A flock of Black Swans could soon eat your profits

Is it me? Or are ‘Black Swan’ events become more frequent? The answer? Diversification. But many investors’ approach to diversification is wholly inadequate.

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As I’ve written before, back in mid-2007, the Bank of England famously saw no chance whatsoever of the 2007-2008 financial crisis and ensuing recession occurring — even though it was just weeks away. Not a single one of the hundred scenarios modelled by its economists in the Bank’s quarterly ‘fantail’ projection envisaged the crisis at all.

When it did happen, everyone scrambled for explanations — discovering in the process that not only could it have been predicted, but that a few soon-to-be-very-rich investors had done precisely that, and positioned themselves to profit from it. (Read Michael Lewis’s The Big Short to find out who they were.)
 
And the crash did a lot to cement the reputation of Nassim Nicholas Taleb, a mathematician, essayist and investor, who had earlier published Fooled by Randomness, and just before the crash published The Black Swan.
 
‘Black Swan events’ have now entered the language: vanishingly improbable events that nonetheless can’t be totally ruled out. They probably won’t happen — but they might.

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A flock of swans

We’ve since seen quite a few. Donald Trump as President of the United States, for instance. I recall hearing several political pundits saying that it would just never happen. Brexit, for another. Even the Brexit campaign didn’t expect the vote to go their way, it emerged afterwards.
 
And a global pandemic, for another. Two years on, supply chains and much else are still in chaos. As I write, easyJet is cancelling hundreds of flights — not because of travel bans, but because so many crews are coming down with Covid-19.
 
Inflation at 10%, or higher. Electricity prices at sky-high levels. And now Ukraine. Black Swans, each of them.

Individual exposure

My point isn’t necessarily about avoiding losses. The Footsie as I write these words is 7,556 — in other words, higher than it was on 23 February, just before the invasion; and higher than it was on 1 January.

It’s a broader point. Because investing in individual companies involves making choices.

And as we’ve seen over the past couple of years, those choices can involve Black Swan risks.

Pubs, leisure businesses, hospitality businesses and non-essential retail businesses closed due to the pandemic, for instance. Airlines not flying and cruise vessels not sailing.

Brexit? Let’s not go there.

What will be the impact of a combination of sky-high inflation, sky-high fuel and energy costs, and an effective ban on dealing with Russia? One way or another, we’re all going to find out.

And I’m certainly not sanguine enough to believe that all my investments will be completely unaffected. What happens to the Footsie is one thing; what happens to individual companies is quite another. Two years on from Covid-19, some of my investments still aren’t paying dividends, for instance.

What to do?

In The Black Swan, Taleb charges that we spend too much time trying to forecast events. This is true: day after day, I see dozens of forecasts, made by all sorts of people, regarding all sorts of things. Predicting the future is a very human trait.
 
But is trying to predict Black Swan events worth the trouble, or even sensible?
 
Taleb argues no. And I tend to agree with him. Better by far, argues Taleb, is to focus on building resilience: extremely unlikely events might occur, but their effects do not have to be catastrophic.
 
And in investing, that means a portfolio that is broadly diversified. Different asset classes, different geographies, different instruments.

It’s not too late

Most ordinary investors don’t do that. As I’ve written before, we’re too subject to home country bias, for a start: huge numbers of us don’t hold foreign shares, don’t hold foreign index trackers, and don’t have exposure to foreign currencies and foreign income streams.
 
We don’t hold enough property — despite the UK stock market being rich in UK and overseas REITs and non-REIT property companies. Ditto infrastructure companies. 

We also tend to hold too much cash, and prefer to invest in well-known businesses whose products we buy, or whose retail premises we patronise.  

And so on, and so on.

If that sounds familiar – if you see yourself in that description, in other words – the good news is that it’s not too late to change your ways.

Because the Black Swans won’t stop coming.

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Malcolm has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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