A "black swan" is an event with a very low likelihood of occurrence that has disastrous consequences when it does occur. Such events have a tendency to overwhelm markets and people, frequently to the damage of their decision-making processes and investment portfolios. Even while black swan events appear to have a negative connotation, the notion is not limited to unpleasant events. Whether an event is beneficial or negative depends on the individual's perception.
What is the theory of the black swan?
Black Swan event is a metaphor for unpredictable or even improbable events, transactions, or acts. Nassim Nicholas Taleb originated the phrase and has also published a well-known book on the subject. Such events are extremely uncommon, significantly influence the economy, society, politics, etc., and receive extensive media attention. Consequently, they must be handled with extreme care.
In 2007, Nassim Nicholas Taleb, a Lebanese-American risk analyst, options trader, and mathematical statistician, created the phrase black swan theory. Taleb discussed black swan events in a New York Times article titled "The Black Swan: The Impact of the Highly Improbable."
Taleb was inspired by the account of the discovery of black swans (the animal). In 1770, James Cook and other Europeans became the first to discover Australia, and they were astonished to report that not all swans were white to the rest of the globe. Taleb used this example to highlight how severely constrained our learning may be when it is based solely on previous experiences or personally observable facts.
There are three defining characteristics of black swan events. The following are:
Rarity
Black swan events are anomalies and fall outside the boundaries of typical expectations. This is because they are so uncommon; if they were common, we could readily forecast and prepare for them.
Extreme impact
Black swan events have enormous repercussions, and whether the impacts are negative or positive totally relies on the event's conditions.
Backward predictability
When making predictions, we frequently consider the future. We can estimate the probability of an event, and we may evaluate the likelihood of rain or sun during the weekend and adjust our plans accordingly.
However, black swans are only predicted and explicable in retrospect. This is because the world has become so complex that it is difficult to know everything. Also, it is hard to assess uncertainty precisely, particularly when it pertains to an event of which one is unaware.
You may be highly familiar with the dangers associated with cryptocurrency and stock trading, and you may be able to assess their impact and likelihood. Unfortunately, you cannot assess an unknown danger, such as a black swan.
The essay caused ripples in several businesses. Numerous cataclysmic events in the history of the globe were defined from an entirely novel angle. Many risk management solutions in the financial and technology industries increasingly incorporate preparation for black swan events.
Characteristics of black swan event
Such events are extremely unusual and have serious consequences. They are unforeseeable, and such possibilities are inconceivable.
These events are deemed catastrophic and significantly influence the global economy; thus, they must be handled with extreme care. They necessitate high-potential talents for resolution.
Science, logic, and astrology are unable to foretell such events. It also needs a substantial managerial boost from national governments.
Such events demonstrate that such possibilities persist despite advances in science, technology, etc. Numerous events of this nature have occurred in the past, proving the aforementioned truth.
All strategic strategists and philosophers foresee such occurrences, but they are erroneous about their frequency. Each time, the magnitude is so enormous that it wreaks devastation on civilization.
Repercussions of a black swan event
A black swan event often has a negative impact on asset values. Due to the impossibility of predicting black swan events, investors must just assume that they will occur. Investors should manage their portfolios to prepare for the worst-case scenario on the basis that a catastrophic event may and will occur.
Historically, the account values of investors who are exposed to a black swan event in the market tend to fall. There may be a great deal of panic selling on the market, sending prices further lower.
Black swans alter the laws of the game, which can be detrimental to certain organizations or assets but advantageous to others. Consider the advent of the Internet as an example. Traditional businesses, such as Sears and J.C. Penney, which ultimately faced bankruptcy, were forced to retreat. Nonetheless, e-commerce titans like Amazon.com Inc. (ticker: AMZN) have skyrocketed to extraordinary valuations by capitalizing on the market change.
What causes black swans?
There are no boundaries on the possible manifestations of a Black Swan event. The reasons for a black swan might be a natural calamity, conflict, or even a viral epidemic. These events do not necessarily have to have instantaneous effects, as the decline of the Roman Empire demonstrates. Black swan disruptions are unavoidably unexpected and typically result from circumstances that do not match conventional models, and this makes it nearly hard to comprehend them before their occurrence.
