What is an Investing Black Swan Event And Can We Prepare For Them?

What is an Investing Black Swan Event And Can We Prepare For Them?

The concept of a Black Swan event was brought to popular attention thanks to an author name Taleb. Taleb, as I understand it, has been involved with Wall Street finances for years though he remains a skeptic in some forms. One major thing that Taleb has been vocal about is the idea of a Black Swan.

Black Swan events are so radical and unpredictable that no one can see them coming. They're completely invisible to statistical models, prediction, or avoidance. Black Swan events are the majorly rare types of events that should, statistically speaking, not even be possible. And yet they happen.

Examples of a Black Swan Event

The Great Depression, The Great Recession, The Tech Bubble, and Black Monday are all examples of extremely rare and unpredictable events that radically alter the landscape of investing.

Major market-shaping events from our history.

Major market-shaping events from our history.

In the historical world, these radical and unpredictable events take the shape of the invention of the wheel, the creation of the automobile, the creation of the computer. Completely unfathomable and unthinkable events that forever altered the landscape of human progression, yet totally un-chartable by mathematics and statistics.

Other events may look like the assassination of Franz Ferdinand, leading to WWI. The events of 9-11-2001. These are all unpredictable, massively impactful, and impossible to stop. They're Black Swan events.

Why Are They Called Black Swan Events?

Taleb argues that before certain Europeans traveled abroad not a soul would believe you if you showed up and told them that swans can be both black and white. White swans were all they knew and, for them, they based their understanding of the world on this. Of course, Black Swans do exist - simply outside of the realm of their understanding.

Imagine you had built a multi-million-dollar empire on farming white swans because of their valuable feathers. Then, one day, a traveler comes back with a hat made of black swan feathers. Suddenly no one wants your white swan feathers anymore and competitors swoop in with black swan feather, now all the rage and your empire crumbles.

Much the same can be said of the investing world.

Can I Protect Myself From The Next Black Swan?

Well, that's the question of the hour. Taleb believes there's no way to anticipate or predict them. By their very nature, these events are such extreme outliers, there's no way to dodge them.

Returns by asset class - one component of diversification.

Instead, Talib argues that we should become more robust, more resilient. What makes our investing more resilient to market impacts?

  • Smart diversification (outside of the stock market too)
  • Multiple income streams (rental incomes, multiple businesses, etc.)
  • Holding some cash or cash equivalents
  • Carefully managing the size of our bets
  • Removing debt and loans from our personal lives

There are many ways to increased the resilience of your investments. These are only a few. We'll talk about a few examples in a moment.

Before we do, let's talk about a few things that might make our investing more fragile and susceptible to massive damage by unpredictable events:

  • Leverage (especially large amounts)
  • Margin
  • Overweighted bets in a single asset
  • Speculative betting in hot markets
  • Ramping up risk in pursuit of returns
  • Incurring debt and loans

What Does an Anti-Fragile Investment Look Like?

Creating an investment that is robust and defensive, prepared to handle wild and unpredictable swings, can be hard! Let me walk you through one possible example (totally made up for illustration).

Mark has $500,000 in an S&P 500 ETF. He's worried that if the market crashes by 40% he'll lose too much money. He's also not content with just buying some bonds. He feels that he needs more protection and more avenues of survival in the worst of cases.

Mark decides to buy a local ice cream shop for $150,000 which he will operate and expects to make $40,000 per year.

Mark also uses $20,000 to build a safe room in his house which he stores with food, water, and survival equipment. He's preparing for any unpredictable event - stock market or otherwise. Mark uses $30,000 to purchase physical gold which he stores in his safe room.

Mark then buys $100,000 worth of forest land which he will use for harvesting wood. He figures that with careful woodland management the lot can yield about $15,000 annualized in timber. He already knows a local timber company willing to buy from him. He may in the future build a house or a homestead there.

With the remaining $200,000 Mark invest in an extremely broad and defensive allocation of securities in the stock market. He still puts money in the S&P index but it's only about 25% of his allocation. He also holds many dividends paying stocks, utilities, consumer staples, and a few long term bonds which he intends to hold to maturity. 

NOTE: I am in no way recommending this as a solution - it is simply an illustration!

What Does a Fragile Investment Look Like?

Dan, Mark's coworker, likes to talk about stocks around the water cooler.

Mark has just bought $80,000 of the latest Marijuana stock that has been hyped up on a CNBC opinion spot. He's certain the stock will be worth at least $800,000 in 5 years time.

Mark also loves to trade Forex (foreign currency). In fact, just yesterday Mark took a leveraged (borrowed money) position for $100,000 on the Japanese Yen against the USD.

Lately, Mark has been going on and on about Bitcoin and other cryptocurrencies. He's pulled over $75,000 out of his other investments in order to buy into this hot market. It's up 180% this year, after all!

Mark also has $475,000 in a home mortgage and he just picked up a new Maserati that he took out a $95,000 loan for. In fact, he tossed his brother $50,000 just the other day to "help him out" but he "knows he's good for it".

Who Survives The Market Crash?

Now it's time for the quiz. Who is more likely to survive the market crash tomorrow morning. Dan? Or Mark?

Hint: if you said Dan, please reread the entire article several times and then send me a message so I can try to help you out.

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