Stock and other investment markets are affected by all types of events. Downturns or crashes such as Black Monday , the stock market crash of , or the dotcom bubble of were relatively "model-able," but the Sept. And, who really expected Enron to implode at the time?
As for the Bernie Madoff Ponzi scheme, one could argue there were red flags. The point is, we all want to know the future, but we can't. We can model and predict some things to an extent, but not the black swan events, which creates psychological and practical problems.
For example, even if we correctly predict some things that impact the stock and other financial markets, such as election results and the price of oil, other events like a natural disaster or war can override the predictable factors and throw our plans totally out of kilter. Furthermore, events of this kind can happen at any time and last for any length of time.
Consider a couple of past wars as examples. There was the incredibly short Six Day War in On the opposite end of the spectrum, people thought "the boys will be home by Christmas" when World War I started in , but those who survived didn't return home for four years. And Vietnam did not exactly turn out as planned either.
Gerd Gigerenzer also provides some useful input. Instead, people make "safer," more conservative decisions. Thus, fund managers may not suggest or make riskier investments simply because it is easier to go with the flow. This happens in medicine, too. Doctors stick to familiar treatments, even when a bit of lateral thinking, imagination, and prudent risk-taking might be appropriate in a particular case.
Complex models, such as Pareto efficiency , are often no better than intuition. Such models only work in certain conditions, so the human brain is often more effective. Having more information does not always help, and getting it can be expensive and slow. A laboratory situation is very different, but in investing, complexity can be handled and controlled. Conversely, it is highly unsatisfactory and very risky to simply ignore the potential for black swan events to occur.
To take the view that we cannot predict them so we will plan and model for our financial future without them is looking for trouble. And yet, this is often precisely what is done by firms, individuals, and even governments. Gigerenzer considers the Nobel Prize-winning work of Harry Markowitz on diversification, and in particular Markowitz's development of modern portfolio theory MPT.
Gigerenzer argues one would really need data extending over years for it to work. He comments wryly that one bank, which promoted its strategies on the basis of Markowitz-style diversification , sent out its letters years too early. After getting the Nobel Prize, Markowitz himself actually relied on intuition. In the and crisis years, the standard asset allocation models did not work well at all.
One still needs to diversify, but intuitive approaches are arguably just as good as complicated models, which simply cannot integrate black swan events in any meaningful manner. Taleb warns against letting someone with an incentive bonus manage a nuclear power station or your money. Ensure that financial complexity is balanced with simplicity. A mixed fund is one way of doing this. Certainly, these vary substantially in quality, but if you find a good one, you can really leave the diversification to one supplier.
Avoid hindsight bias. Be realistic about what you really knew back then, and don't bank on it happening again, certainly not exactly the same way. Take uncertainty seriously—it is the way of the world. No computer program can forecast it away. Don't place too much faith in predictions. Markets can be clearly too high or too low, but reliable, accurate forecasts you can bank on are just a fantasy. Predicting financial markets can be done, but their accuracy is as much a matter of luck and intuition as of skill and sophisticated modeling.
Too many black swan events can happen, nullifying even the most complex modeling. This does not mean modeling and prognoses cannot or should not be done. But we also need to rely on intuition, common sense, and simplicity. Furthermore, investment portfolios need to be made as crisis-proof and black-swan-proof as possible.
What is a black swan event? Here are a few basic black swan questions and explanations. According to Taleb, Dutch explorers who traveled to Western Australia in were the first Europeans to see black swans. Other black swan examples include the rise of the internet and the personal computer, World War I, the dissolution of the Soviet Union, and the September 11, , terrorist attacks, according to Taleb.
Why do we keep focusing on the minutiae, not the possible significant large events, in spite of the obvious evidence of their huge influence? Red flags were fluttering all over the place, but few caught on at the time. In reality, nobody really knows what causes a black swan. A black swan event, by definition, is nearly impossible for anyone to see coming.
Still, investors can watch a few indicators, such as Treasury yields or the Cboe Volatility Index VIX , for signs of escalating concern among market professionals. Another potential warning sign is volatility skew, a measure of the implied volatility IV of out-of-the-money put options versus the IV of out-of-the-money call options.
For investors, constructing a portfolio strategy entirely around doomsday expectations for an impending black swan is probably ill-advised. According to Desai, owning a portion of your portfolio in U. Another way to look at it: Risks and potential black swan events will always be there, but so will opportunities. Not investment advice, or a recommendation of any security, strategy, or account type. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade.
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I believe he coined the term. Basically, it's a very rare event with significant consequences. I think we can summarize it that way. There are scenarios. Let's say that the entire cryptocurrency market is just tanking. For whatever reason, something happens and there's not a single coin out there that is up, they're all dropping by double-digits in a short amount of time, in that scenario, there's theoretically an arbitrage opportunity for TerraUSD, but nobody is willing to take advantage of that opportunity because the entire cryptocurrency world is falling apart.