According to Taleb, black swans are generally hatched deep within the human mind.
Taleb's book's core theme is "our blindness with respect to randomness, particularly the enormous deviations: Why do we, scientists or nonscientists, superstars or average Joes, choose to focus on the pennies instead of the dollars? Why do we continue to focus on minutiae rather than possibly big events despite the overwhelming evidence of their enormous impact?"
No one element, for instance, caused the 2008 financial catastrophe. However, an excess of cheap, easy financing and a "this-time-it's-different" or "irrationally euphoric" mindset likely led to the housing bubble that turned into a crash. At the time, red flags were flapping everywhere, but few caught on.
After more than a decade, we can easily notice this now. However, one of the most frustrating aspects of black swans is that hindsight is 20/20, and nobody understands what triggers a black swan event in actuality.
Positive aspects of the black swan event
One understands the necessity to extend one's perspectives; this event may shake one's beliefs. People will need to redo their research and broaden their minds since these events are unimaginable.
Required controls can be identified: The impact of such events is largely determined by chance, and one can determine the necessary placement of controls. In addition, it helps ensure that the business continuity procedure is in order.
Due to such events, it is possible to understand the significance of forecasting and planning in the context of national and economic activities. One learns how to efficiently predict or plan necessary adjustments.
Negative aspects of the black swan event
The entire theory is based on probability theory: Even, in theory, the black swan is heavily dependent on probability. One cannot answer if such an event is possible or not.
Nobody is aware of the situation: Nobody can predict what will occur in the local, national, or global market or economy with absolute certainty. No one can foresee future events in a certain sequence or pattern based on the current state of affairs.
The Dot Com Era and Bubble
In 2001, many began to see the usefulness of the Internet. Especially after the massive worry over the Y2K problem, followed by relief when nothing occurred. Unfortunately, a severe recession struck the economy shortly thereafter.
Investors were eager to invest venture cash in tech startups, disregarding conventional analytical measures. They concentrated on the possibility of another significant technology innovation and on becoming the next Apple or Microsoft. Some firms, like Qualcomm, saw their stock values increase by more than 2,000 percent.
The bursting of the bubble was triggered by the excessive inflation of stock prices, which forced enterprises to default and quickly close their doors. The recession caused a precipitous decline in stock values, and its consequences were felt for years.
2008 Recession
Everyone in the United States remembers 2008 as the worst episode in financial history when the stock market fell. Wall Street was awash in blood, and Lehman Brothers, one of the major financial firms in the United States, filed for Chapter 11 bankruptcy.
No one could have thought that one of the most prominent financial institutions of the U.S. economy, with such an illustrious history, would reach this point. However, it resulted in a disastrous scenario for the U.S. stock exchange; the impact was enormous, impacting practically every stock exchange around the globe. This disaster took out a substantial chunk of market capitalization.
Covid-19: Is it a black swan?
This viewpoint is widely held. During the Ideas Lab meeting in Brussels, for instance, experts stated that the coronavirus exemplified the global community's fragility and the government's incapacity to act effectively. As a result, we were separated and divided by borders, the economy descended into disarray, and the WHO offered inconsistent and tardy advice.
As befits a true "black swan," the pandemic of recent years was unanticipated to the global community (with the exception of Bill Gates's forecasts, to which no one paid attention) and had worldwide repercussions.
In economics, more contemporary examples of the black swan include the outbreak of the COVID-19 worldwide pandemic in early 2020. Black Thursday occurred on March 12; the market decline may be described as catastrophic on that day.
The S&P 500 fell 9.5% on the day, marking its largest daily decline since October 19, 1987. Indicators of other global markets also reached their highest point. Only in November did American indices rebound to the level of January 2020.
How to predict black swan events?
After laying the theoretical groundwork for black swan events and analyzing real-world instances, we can now examine how to forecast black swans.
