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The black swan theory: What it is, and how to use it

By Connor Freitas

Black swan events are highly improbable, difficult to predict incidents that end up having drastic consequences

Black swan events are highly improbable, difficult to predict incidents that end up having drastic consequences. These events have such magnitude that they can bring down economies, societies and people.

The man who coined the black swan theory, Nassim Nicholas Taleb, said there were three key ingredients that contributed to such an event: it is so rare that no one could have even anticipated it, its effects are catastrophic, and it is regarded as predictable in hindsight.

Black swan event examples

Ironically, Taleb wrote his book about the black swan theory a year before an event that illustrated his point perfectly: the 2008 financial crisis. It was a downturn so big that Lehman Brothers made the largest bankruptcy filing in history — with 25,000 people losing their jobs and $46 billion of the institution’s market value vanishing. The impact was also felt across the global equity markets, with $10 trillion wiped out. When it comes to black swan events, this recession ticked all of the boxes: no one could have anticipated Lehman Brothers collapsing, the economic ramifications were massive, and experts now argue that the warning signs were in place before disaster struck.

There are many black swan event examples outside of the financial markets, too. No one could have guessed that the twin towers of the World Trade Center would have been targeted on September 11, 2001. The consequences were dire — 2,996 people were killed, and it triggered a war on terror. And after the fact, some argued it was predictable given how Osama bin Laden had founded al Qaeda 13 years earlier, airlines and airports were told to be on high alert in 1998, and intelligence agencies had warned that bin Laden was determined to strike America.

Black swan events can also be political — and results such as Trump’s victory in the 2016 presidential election, not to mention the UK voting to leave the European Union that same year — could be interpreted as falling nicely into the black swan theory. Even personal matters, such as losing a loved one in a freak accident, apply.

It is also worth bearing in mind that the black swan theory isn’t confined to negative events. JK Rowling, who wrote her Harry Potter series in cafés while on welfare and suffered countless rejections from publishers, had her own black swan event when her wizarding world captured the imagination of millions of people, and she now has an estimated net worth of $920 billion.

The man who invented the black swan theory

Lebanese scholar and former Wall Street trader Nassim Nicholas Taleb released his book — The Black Swan: The Impact of the Highly Improbable — in April 2007. The author argued that the best way to mitigate a black swan event is not to try and predict it, but rather to build resilient systems that can reduce their likelihood even further. For example, stress tests are now a common occurrence in the banking world — simulations that see whether a financial institution could survive another crisis like in 2008 — but some central banks, like the Bank of England, only began these exercises several years after the recession took place.

He also used a witty example to show that surprise events depend on a person’s perspective or position. Whereas being slaughtered for Thanksgiving would be a black swan event for a turkey, it wouldn’t be for the butcher doing the killing. Tying into the point of enforcing preventative measures, Taleb says the goal is to “avoid being the turkey.”

Benefiting from the black swan theory

From an investment standpoint, there are several ways to capitalize on black swan events and prevent portfolios from suffering catastrophic losses when they occur. These tips include:

· Accept they will happen. By understanding the market, you’ll appreciate that black swan events are a fact of life. Removing the element of surprise from your response means you can calmly and rationally decide what action to take.

· Seize the opportunities they provide. If the stock market crashes and share prices tumble because of an unpredictable event, this could be a good time to invest in resilient companies. When a recovery eventually happens, investors can sell high because they bought low.

· Embrace diversification. Those who suffer the worst consequences from a black swan event are people who had all of their eggs in one basket. By splitting capital across multiple investments with varying levels of risk, mitigating the impact of an unexpected downturn becomes possible.

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