The Alert Investor

Black Swan

Minor Blip or Black Swan? Sizing Up the Unexpected in Financial Markets

Feb 10 2017 | By Alice Gomstyn

Could you identify a black swan if you saw one? The creature is native to Australia, but even those who’ve never been to the land Down Under might still recognize one should it cross their path—after all, it looks an awful lot like the more widely known white swan, except, as its name suggests, it’s black.

If only identifying Black Swans were as easy. The term Black Swan—note the capitalization—was popularized about a decade ago by scholar and author Nassim Nicholas Taleb in his book, “The Black Swan: The Impact of the Highly Improbable.” The book explores wholly unexpected events that have an “extreme” impact and that humans are able to explain only in retrospect—Taleb calls such events Black Swans.

Though a Black Swan can impact various spheres of public life, the term has figured prominently in financial news headlines in recent years. As such, it may be helpful for investors to have a deeper understanding of Black Swans and the ongoing debates about whether certain events should be classified as Black Swans at all.

Taleb seized on the term Black Swans because the existence of real black swans came as a total shock to those who discovered Australia in the 1700s—before then, citizens of the “Old World” had only ever had reason to believe that swans were white. A Black Swan, “lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility,” Taleb wrote in his book, which was excerpted in the New York Times.

Under that definition, some would argue that the historic vote by the United Kingdom to leave the European Union was a Black Swan. The so-called Brexit vote caught many in the financial world off guard and led to market volatility around the globe.

Within months of the vote, however, major stock market indices in the both the U.K. and the U.S. recovered and, in fact, hit new highs, suggesting that the Brexit’s economic impact was short-lived. Meanwhile, some say that the fact that polls showed that the Brexit vote would be close means it’s tough to argue that the final vote tally was unexpected.

“The idea of the EU not being particularly popular in the country that coined the word euroscepticism should not have come as a surprise,” Mark Pengelly, an editor for financial industry trade publication Risk, wrote in September.

If the Brexit vote, in fact, was not unexpected and did not have a major impact—at least, not a major, lasting impact—does that disqualify the vote as having Black Swan status? Perhaps, since as a Black Swan is defined not just as an unexpected event, but as an unexpected event that has an extreme impact.

Only time will tell if the Brexit was truly a Black Swan, Richard Sylla, a professor emeritus of the history of financial institutions and markets at NYU Stern School of Business, says.

“If it does in fact lead up to a break up to the European Union, people might look back 10 to 20 years from now and say, ‘Yes, that was a Black Swan event that had major consequences.'”

So if Brexit doesn’t count—at least not yet—are there other recent events that qualify as Black Swans in the world of finance? Sylla cites the collapse of the brokerage firm Lehman Brothers in September 2008. The fact that just months earlier the U.S. government helped bail out and orchestrate the acquisition of Bear Stearns, another struggling financial firm, led most to assume that all major financial firms would receive similar treatment, Sylla said.

“There was a notion that if they did it for Bear Stearns certainly any bigger firms like Lehman would be bailed out,” Sylla said. “When it was allowed to fail, everyone said, ‘Gee we didn’t think this could happen because they took care of Bear Stearns.’ Obviously the consequences were very great.”

Another possible Black Swan? Try the shocking June 1914 assassination of Archduke Franz Ferdinand of Austria, which ultimately led to the start of World War I. Not only did the assassination have a huge geopolitical impact, it also resulted in financial upheaval, including in European and American stock markets, which were shut down for months during the war, and the repositioning of the U.S.’s role in the world economy.

“In 1914, the U.S. was the biggest debtor nation in the world,” Sylla said. “By 1918, it was the biggest creditor in the world.”

For Americans born in the latter half of the 20th century, the mother of all Black Swans, however, might be the terrorist attacks of September 11, 2001.

As with the archduke’s assassination, the attacks had an enormous geopolitical impact and also led to the closure of the New York Stock Exchange (albeit for a shorter time— just several days.) But Sylla argues that the attacks should be considered more of a political Black Swan than an economic one.

The U.S. economy, after all, had entered a recession months before the attacks and officially exited the recession just two months after September 11, suggesting that the impact of the attacks on the economy were smaller than some believe. Still, it’s undeniable that the attacks were unexpected and had an extreme impact—leading to war and the creation of new government agencies, among major geopolitical events.

Whether an unexpected event does, in fact, qualify as a Black Swan as far investors are concerned may indeed be irrelevant. What matters more is that investors take care to manage their portfolios in a way that helps them withstand unexpected events, whether such events reach Black Swan proportions or not.

How do they do that? Robert R. Johnson, the president and CEO of The American College of Financial Services, says that, for most investors, it’s best to avoid trying to make decisions specifically in reaction to major events.

“Many people want to believe you can control the situation or you can anticipate the next step, and a lot of times, it’s just very, very difficult,” he said. “You really need an all-weather investment plan— one that you don’t alter depending on the crisis du jour.”

Johnson’s advice is to keep it simple. Those investors who do their research, choose investments based on solid fundamental characteristics, and stay the course over the long-term tend to be rewarded, he said, even in the face of the unexpected.

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