Sometimes, the world throws us a curveball that shakes up the financial markets. Black swan event comes from nowhere. That’s why they are called black swan event. These are the big shocks that we need to be ready for. Think back to the glorious days of the 80s and 90s, when the stock market seemed unstoppable. Investors were on cloud nine until 9/11 happened.
That’s when they realized that there are bigger forces at play than just the market itself. We can call these “macro events”, and they have been haunting the markets ever since 9/11. The markets have become super sensitive to any global disruption, resulting in wild swings up and down. The problem for investors is that these macro events are hard to predict and quantify, which makes them even more scary.
What exactly are macro events?
Life is full of surprises, but some of them can be really nasty for your portfolio. These are the macro events that can shake the world and send the markets into a tailspin. You know, things like natural disasters (remember Hurricane Katrina?), geopolitical shocks (who saw the Arab Spring coming?), or systemic failures of markets and national economies (the European debt crisis or the Chinese currency devaluations of 2015, anyone?). These are all examples of black swan events, named after the rare and unexpected appearance of black swans in nature. They are unpredictable, high-impact, and hard to explain after the fact. And they can wreak havoc on your portfolio if you’re not prepared.
The bad news is that black swan events seem to be happening more often than before. In the past, we might have encountered one every few decades, but in the last decade alone, we’ve seen several, such as the 2008-2009 financial meltdown and the Japanese earthquake tsunami. These events have made investors more anxious and uncertain about the future.
How can you protect your portfolio from the next black swan?
The good news is that there are some strategies you can use to reduce your exposure to black swan events and even benefit from them. Here are some tips from Nassim Nicholas Taleb, the author of The Black Swan: The Impact of the Highly Improbable:
- Diversify your portfolio across different asset classes, geographies, and sectors. Don’t put all your eggs in one basket.
- Hedge your bets with options, futures, or other derivatives that can protect you from extreme losses or give you upside potential in case of a black swan event.
- Be flexible and adaptable. Don’t get too attached to your beliefs or predictions. Be ready to change your mind and adjust your portfolio when new information or opportunities arise.
- Seek out opportunities that have a low probability of success but a high payoff if they succeed. These are called “positive black swans” and they can offset the negative ones.
- Learn from history and experience. Don’t rely on models or theories that assume normality or stability. Be aware of the limitations of your knowledge and the biases of your perception.
As Taleb writes in his book: “The idea is to avoid being the turkey by identifying areas of vulnerability in order to ‘turn the Black Swans white’.” By following these tips, you can make your portfolio more resilient and robust in the face of uncertainty and randomness.
Top 5 Structures For Black Swan Event Protection
1. Mindset Of Steel
Don’t panic, you can still protect your portfolio from the uncertainty of macro events. It’s not rocket science, but it does require some discipline and common sense. Especially if you have been tempted by the fads and trends of short-term investing, you may need to rethink your strategy. The most important thing is to have the right attitude. You have to be able to stay calm and rational in the face of chaos and fear.
Take a lesson from the legendary investor Warren Buffet, who made a fortune by exploiting investors’ fears, buying low when everyone else was selling high.
In his 1994 Berkshire Hathaway shareholder letter, he wrote: “Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist… A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results.”
How awesome is that? He basically tells us to ignore the noise and focus on the fundamentals of investing. That’s how you can survive and thrive in a black swan market.
2. Stop Listening To Everybody
The world is full of noise that can distract you from your investment goals. You have the gurus, the pundits, the social media, and the water cooler guys all telling you what to do. But most of that noise has nothing to do with your specific goals and objectives. The markets are driven by herd mentality as much as by fundamentals, and they often go in opposite directions. Your gut feeling is probably more reliable than any market expert. Or if you don’t trust yourself, you can get a dart-throwing monkey to do the job for you. It can’t be worse than following the crowd. But the best thing you can do is to set a strategy based on your own investment objectives, preferences, priorities, and risk tolerance. These are the only things that matter for your portfolio.
3. Diversification Is Key
Diversification is not just about mixing and matching different stocks and bonds. It’s about choosing the right asset classes that can balance each other out in different scenarios. Asset classes are groups of securities that have similar features and responses to market changes. For example, a macro event that causes the dollar to drop will likely make gold more valuable. A surge in inflation could hurt most small and mid-cap stocks but help large, dividend-paying stocks. By having more non-correlated asset classes, your portfolio will be more stable over time.
