s the things that no one sees coming that have the biggest impact on markets, and on the world. The global economic crisis of 2008 proved Taleb right, and now we see the term used often in the media – “experts” are often predicting the “next Black Swans.”
But no one can predict the next Black Swan event – that’s what makes them Black Swans. If everyone knows something bad is about to happen, they can prepare for it. Then the event isn’t as devastating.
No one predicted the September 11 terrorist attacks, the 2004 tsunami in Southeast Asia, the 2008 financial crisis, or the Fukushima tsunami and nuclear disaster. Even the 2015 collapse in oil prices qualifies – it was unexpected and unprecedented.
Another thing about Black Swan events is that after it’s happened, people line up to tell everyone how obvious it was. Those who study behavioural economics call this the “hindsight bias,” or the “knew-it-all-along effect.” It means people tend to view an outcome as predictable – but only after the fact.
As a result of hindsight bias, we usually don’t learn the full lesson from Black Swans. We start to think that, based on the latest devastating event, we’ll know how to be ready for the next one.
For example, because of the 2008 financial crisis everyone is now confident that if something like that happens again, they’ll know what to look out for and will be prepared.
But the point of a “Black Swan” is that you don’t see it coming.
Nassim Taleb uses the example of a turkey to make the point. In the U.S., Thanksgiving Day is traditionally celebrated by eating turkey. The turkey farmer gets the birds ready for the big day by feeding them more to fatten them up.
“Consider a turkey that is fed every day,” Taleb writes. “Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race ‘looking out for its best interests,’ as a politician would say.”
“On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.”
That “something unexpected” is the separating of its head from the rest of its body – the turkey’s Black Swan event.
This is how Taleb charts the bird’s feelings:
The bird’s happiness increases every day, as it gets fed regularly and is cared for by the nice farmer. Then the unexpected happens and everything changes. The turkey’s experience up until Thanksgiving did not encompass all possible daily events.
Now consider what Tsuneo Futami said after the Fukushima disaster in 2011. In the late 1990s, Futami was a nuclear engineer and director at Fukushima Daiichi, the site of the tsunami-triggered nuclear accident: “We can only work on precedent, and there was no precedent. When I headed the plant, the thought of a tsunami never crossed my mind.”
Tragically, Mr. Futami, and the other experts responsible for safety at the nuclear facility, made the same mistake as Taleb’s Thanksgiving turkey. They focused on what had happened in the past when designing the facility’s safety features. They did not take into account any Black Swan events, because they had never happened before.
Black Swan logic makes what you don’t know far more relevant thanwhat you do know. Using past events to predict the future is a problem. There were no tsunamis caused by severe earthquakes in the recent history of Fukushima, so engineers didn’t expect this to happen.
So how can we apply Black Swan wisdom to our portfolios? Taleb’s basic message is to remain wary and informed. Do not place too much faith in what’s happened in the recent past, and avoid complacency when markets are calm. Think carefully about how extreme events might affect individual holdings.
But don’t be paralyzed by fear and do nothing, either. Remember, Black Swan events are very rare, and you’ll miss out on good investment opportunities if you’re too worried about the next disaster.
There are a few basic steps every investor should take regardless of whether they’re market optimists or pessimists:
- Diversify – Don’t invest in just one type of asset, but own stocks, bonds, gold, real estate and cash. And make sure these assets are not all in the same industry or country.
- Don’t borrow too much to invest – Investing with borrowed money will make Black Swan losses even worse.
- Hedge – Understand correlation in your portfolio. Try to have some holdings with prices that usually move in opposite directions.
- Own quality companies – Focus on businesses, not stocks. Warren Buffett famously says: “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”
- Prepare for opportunity – As the saying goes, “Buy when there’s blood in the streets.” Keep some cash on hand so you’ll be ready to invest at cheap prices when everyone else is running away. If you’ve been expecting the unexpected, you’ll be prepared to take advantage.