A Black Swan event is a single improbable event with enormously far-reaching consequences. In retrospect, people develop explanations for why the event was predictable – known as hindsight bias. However, the unpredictable nature of a Black Swan event is often the reason for its powerful effect. The 9/11 terrorist attacks, the 2008 financial crisis, the 2011 Fukushima Nuclear Disaster, and the Covid-19 pandemic are all commonly cited examples of Black Swan events.
What is a Black Swan event?
In 17th century England, black swans were not believed to exist. It was considered a fact that all swans were white. But in 1697, a Dutch explorer named Willem de Vlamingh sighted a black swan in Western Australia. Until that point, it was assumed among Europeans that a black swan couldn’t possibly exist because no one had ever seen a black swan.
Scottish philosopher David Hume later summed up the ‘black swan problem’ by saying, “No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion.”
Later, writer, statistician, and former options trader Nassim Nicholas Taleb popularised the concept of the Black Swan event in his books Fooled by Randomness and The Black Swan.
What are the characteristics of a Black Swan event?
Taleb experienced his first Black Swan event during his adolescence when his once-peaceful homeland of Lebanon plunged into civil war. But it wasn’t until he profited enormously from the Black Monday stock market crash of 1987 — an event that shocked Taleb, as well as the entire investment world — that he developed the black swan concept.
Taleb argues that the world is far more random than we realise. The big, unpredictable events are the ones that shape the world. By their very nature, however, they’re impossible to forecast. The problem is less about our inability to predict these outlier events than “our blindness with respect to randomness.”
While the term ‘Black Swan event’ often carries a negative connotation, some Black Swan events are actually positive. The rise of the internet is one example of a Black Swan event that has changed the world for the better.
There are three criteria for a Black Swan event:
1. It’s an outlier
A Black Swan event isn’t just unlikely. It’s completely unexpected, with nothing in the past suggesting that such an event would occur. As such, these events almost always fall outside of the financial models and forecasts that investing experts typically rely on.
Most risk models used by analysts and economists are built based on normal distributions. They predominantly focus on events that cluster near the centre. These are far more common and easier to predict and plan for.
However, a Black Swan event doesn’t sit near the centre of a normal distribution but rather at the edges, or “tails”. This makes them outliers in the data, which traditional systems are often blind to, given they are filtered out during the data processing stage of financial modelling. This is one of the many reasons why they are so hard to model and predict.
2. There is an extreme impact
When a Black Swan event emerges, it doesn’t just create short-term headwinds. The impact is far more extreme, with massive consequences that can result in changing behaviours, laws, regulations, and beliefs within a particular market, industry, country, or even the entire world.
For example, the 2008 financial crisis resulted in a complete redefinition of risk and reshaped global finance regulation. Covid-19 disrupted economies and healthcare systems worldwide while simultaneously changing work culture across the globe.
Taleb’s point is not that a Black Swan event isn’t just a surprise. It also has a significant, lasting impact on the economy and society.
3. They suffer from hindsight bias
Whenever a Black Swan event happens, people often rush to rationalise it. So-called ‘experts’ come out of the woodwork, creating stories and highlighting patterns that give the impression the event was entirely predictable.
For example, the 9/11 terror attacks were a highly improbable event whose seismic impacts were felt across the globe. Yet, after the attacks, countless experts claimed that intelligence communities should have been able to predict the attacks.
This is a classic example of a narrative fallacy, where people prefer simple linear stories rather than the complexity of reality. In practice, this can be problematic as it misleads investors and individuals into thinking they understand risk better than they actually do. This, in turn, leads to overconfidence, increasing the likelihood of falling prey to another Black Swan event in the future.
Can investors prepare for a Black Swan event?
By definition, a Black Swan event is impossible to prepare for. After all, these are outlier events that fall outside the realm of our imaginations.
A Monte Carlo simulation, which is commonly used in financial modelling and retirement planning, uses thousands of potential scenarios to predict a certain outcome.
For example, in retirement planning, the tool may conclude that someone has a 95% likelihood of accumulating at least $2 million by age 65. The problem, though, is that a true Black Swan event wouldn’t be captured in these scenarios because it’s an event that’s never been seen before.
Still, there are some steps investors can take to better absorb the shock of a Black Swan event.
Having a substantial emergency fund and a diversified portfolio can protect you from the market volatility often associated with such outlier events. Diversification can help you maximise your returns. By spreading your money across many different stocks and asset classes, you’re more likely to reap the benefits of a Black Swan event.
Example of a Black Swan event in finance
The stock market crash of 1987 is an example of a Black Swan event in finance. On 19 October 1987, the Dow Jones Industrial Average tanked by almost 23%, the largest single-day drop in history.
In hindsight, many observers pointed to warning signs that a crash was coming. The Dow had risen 44% in the first seven months of 1987, leading analysts to say, retrospectively, that there was clearly an asset bubble. Investors had enjoyed a bull market since 1982 with no correction. But the week before Black Monday had been a terrible one for the stock market.
Still, no one knows exactly what triggered the panic on the morning of 19 October 1987. One explanation is the rise of computerised programmes that were set up to sell automatically when stock prices dipped below a certain threshold. Heavy sales dragged markets down, triggering more panic. Explanations aside, the point is that very few people predicted the Black Monday crash because it was unlike anything markets had ever seen before.
Taleb notes in The Black Swan, “After the stock market crash of 1987, half of America’s traders braced for another one every October — not taking into account that there was no antecedent for the first one.”
More examples of Black Swan Events in finance
Other notable Black Swan events include:
- 2000 Dot-Com Bubble – Overhyped technology company IPOs paired with excessive speculation despite a lack of financial fundamentals, resulting in a massive share price crash for technology stocks.
- 2001 9/11 Terrorist Attacks – Coordinated terrorist attack by Al-Qaeda that tragically resulted in thousands of people being killed, the launch of the war on terror, a global security overhaul, and massive economic disruption.
- 2004 Indian Ocean Tsunami – A 9.1 underwater earthquake off the coast of Sumatra that resulted in over 230,000 deaths across 14 countries.
- 2011 Fukushima Nuclear Disaster – A 9.0 underwater earthquake caused a tsunami that caused the cooling system of a nuclear power plant in Japan to fail, resulting in widespread radioactive contamination and a revival of global nuclear fears.
- 2015 Swiss Franc Shock – The Swiss National Bank removed its Euro peg unexpectedly, causing the Swiss Franc to surge by around 30% overnight, triggering massive losses for some currency traders.
- 2022 Russia-Ukraine War – The unexpected Russian invasion of Ukraine following years of geopolitical tension and NATO expansion concerns resulted in massive energy and food price spikes, a refugee crisis, and war-driven inflation.