Have you ever seen a black swan? No? Well neither had anyone in Europe or the western world during the 17th century. It was widely believed for centuries prior that there could be no such thing as a “black” swan. Having seen only white ones, Europeans naturally assumed that white was the only color that a swan could be, but they eventually learned otherwise. In the late 17th century, William de Vlamingh, a Dutch explorer, discovered black swans in the wilds of Western Australia. It was a shock to many to learn that black swans, which they had long thought impossible, actually existed.
Fast forward to the early 2000s in America where we meet a gentleman named Nassim Nicholas Taleb. Taleb was a finance professor, Wall Street trader, and is a writer. He wrote Fooled by Randomness – The Hidden Role of Chance in Life and in the Markets in 2001, where he applied the history of the black swan to various random events from more recent history. Following the mortgage debacle and subsequent market meltdown of 2008 and the early months of 2009, he further refined his black swan theory of events in another book, The Black Swan: The Impact of the Highly Improbable. The theory of black swan events has evolved further still and is now used to describe any phenomenon which occurs which had previously been thought impossible and subsequently has a major impact.
Specifically, according to Taleb, a Black Swan event has three defining characteristics:
1. The event had been thought highly unlikely and is a major surprise.
2. The event has a major effect.
3. After the event it is rationalized by hindsight as if it could have been expected. "We should have seen that coming!"
The terrorist attack of 2001 is a perfect example of a Black Swan event, but not all Black Swans are catastrophic and harmful. The development of the internet and widespread use of personal computers can also be viewed as Black Swan events. The Japanese earthquake and the subsequent nuclear reactor problem, the dissolution of the Soviet Union, and the Arab Spring are other Black Swan events. In short, any occurrence previously thought impossible but which eventually occurs and has a major impact can be seen as a Black Swan. Could we be experiencing one even now in the political arena of our country?
It is now taken for granted in the financial world that Black Swan events will continue to appear from time to time, so can we prepare for them? Of course, if we could adequately prepare for them, they would not be Black Swans! But, we can arrange our affairs as if we expect the unexpected to continue to occur. We can live our lives with the knowledge that Black Swans will visit from time to time and note where we may be vulnerable so we can take measures to lessen their unpleasant effects. For our finances that means having an emergency fund in place, and ensuring that our portfolios are well diversified. The tech stock bubble and subsequent crash of 2000 was a Black Swan for those who had piled into all of the speculative tech stocks of that era, and it quite thoroughly highlighted the risk of not being properly diversified. Proper diversification cannot completely protect from market Black Swans, but it has historically helped to lessen their effect when compared to the practice of making big bets on single stocks or on just one asset type (think real estate in 2008.)
Black Swan theory is fascinating, and it is an interesting exercise to contemplate when the next one may appear. I have noticed that more and more commentators on the various financial channels have recently been using the term (and not in the ornithological sense), but they likely have no better idea of when the next one may appear, or what form it may take, than do you or I. I don't plan to lose sleep over Black Swans, but I will try to make sure that I am not caught completely off guard when one shows up. So, be alert for Black Swans as you face your future; you will likely see one sometime, somewhere. And, always bear in mind that though it will never be the most important thing, still, money matters.