In that scenario, the stable coin will lose its peg, and in so doing, faith in the entire system is lost. If it can't maintain that one-dollar peg, then nobody is going to have the incentive to use it. This has never happened so far, but it could theoretically happen. The founder is here saying, "You know what, let's have some reserves at hand that we can deploy to remedy the situation if this one in a million situation happens. Now, if you hold LUNA tokens, that probably sounds a little bit unsettling because all of a sudden there's all these tokens out there held by these private investors.
Well, they are required to hold them over a four-year vesting period. They're not just going to go ahead and dump them onto the market tanking LUNA's price, this has a time element in place. There's time to grow this whole ecosystem here. They are fundamentally different from the U. The thought process here is if we have one of these outlier events, we're going to have funds that are going to be diversified and ready to put to use to maintain faith in the system and TerraUSD at a dollar.
Hoium: My question for this is if the black swan event is that there's a correlated sell-off in all of these digital crypto assets, and your answer is to buy assets that would also be correlated with that sell-off. That seems a little strange to me.
The argument here, I think from their perspective would be Bitcoin is a hedge. But we've seen over the last six months that Bitcoin really trades more like a high-risk asset like a growth stock like the board is supposed to. Inflation is going up, the value of Bitcoin is going down. If it was a hedge, we should see the opposite happening. On the same token, this is what the financial crisis in taught us, was that great you own bonds instead of all stocks, but stocks were down and bonds were down.
There was no safe place, there was no uncorrelated asset. Quast: I think that's really fair, Travis. To be honest with you, I don't know if they are thinking about other black swan scenarios in this as well. The reasoning, the argument that I read was that the entire cryptocurrency market is tanking, and that is the black swan event that we are hedging for.
I don't know if they have other ones in mind because to your point, this does seem a little bit like circular reasoning. If the entire thing is tanking, then wouldn't Bitcoin itself be tanking. I think that's really fair. I guess at the same time, Bitcoin probably wouldn't be worth zero. They'd still have some firepower to work with to get their peg back in order, but it is an interesting point and a point well taken there. Hoium: Their answers to regulators have been interesting as regulators try to dive into what they're doing and how they are pegging versus other stable coins are pegging.
Cost basis and return based on previous market day close. Avoid hindsight bias. Be realistic about what you really knew back then, and don't bank on it happening again, certainly not exactly the same way. Take uncertainty seriously—it is the way of the world. No computer program can forecast it away. Don't place too much faith in predictions. Markets can be clearly too high or too low, but reliable, accurate forecasts you can bank on are just a fantasy.
Predicting financial markets can be done, but their accuracy is as much a matter of luck and intuition as of skill and sophisticated modeling. Too many black swan events can happen, nullifying even the most complex modeling. This does not mean modeling and prognoses cannot or should not be done. But we also need to rely on intuition, common sense, and simplicity. Furthermore, investment portfolios need to be made as crisis-proof and black-swan-proof as possible.
Our old friends—diversification, ongoing monitoring, rebalancing , and so on—are less likely to let us down than models that are fundamentally incapable of taking everything into account. In fact, the most reliable prediction is probably that the future will continue to remain a mystery, at least in part.
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Key Takeaways Black swans are extremely rare events, often with large negative consequences. A black swan event cannot be predicted beforehand, but may seem obvious in hindsight. Reliance on standard forecasting tools and investment models can both fail to predict and potentially increase vulnerability to black swans by propagating risk and offering false security. Compare Accounts.
The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Related Articles. Partner Links. Related Terms. Black Swan A black swan is an event that is rare, very important, and is both difficult to have predicted but is considered obvious in hindsight.
Grey Swan Definition A grey swan is an event that is possible and known, potentially extremely significant but considered not very likely to happen. Tail Risk in Investments Tail risk is portfolio risk that arises when the possibility that an investment will move more than three standard deviations from the mean is greater than what is shown by a normal distribution.
What Is Anti-Fragility? Anti-fragility is the opposite of fragility, describing things that gain from chaos but may need to survive and flourish. Who Is Harry Markowitz? Harry Markowitz is the U. What Is a Black Box Model? A black box model is a system using inputs and outputs to create useful information, without any knowledge of its internal workings.
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Black swans are world-changing events that are rare and difficult to predict, but they have serious implications for your investments. A black swan event in the stock market is often a market crash that exceeds six standard deviations, making it exceedingly rare from a probabilistic standpoint. A so-called black swan event is defined, in part, as an “outlier” that carries deep, far-reaching consequences for investors.