Where the Black Swans Hide

What is a “Black Swan”?

Photo: Sergio Valle Duarte. Source: Wikipedia

A Black Swan event is a development that comes as a total surprise, has a major impact, and that we later see as inevitable – with the benefit of hindsight. The term was popularized by the author Nassim Taleb, and it is based on an ancient Latin expression that assumed all swans were white. After Europeans discovered black swans in Australia, however, the phrase was revised.

Taleb notes that many – if not most – scientific, historical, and artistic developments can be seen as Black Swans. They come from outside our normal expectations. They have a deep and widespread impact: it’s impossible to think of the world the same way after they happen. And they seem inevitable after the fact – we rationalize their occurrence as we try to understand our world.

Many major events that we take for granted today could be considered Black Swans: 9/11, smart-phones, the rise and fall of Soviet Communism, the growth of rock music, and so on. Personal events can also be seen this way: meeting a spouse, a car accident, getting into college, receiving new insight regarding a vexing problem. By definition, outliers like these cannot be predicted

When we invest, we want to be prepared for Black Swans. We want to have assets that do well under widely divergent circumstances because we don’t know the future. Stock market returns are not normally distributed. In theory, a one-day 5% rise or fall in the market should happen perhaps once in a 100 years. In reality, it has happened over 100 times in the past century. We call this a “fat tailed” distribution.

One-day returns of S&P 500 over the past 2 years. Source: Bloomberg.

Where do Black Swans hide? They’re embedded in the indeterminate character of the news. It’s our nature to look for patterns and explanations after something happens – to tell ourselves stories to make sense of the world. But our knowledge and understanding are limited. While we can all grow and learn to organize information in useful ways – and have institutions that encourage this – not everyone does.

We don’t know the future. The best we can do is prepare for unknown unknowns by understanding how markets have reacted in the past.

Douglas R. Tengdin, CFA

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