Black Swans in Finance

Only when the tide goes out do you discover who’s been swimming naked. – Warren Buffett

In finance and investing, a ‘black swan’ is an unexpected event that has big macro-financial consequences. When a black swan event occurs, the proverbial tide goes out and it becomes clear to investors whether they were over-exposed. The idea of a black swan in finance was popularized by Nassim Taleb in his book The Black Swan.

This article provides suggestions for a black swan strategy to best position yourself as an investor in the case of a black swan event, while also receiving investment returns during good times.

Examples of Black Swan Events in Finance

Black swans represent extreme and unpredictable situations. They can occur in the stock market and in other financial markets. Here are some examples of events that you want to be resilient against as an investor.

back swan finance
Black swans are unexpected – in nature and in economics – if you have only ever seen white swans.

Black Swan in the Stock Market

The stock market crashes of 1929, 1987, and 2008 are examples of black swan events. The crashes were unpredictable and had macro effects on the stock market. Investors who were overexposed through leverage or concentrated bets were wiped out.

After the start of World War I, the New York Stock Exchange shut down for four months. Investors couldn’t change their asset allocation or quickly sell if they had lost faith in their investments.

These events show that black swan events do happen from time to time, and investors should be positioned to be able to recover from such events.

Black Swan in Currency Markets

In the 1970s, inflation rates in the U.S. were very unstable and reached above 10%. This is one example of currency and interest rate issues that can occur as black swan events. Investors who had a large exposure to government bonds – supposedly safe investments – suffered major losses. While government debt yielded a nominal 7%, money lost value so rapidly that bond investors lost most of the real value they put in long term treasury bonds.

A black swan in currencies could also take the form of major differences in inflation for different groups, which could create unrest. For example, millennial inflation can be different than inflation for other generations.

Black swans in currencies are not uncommon. In 1997, South East Asian countries (as well as South Korea) devalued their currencies and the value of their stocks fell sharply. When the Brexit vote came in, the British pound fell 10% against the Euro.

Having a Black Swan Strategy

Given that black swan events happen in finance, investors would be wise to have an investment strategy that can deal with black swan events. Black swans can wipe out major asset classes like stocks in a depression or bonds when there is high inflation. Having a diversified portfolio with different asset classes should be part of a black swan strategy. At the same time, investors should mainly hold value-producing assets (like stocks or bonds) as opposed to commodities like gold, bitcoin, or oil- and wheat futures. Although diversified commodities are a good strategy to recover from a black swan event, commodities don’t produce any value in the long stretches between black swan events.

Black Swan Investments Are Antifragile Investments

It is recommended to have most investments in a broad-market stock-index fund. But you can also add specific investments to be better equipped to deal with a black swan event. Here are some investment suggestions for a black swan strategy. These investments all have some form of antifragility; they can gain from disorder relative to other assets. At the same time, the investments in this selection will also perform reasonably under normal circumstances.

Berkshire Hathaway led by Warren Buffett is a company that would probably do relatively well during a black swan event. The company is well diversified with subsidiaries including a large (re)insurance operation, a railroad, an energy utility company, and many more all-weather champions. Berkshire really shines when times are tough. The company acts as a lender of last resort, which gave it plenty of opportunities in the wake of the 2008 financial crisis. For example, when Bank of America ran into troubles in 2011, Berkshire was there to take a preferred stake in the company – something no other investors could do at the time. Berkshire is a good hedge against a black swan in the stock market, like a crash, a streak of company bankruptcies, or a closing down of the stock market.

Inflation Linked Bond IssuanceInflation Linked Bonds are becoming more common, and will give you protection against rising inflation. These bonds give interest and principal on real value, regardless of inflation. So if inflation shoots up, as it did in the seventies, so does the bond’s value.

Similarly, long-term bonds that pay a nominal amount are a good hedge against deflation, which was a problem in the 1930’s. These are the traditional bonds that pay a fixed amount, even as the real value of money changes.

To further diversify, you can add real estate via a Real Estate Investment Trusts, in the form of a REIT-index tracking ETF. These companies are backed by real assets like shopping malls and apartment complexes, which are rented out. REIT operations are simple and these companies cannot be competed away like an IBM or Alta Vista.

Asset Allocation

I think that these four assets – Berkshire Hathaway, inflation linked bonds, nominal bonds, and REITs – are a good hedge against black swan events. How much you want to allocate to each is up to you. A low allocation would be to put 5% in each of these black swan investments (together 20%), and 80% in a fund that grows in value more rapidly during good times, like a broad market index fund. To be better prepared for a black swan event, you could put 10% or 15% in each (together 40% or 60%) and feel safer about your ability to weather a black swan.

What is your asset allocation? Leave a comment to let us know how you think your asset allocation will perform during a financial black swan event! Or let us know what black swans you think we might see in the coming decades.

When the tide does go out, you don’t want to discover that you have been swimming naked.

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