How would you have felt if you were in the shoes of John Maynard Keynes, a notable economist who lost 75% of his stock investment to the stock market crash of 1929, or among the Americans who lost $19 trillion in their net worth to the 2008/2009 Global Recession?
These two black swan events remind us that unpredictable events can have outsized negative consequences on our wealth and throw our best plans off-kilter.
Though we cannot predict these rare events, we can prepare for them by using defensive strategies that will help us stay afloat (and even profitable) when they occur. Welcome to the world of black swan theory and its impact on investing.
In what follows, we will consider what black swans are, how they affect investors, and how you can prepare for them through black swan investing. We’ll cover:
- What is the black swan theory?
- The black swan theory and the investing world
- Pros and cons of black swan investing
- Black swan portfolios: How to benefit from the black swan theory
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1. What is the black swan theory?
If you had asked any European before the discovery of Australia if black swans (with black feathers) existed, they would have responded with an affirmative “No.” White swans (with white feathers) were all they knew in Europe, and from their perspective, that’s all that existed.
That was until Dutch explorers led by Willem De Vlamingh discovered black swans in Australia.
One implication is that what we don’t know is sometimes more important than what we do know.
A popular statistician and writer, Nassim Nicholas Taleb, introduced the black swan theory in 2001 in his book “Fooled By Randomness” and expanded on it in his 2007 book, “The Black Swan: The Impact of the Highly Improbable”.
We can define black swan theory as a metaphor for unpredictable events that have severe consequences and look inevitable in retrospect.
Black swan events can be political (the world wars, the fall of the Soviet Union, terrorist attacks like the 9/11 attack in New York), economic (financial crashes), and environmental (an unprecedented natural catastrophe).
These outlier events left significant and outsized negative consequences that many people (and nations) struggled (and still struggle) to completely overcome even as experts bemoan their inability to foresee it.
This inability to foresee such negative events can even leave long-lasting impacts on experts. Many people still berate orthodox academic economists for not predicting the global financial crisis and economic recession of 2008/2009.
But that’s in the very nature of black swan events: it only seems that we should have anticipated them in hindsight. As they say, “hindsight is 20/20.”
2. The black swan theory and the investing world
The impact of black swan events on investors
You may have noticed from the above that some black swan events are economic, whether it’s the Great Depression of 1929-1936 or the Great Recession of 2008/2009.
What is more? Even non-economic black swan events end up having significant economic impacts.
Of course, we can consider the negative economic effects of black swan events at a macro level (in terms of economic growth and unemployment). But since we are considering the financial markets, let’s narrow down to the stock market effects (the extreme volatility in stock prices).
In the heyday of the great depression, the Dow Jones Industrial Average (DJIA) fell by 89.2% between its September 3, 1929 peak (top) and its July 8, 1932 trough (bottom), as seen below:
Source: Investopedia
Furthermore, during the 2008/2009 financial crisis, the DJIA fell (peak to trough) by 51.1% and the S&P 500 fell (peak to trough) by 56.8%, as shown below.
Source: Atlanta Fed
Finally, let’s consider a non-economic event that had massive economic impacts: COVID-19.
The S&P 500 fell by 23.9% (peak to trough) between February 18 and March 23, 2020, when the pandemic was at its pinnacle:
Source: MDPI Open Access Journals
Similarly, the DJIA fell by 26.4% between its peak on Feb 10, 2020, and its trough on March 23, 2020:
Source: Wikipedia
All of these make the point that many investors and traders took very significant losses because of these black swan events.
As we saw in the introduction, US households lost $19 trillion in net worth due to the 2008/2009 stock market crash and John Maynard Keynes, the great pioneer of Keynesian Economics (and some will say Behavioural Finance) lost about ¾ of his investment in the stock market during the Great Stock Market Crash of 1929.
The need to prepare and play defense
Since we can’t predict black swan events and their financial impacts can be catastrophic, Taleb emphasizes the need to include them in decision-making: preparing for them by considering defensive strategies when building a portfolio.