The short explanation is that we cannot forecast black swans reliably, and not even industry professionals are capable of doing so. Black swan events are uncommon and have a low likelihood of occurring.
Nonetheless, you may plan for more general unlikely events that are certain to impair your bitcoin trade. With our recommended risk management measures, you may design your black swan strategy and learn how to trade securely.
A black swan event is, by definition, very difficult to predict. Nonetheless, investors may monitor a few indicators, like Treasury rates and the Cboe Volatility Index (VIX), for indications of growing market experts' worry. During instances of the global market or political turbulence, the VIX, often known as the "fear index," typically increases.
Volatility skew is a measure of the implied volatility (IV) of out-of-the-money put options relative to the implied volatility (IV) of out-of-the-money call options. Some refer to the Cboe SKEW Index as the black swan index, and it estimates the chance of outlier events or declines of two to three standard deviations.
The SKEW's value normally fluctuates between 100 and 150. However, it might be higher or lower. A Cboe SKEW value of 100 or near to it implies a "regular" market (meaning the market views the likelihood of a black swan event as low). A SKEW of 115 indicates a 6 percent probability of a black swan event; at 135, this probability increases to 12 percent. (At the end of January 2021, the SKEW was around 147)
How to handle black swan events?
As previously said, black swans are unpredictable, and this implies that you cannot plan for any particular black swan event. Investors frequently commit the error of planning for the previous bear market rather than the subsequent one. You may prepare for the unexpected by managing your portfolio so that it is not overexposed to any one investment or asset class. This generally implies that a portfolio must be diversified.
Effective asset allocation is the greatest approach to ensure a portfolio's long-term viability, given that black swan events are inevitable. Chasing gains in the top-performing parts of the market may provide excellent returns in the near term, but a single catastrophe can wipe out a non-diversified portfolio. One can diversify a portfolio by asset class, geography, and investment or product type.
Keep in mind that not all black swans are harmful and that capitalizing on some events might assist in offsetting portfolio losses. An investing plan should anticipate and adjust for the occurrence of the odd stock market crash or severe correction. A bear market can be viewed as an opportunity, and a well-positioned portfolio can gain on price volatility and declines. For instance, hedge funds can profit from dropping prices through short positions and relative value transactions resulting from volatility.
How should investors plan for black swans?
Occasionally, the power of the black swan is instantaneous and pervasive. How do you safeguard yourself?
In his book, Taleb argued that attempting to forecast the black swan is the worst method to mitigate its impact. According to the author, it is vital to recognize its inevitability and build robust and lasting preparations to lessen the possibility of such an event. Or mitigate its repercussions.
For instance, banks conduct stress tests - simulations aimed to determine if a financial institution can withstand another crisis. After 2008, this strategy grew prevalent in companies. A few years after the crisis, for instance, the Bank of England began to conduct its own stress tests as a result of their example.
However, as Taleb highlighted, both professional companies and private traders may prepare for catastrophic events.
In trade, like in other fields, the black swan occurs abruptly and without notice. Therefore, you should constantly attempt to safeguard your portfolio to the greatest extent feasible. There are several rules:
Recognize that the next black swan is inevitable
When examining the history of market movements, it is evident that negative events occur frequently. Accidents are not a cause for surprise but rather a natural part of life's cycle.
Take advantage of the chances presented by black swans
When the stock market declines and stock prices fall as a result of this event, it is prudent to consider investing in sustainable firms. Eventually, they will be able to escape the crisis, and the value of assets will increase once more.
Diversify your holdings
This advice is applicable to each and every investor. Remember that if your portfolio consists of only one asset, you will be severely impacted by a black swan event. To protect your investments, you should diversify them among other instruments.
Conclusion
Black swan events are extremely unpredictable, full of surprises, and accompanied by novel developments. Unfortunately, it cannot be mastered, nor can it be definitively determined whether such an event falls under the black swan category. To protect yourself and your money from these events, you must position yourself so that you will not be wiped out if they occur. All hedge funds, real assets, quantitative methods, and options may be used to safeguard a portfolio's downside and profit from weak markets and heightened volatility.
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