Tackle Financial Uncertainty in 2024: Protecting Your Investments from Black Swans. Discover key strategies to strengthen your portfolio in the face of unpredictable events.
Preparation for the Unpredictable
A black swan event must meet three main criteria: it must be completely unpredictable, have a massive impact, and only be “predicted” after the fact. We can learn a lot from these events. For example, there are more things we don’t know than we know, we must challenge what we think we know, we must not get caught up in historical data, we must be careful with narratives, and we must not blindly trust models. Don’t try to predict black swan events, but prepare for their impact by testing your portfolio for extreme scenarios and maintaining a truly diversified portfolio. You may also consider using “insurance” options to reduce your losses in extreme cases.
As the world becomes increasingly complex and volatile, we are likely to see more impossible-to-predict but highly disruptive black swan events. So the challenge for you is to get comfortable expecting the unexpected and take steps to protect your wallet; even against threats you can’t foresee.
What are these “black swans”?
Well, the term was popularized by Nassim Nicholas Taleb in his 2007 book, “Black Swans: The Impact of the Highly Improbable.” However, its centuries-old origins date back to a time when the Western world believed that all swans were white; simply because no one had ever seen otherwise. That was until the late 17th century, when live black swans were discovered in Australia, and, you see, the highly unlikely became reality, and these long-held beliefs were shattered. One can describe these events in another way; Imagine being a Thanksgiving turkey, well fed and living the good life until, one fine November day, things take a sharp and unforeseen turn.
Taleb’s theory of black swan events describes how stridently unpredictable events can occur, have a massively disruptive impact, and then be endlessly dissected and explained with the benefit of hindsight.
Under the theory, a true black swan event must meet three main criteria:
01) Surprising rarity.
These events are far outside our normal expectations, usually because nothing in the past gives a solid clue about their possibility. They are the very definition of “unpredictable”.
02) Unprecedented impact.
When they occur, these events are transformative.
03) Hindsight bias.
After the event, many people don their “I knew it” hat. Spoiler alert: they didn’t know.
Black swan events are the ultimate shockers – think: 9/11 or the Covid-19 pandemic. The birth of the internet, the world wars, the global financial crisis: all black swans. They are not just unlikely scenarios or debatable outcomes, like the dot-com bubble burst, Brexit, or the Fed’s latest audacious rate hikes. If these events are “known unknowns,” black swans are the “unknown unknowns” – the ones people didn’t see coming. And when they happen, the impact is seismic.
So why does this matter?
Black swan events can trigger waves of change, spreading across economies, societies and, of course, your carefully crafted portfolio. They serve as blunt reminders of the complexity of our world and the limits of our knowledge and predictive capabilities. Here are some lessons you can take from these birds:
01) Recognize that there are more things you don’t know than you know.
Instead of fearing the unknown, try to manage what is within your power and be prepared for what you cannot control.
02) Challenge what you think you know.
Continually question your assumptions and consider where the blind spots in your logic might be.
03) Don’t be obsessed with historical data.
Just like the Christmas turkey, it is risky to read too much into past events and assume that the status quo will remain.
04) Be careful with narratives.
We love creating elegant stories to understand complex situations, but reality often refuses to fit into our simplified tales.
05) Don’t put all your faith in models.
Of course, traditional models can be very useful most of the time, but they cannot predict black swan events. They often assume a normal distribution and underestimate the probability and impact of extreme events.
How to Protect Your Wallet?
Let’s face it, you won’t be able to identify or time the next black swan event, so there’s little point in trying. Instead, brace yourself for its impact. This means focusing on building a robust portfolio; or what Taleb would call “antifragile”; that can survive shocks and unpredictable events. Here’s how you can protect yourself:
01) Test your wallet.
Periodically evaluate your portfolio in extreme scenarios (using a tool like Portfolio Viewer, for example) to assess how well you would do in the most adverse conditions. This means managing your leverage wisely, limiting your maximum losses (using stop-loss orders, for example, and, of course, avoiding positions where your losses are unlimited, such as selling options), and avoiding excessive concentration in any single asset. Sounds simple, I know, but you’d be surprised how many hedge funds have blown up by not abiding by these simple rules.
02) Diversify your investments.
If you can’t predict black swans, you probably won’t be able to correctly predict the future, given how important they are in shaping it. To reduce the need to make accurate predictions, make sure you own assets that can withstand different macroeconomic climates, not just stocks but also gold, Treasury bonds, and bitcoin.
03) Consider “insurance” options like “hedges”.
Depending on your risk tolerance, you may want to explore the possibility of spending some money on options that could act as an insurance policy if things go wrong. Implementing a strategy like an options spread on a stock or index could help offset some losses in the rest of your portfolio in the face of a black swan event. However, keep in mind that these strategies are not cheap and generally impact your returns most of the time. Another disadvantage is that they tend to quickly lose their earnings after the event has passed, so you will need to plan when to take your profits. Still, a small allocation for these asymmetric payments can make sense. Hedging in futures markets also falls under this type of protection.
04) Last but not least, you might consider focusing on the positive.
Yes, black swans seem like omens of the apocalypse, but they also bring opportunities. As Taleb correctly points out, some great scientific or technological advances have emerged from these unpredictable events. Most discoveries are unplanned, but are found, often because of a black swan event. So, with that in mind, a small exposure to assets like bitcoin or technology stocks, which could benefit hugely from such events, might make sense.
Always remember that the key to dealing with black swan events is preparation and flexibility. By accepting the unpredictability of the future and adopting a cautious approach, you will be better equipped to face the challenges that may arise. Stay informed, diversify your investments, and be open to adjusting your strategy as circumstances evolve. Long-term success in the financial market often comes from the ability to adapt to change and learn from the lessons of the past.
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