If you are getting a 10% return on investment (ROI) in the stock market but can lose up to 50% of your portfolio in just a single black swan event, then it makes sense to design your portfolio to be better prepared to withstand black swan events
This simple case illustrates Taleb’s point: having a portfolio that can survive the extreme impacts of black swan events can make you more profitable over the long term.
Some of the risk-mitigation strategies used by black swan theorists include:
- Portfolio hedging with derivatives:
Hedging is a strategy that reduces or eliminates the potential loss in a position by entering an opposite position. Derivatives like options and futures remain the favourite hedging tools for both retail and institutional investors.
Black-swan investors can hedge against the possibility of black-swan events by taking positions that will be very profitable should those events occur.
For example, if you are going long on a stock because you believe the market will go up, you can purchase a put option to hedge against the risk that a black swan event (or even normal bear markets) can cause the market to go down.
With such a strategy, your potential loss is limited to the premium you paid for the put option.
Financial institutions will even deploy more complex futures strategies, options strategies, and volatility derivatives to hedge against various market risks.
[For more on how futures and options work, read “What are Futures and Options in the Stock Market?”]
- Allocating funds to asset classes like gold that do better during recessions and market downturns:
Black swan investors also mitigate risk by allocating a portion of their portfolios to asset classes that tend to outperform during market downturns.
Gold is an example of such an asset class. It has outperformed the S&P 500 during all economic recessions between 1968 and 2022, according to Forbes.
Also, as seen in the chart below, gold has produced positive returns in six of the last eight recessions in the US:
It is no wonder then that most people become interested in learning how to invest in gold when there are economic (or even socio-political) uncertainties.
Though bonds have been touted as a haven during economic uncertainties, their actual performance during market downturns does not support this perception. Academic research in the US, China, and Thailand converge on the fact that bond is a weak haven while gold is a strong haven during market downturns and economic uncertainties.
The low return provided by bonds during market upturns is another reason why black-swan investors do not fancy them. Since there is insurance in place against negative black swan events, there is more room to go big on high-return assets instead of low-return assets that hardly provide any hedging advantage.
“If you’re frustrated by the large share of bonds in your portfolio or their poor performance during key shocks in recent years, then the Black Swan Protection Protocol by Universa (more on this below) is for you,” according to Mark Chawan, the CEO and co-founder of Sarwa. “It helps you manage tail-risk and hedge against big market shocks. At the same time, it lets you invest more aggressively in higher-growth assets like US stocks. It’s a win-win: you are “anti-fragile” during crashes while benefiting from strong equity exposure in non-crash years.”
One essential point remains to be made. While most active investors will use any or all of these risk management strategies during market downturns, black swan investors don’t wait for these events to occur before they take these actions.
In essence, these defensive strategies are built into the very process of building a portfolio.
Why is this so? It goes back to the very definition of black swan events. Since these events cannot be predicted, it is better to be ready for them than to try to manage them.
“Let’s face it, you’ll neither be able to identify nor time the next black swan event, so there’s little point in trying,” said Stéphane Renevier, CFA and Global Markets Analyst at Finimize, a financial education and analytics platform. “Instead, brace yourself for its impact. That means focusing on building a robust – or what Taleb would call ‘antifragile’ – portfolio that can survive shocks and unpredictable events.”
Before even the best financial experts can get a handle on the right way to approach them, the losses may have accumulated significantly. Even if the market rebounded, the opportunity cost of the losses sustained will remain.
In sum, fund managers can adequately respond to regular bear markets but unforeseen events are harder to tame.
Black swan funds
Mark Spitznagel created Universa Investments in 2007 (with Taleb as the founder) as the first black swan fund. It aims to protect investors from negative black swan events so they can have higher long-term returns.
Spitznagel and Taleb use what is called tail-risk hedging to protect investment portfolios. This involves investing a portion of their portfolios in far out-of-the-money options to provide a sort of insurance against black swan events.
Since the risk of these events is small (statistically), these options are cheaper and often mispriced. While they tend to expire worthless, they become priceless (in the money) when black swan events occur.
3. Pros and cons of black swan investing
Pros of black swan investing
- Higher returns during black swan events: NZ Funds, a wealth management firm that uses Universa’s Black Swan Protection Protocol, reported that it recorded a higher rate of return during COVID-19 when compared to stock market indices.