But how do you know which asset classes to choose? There are many types of asset classes, such as equity, cash and cash equivalents, fixed income, real estate, and derivatives. Each one has its own risk profile, return potential, and correlation with other asset classes. You need to consider your investment objectives, preferences, priorities, and risk tolerance when selecting the asset classes for your portfolio.
Modern Portfolio Theory (MPT)
One way to do this is to use the Modern Portfolio Theory (MPT), which is a mathematical framework for creating an optimal portfolio that maximizes the expected return for a given level of risk. MPT uses historical data to estimate the expected return, risk, and correlation of different asset classes and then uses an optimization algorithm to find the best combination of asset weights that achieves the highest possible return for a given level of risk.
Core-Satellite Approach
Another way to do this is to use the Core-Satellite Approach, which is a more flexible and dynamic way of diversifying your portfolio. This approach divides your portfolio into two parts: a core and a satellite. The core is the main part of your portfolio that consists of low-cost, diversified, and passive investments that track the performance of major asset classes or market indices. The satellite is the smaller part of your portfolio that consists of more active, specialized, and opportunistic investments that aim to generate higher returns or hedge against specific risks.
Both methods have their pros and cons, and you can use either one or a combination of both to diversify your portfolio. The key is to find the right balance between risk and return that suits your goals and personality.
As Graham Kenny writes in his book Diversification Strategy: How to Grow a Business by Diversifying Successfully:
“Diversification is not an end in itself; it is a means to an end. The end is a superior performance for shareholders. Diversification only makes sense if it adds value for shareholders.”
4. Do Not Time The Market
Don’t fall for the trap of selling low and buying high. That’s what most investors do, and they end up losing big time. Investors who ran away from the market in 2008-2009 will never get back the 40% or 50% loss they suffered when they sold at the worst time. Instead, adjust your exposure based on what you see happening. Stick to your allocation strategy and use market dips as chances to buy while using market spikes as chances to take some profits, but always try to keep your allocation the same.
5. Invest In Your Own Purposes
Don’t lose sight of your goal. That’s the only thing that really matters. You don’t need to chase market returns (the latest hot stock or mutual fund). If your portfolio is averaging the 7% or 8% return you need to achieve your long-term investment objectives, who cares if XYZ fund gained 27% this year? There’s a good chance that the fund will suck next year.
Before You Go – Black Swan Event: How To Protect Your Portfolio
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FAQs – Black Swan Event: How To Protect Your Portfolio
What is a black swan event?
A black swan event is a rare and unpredictable event that has a major impact on the economy, society, or nature. The term was popularized by Nassim Nicholas Taleb, a former Wall Street trader, and risk analyst, in his book The Black Swan: The Impact of the Highly Improbable. Taleb argues that most of the big events that shape history are black swans, such as wars, revolutions, pandemics, technological breakthroughs, and financial crises. He also claims that conventional methods of forecasting and risk management are unable to account for these events, which often defy logic and common sense.
How can a black swan event affect your portfolio?
A black swan event can have a significant impact on your portfolio, depending on the type and magnitude of the event. Some black swan events can cause a sharp decline in the stock market, such as the 2008 global financial crisis or the 2020 coronavirus pandemic. Other black swan events can create new opportunities or challenges for certain sectors or industries, such as the 1973 oil crisis or the 2001 dot-com bubble. A black swan event can also affect your portfolio indirectly, by changing the economic, political, or social environment in which you invest.
How can you protect your portfolio from black swan events?
There is no foolproof way to protect your portfolio from black swan events, as they are inherently unpredictable and hard to prepare for. However, there are some strategies that can help you reduce your exposure to potential losses and increase your chances of recovery or growth. Some of these strategies are:
- Diversify your portfolio across different asset classes, geographies, and sectors. This can help you reduce your risk and volatility by spreading your investments among different sources of return and risk.
- Hedge your portfolio with options, futures, or other derivatives that can protect you from extreme losses or give you upside potential in case of a black swan event. For example, you can buy put options on stocks or indices that can increase in value if the market drops significantly.
- Be flexible and adaptable. Don’t get too attached to your beliefs or predictions. Be ready to change your mind and adjust your portfolio when new information or opportunities arise.
- Seek out opportunities that have a low probability of success but a high payoff if they succeed. These are called “positive black swans” and they can offset the negative ones. For example, you can invest in startups, innovations, or emerging markets that have the potential to disrupt the status quo or create new value.
- Learn from history and experience. Don’t rely on models or theories that assume normality or stability. Be aware of the limitations of your knowledge and the biases of your perception.
