In this article, we discuss black swan events — the term made popular by Nassim Taleb — how and why they happen, and what you can do to be prepared in the event of one.
Chances are high that you've heard the term "Black Swan" at some point in your trading or investing journey. When used in the context of trading, the term has nothing to do with animals, but everything to do with unexpected events that impact the market to such a degree that it is nearly impossible to prepare for.
In the last few years, the world has seen its fair share of unexpected news with far-reaching impacts. The outbreak of the coronavirus and the invasion of Ukraine are just two examples of recent events that could be dubbed a "black swan event."
What is a black swan event, and how can I prepare for it? Read on to find out.
What Are Black Swan Events?
In the simplest of definitions, black swan events are unexpected events with significant, far-reaching consequences on the market.
According to famous economist and investor Nassim Nicholas Taleb, who coined the term in this book: The Black Swan: The Impact of the Highly Improbable, black swans can be identified by three key characteristics: the event is rare (and therefore unexpected), has an extreme impact and should be easy to rationalize after the fact.
History of the Term "Black Swan Event"
While Nassim Nicholas Taleb is officially recognized as the inventor of the term, the concept has been around for much longer. In fact, it can be found in literature as early as the Roman empire, in works by a poet named Juvenal.
Juvenal was one of the great poets in the late first century, seen by many as the forefather of modern day satire. He described the black swan as a rare bird in the lands – and rare it was, as the people of Rome had never seen a black swan in their lives. In fact, it wasn't until Europeans set foot on Australia, that we discovered they actually existed.
Almost two thousand years after Juvenal described the black swan, Taleb brought the idea to financial markets in his book The Black Swan: The Impact of Highly Improbable, where he explained the concept along with a few examples of what he considered black swan events:
- The fall of the Berlin Wall
- The invention and rise of the internet and personal computer
- The September 11, 2001 attacks
How Do Black Swan Events Affect the Market?
Black swan events – because of their unexpected nature and extreme impact – often cause significant moves in the market, as was the case when the coronavirus broke out. It took quite a while for markets to completely price in the severity of the crisis, and once that process completed, most assets traded more than 50% lower than before the pandemic hit.
The price of Bitcoin crashed more than 60% after the breakout of COVID-19
As discussed, a black swan event has three key components:
1. It is unexpected, rare and unlikely to happen: Because of how surprising the event is and how market participants were not expecting the event, this triggers all kinds of emotional reactions to the news.
2. Its impact is extreme: These emotional reactions are further amplified by the extremity of the impact. Black swan events generally have crystal-clear, far-reaching consequences, such as the outbreak of the Ukraine war, or the collapse of Lehman Brothers.
3. It is (seemingly) easy to explain after the fact: Experts and non-experts are keen to point out and explain the signs that "predicted" the black swan event, after it has happened, as a form of hindsight analysis.
All things considered, the unpredictability and extremity of these events is what triggers a significant response in the market. After all, the conditions under which the market operated, are suddenly much different – and prices will move to reflect that.
Examples of Black Swan Events in Crypto
When you look back on the past year, there have been many different events that can be categorized as a black swan. The infamous collapse of FTX is a perfect example – especially considering the way it went under. After the exchange was busted for allegedly using user funds to take directional trades, users rushed to withdraw capital from the exchange, and markets crashed. To this day, FTX still owes billions of dollars to its users.
A similarly infamous collapse happened in May of 2022, when a whale sold a large amount of UST on the open market. The capital pool that backed the stablecoin was drained as a result, and a depeg of UST followed, triggering a chain-reaction which resulted in the total demise of the Luna ecosystem, and a significant selloff in the crypto market.
The outbreak of the coronavirus pandemic in 2020 is another example. After the World Health Organisation originally declared a pandemic, the value of Bitcoin dropped by close to 50% in a matter of 24 hours, and the rest of the crypto market crashed just as hard.
Protecting Your Portfolio: How To Prepare for Black Swan Events?
While black swan events are impossible to predict, that does not mean you cannot prepare for them at all. By using proper risk management, and a few other tricks, you can significantly boost the odds that your portfolio survives these events.
Firstly, a powerful method is to diversify your investments. Black swan events rarely affect all markets the same, and spreading your capital across different markets therefore reduces the impact of a black swan event on your total portfolio. The crash and collapse of Luna is a perfect example, where it would have a far lesser impact on your portfolio if you would have been well diversified.
Seasoned investors have learned to use black swan events to their advantage, and therefore always keep a portion of their portfolio in liquid assets (cash, or cash equivalents) – allowing them to react to the volatility associated with a black swan. For example, by having a portion of their portfolio in stablecoins, they were able to buy the panic after FTX's collapse.
Finally, be ready to weather a storm! Black swans rarely wipe out an entire market permanently. Investors with a low time preference often hold through the volatility and/or correction, and wait for the recovery that usually follows. For example, since the collapse of FTX, Bitcoin has rallied nearly 100%, allowing those who held through the collapse to recoup their losses, and then some.
Closing Thoughts
All in all, there are quite a few steps you can take to prepare yourself for a black swan event. However, there is always an element of surprise in these events that you cannot account for – even the most experienced investors get caught off guard by them.
Understanding black swans and why they occur is a great first step towards being ready, while solid risk management, diversification and having cash at hand will further boost your preparedness. Good luck!
Author's Disclaimer: This article is based on my limited knowledge and experience. It has been written for informational purposes only. It should not be construed as trading or investment advice in any shape or form.
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