Also, in April 2020, Business Insider reported that Spitznagel had noted in a letter to shareholders that “If an investor had just 3.3% of their assets in Universa and the balance in an S&P 500 tracker fund, they would have made a 0.4% return last month (March 2020) despite the benchmark slumping more than 12%.”
This was due to the fund making a 4,144% return on its put options premium in the first quarter of 2020.
Wall Street Journal also reported that the fund netted more than $1 billion (a 20% return) on a day when the DJIA lost more than 1,000 points.
- Higher long-term returns: Business Insider also reported that the fund made an average annual return of 105% between 2008 and 2019.
In the letter to the shareholders referenced above, Spitznagel also mentioned that the investors who had 3.3% of their assets in Universa would have outperformed the S&P 500 by 2.6% between March 2008 and 2009.
However, given that these results are from internal conversations, it is not clear how much we can confidently rely on them.
- Sticking to long-term strategy: NZ Funds noted that “fewer of our clients panicked and were able to stick with their long-term growth strategies” due to the fund outperforming market indices during COVID-19.
This is one advantage of defensive strategies in general and black swan investing in particular. It protects investors from emotional investing as they can keep their heads even when the market is crashing.
- Deploying cash during downturns: Most investors want to sit on their cash during market downturns. But market bottoms often provide an opportunity to snatch up great stocks at a discount on their intrinsic value.
The protection that black swan investing provides during market downturns and recessions gives black swan investors the confidence to deploy their cash (instead of sitting on it) and grab opportunities that others will run away from.
“The risk of having a lot of cash is that if the market rallies — for the individual investor it doesn’t work well — you have all this cash, you missed on a big move,” according to Taleb, in an interview with Motley Fool. As he said in an interview with The Edge Malaysia, a Malaysian newspaper: “You do a lot better because of what you can buy when you have cash in a crisis.”
NZ Funds provide us with an example. According to them, the better returns their investors had during COVID-19 placed them in a position to buy quality assets for cheap, assets that then went on to produce incredible returns in the 12 months that followed.
Cons of black swan investing
This might seem like we are spoiling the fun but in the interest of full disclosure, it is worth mentioning some concerns with investing based on the black swan theory.
Low-probability events
Black swan investing is very complex to execute and can be very expensive and time consuming. While it provides active protection, there is no high quality ETF that makes it liquid as of yet. In normal years contracts will expire worthless for events that are unlikely to occur.
Whether the strategy will end up providing higher returns will depend on how significant stock market crashes are.
Nevertheless, since one cannot predict when black swan events will occur or how significant they will become, these cons are only relative to the investor’s perception of these matters.
4. Black swan portfolios: How to benefit from the black swan theory
Since one of our goals at Sarwa is to help our customers grow their net worth, we are now introducing Black Swan portfolios, based on the Black Swan Protection Protocol by Universa, to both long-term investors (via Sarwa Invest) and active investors (via Sarwa Trade).
“I can’t think of anyone who’s contributed to real-world risk more than Nassim Taleb, Mark Spitznagel and the Universa team, and it feels unreal to bring such a powerful hedging tool to our clients’ portfolios,” said Mark Chawan, the CEO.
If you have ever experienced massive financial losses due to stock market crashes or have been concerned about such losses, these Black Swan Portfolios are your chance to mitigate that risk and even enjoy higher long-term returns.
As a long-term investor, this means focusing on your long-term goals instead of worrying about how black swan events can cripple your portfolio. And as a trader, this means hedging against the risk that unexpected events will ruin your trading capital.
[Are you ready to minimise your risk and earn higher long-term returns? Sign up for Sarwa today to get access to our Swan portfolios.]
Takeaways
- Black swan events are unpredictable and have significant impacts, such as the 1929 stock crash and 2008 recession, underscoring the need for investment defense.
- Defensive strategies yield consistent, if modest, returns but can prevent major losses during unexpected downturns.
- Tail-risk hedging funds and Black Swan protection hedge against severe downturns, aiming for higher long-term returns and stability.