Black Swans are a term invented by a writer and stockbroker called Nassim Nicholas Taleb. They are events that nobody had been expecting or thinking about — but which suddenly overwhelm the market.
They’re so-called because only a very few swans are black. In fact, the first black swan was discovered in 1697 in Western Australia. Before that, Europeans and Americans thought that all swans were white.
Taleb postulates that there are more Black Swan events than we think, in other words, that the unexpected is not all that unlikely to happen. I would agree — and I would argue that this is because markets are not Gaussian and random walk. They have both hidden correlations, which you can handle with fuzzy logic… and fat tails, which you can handle with a Cauchy distribution.
Black Swans or non-randomness is why Wall Street’s risk management models don’t work. And we saw in 2008, and we saw again with the London trade in 2012: The big Wall Street institutions relying on their models can often have huge unexpected losses simply because the models stop working when some Black Swan event happens.
David Viniar, who was Chief Financial Officer of Goldman in August 2007, said that just as the crisis was emerging, “We are seeing 25 standard deviation events one day after another.” Well, the reality is that if the market is anything like Gaussian, you should see less than one of the 25 standard deviation days in the history of the universe. Therefore, that proves pretty well that the market is not Gaussian and life is more complex than simple market models think.
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The real cause of Black Swans is herd behavior by traders and others such as Central Banks not seeing possibilities that are perfectly obvious to an outside observer — and therefore doing foolish things. The housing meltdown of 2007-2008 is perfect example of that. Everybody went on making risky home mortgage loans long after they should have done.
Likewise, the London Whale trade of 2012 —a Black Swan behavior of a portfolio of credit defaults swaps. These are particularly subject to Black Swan behavior for various technical reasons. It lost JPMorgan $12 billion.
The New York Stock Exchange Black Monday stock market crash of 1987 — when the market dropped 21% in one day — was also a Black Swan. It was caused by programmed trading, which is a silly arbitrage strategy. One of the advantages of getting old is you remember examples that nobody else now remembers.
The bottom line is that with the extreme monetary policies for the last decade, zero interest rates or even negative interest rates, Black Swan events are now quite likely.
For the individual investor, there are two strategies.
Firstly, you should protect yourself with gold and long-dated out-of-the-money S&P 500 put options. The point of those options is if the market really crashes, you’ll make money on them and that will give you money to reinvest at the bottom.
Then second, obviously, see if you can spot a Black Swan coming. As a non-trader and a non-politician, this is where you have an advantage over the pros.
You’re not hearing conventional wisdom every day. If you think you’ve seen a Black Swan, invest only a small amount — leveraged as much as possible. For example, out-of-the-money, long-dated calls or puts.
As the movie, The Big Short showed, spotting a Black Swan could be painful. But it can also make you rich.
Senior Analyst, Wall Street Daily