Black Swans: Part of the Wall Street Menagerie of Bulls and Bears

Learn about “black swan” events and how you can attempt to protect yourself and your portfolio from adverse shocks.

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https://tickertapecdn.tdameritrade.com/assets/images/pages/md/Black swan: Learn about “black swan” financial events and how you can attempt to protect yourself and your portfolio from adverse shocks.
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In a Wall Street arena often characterized as a battle between bulls and bears, there’s another, very different kind of “animal” that can spook even the most seasoned market professionals: the black swan.

So-called black swan events happen inside and outside the financial world, and they’re remembered for a long, long time. The collapse of Lehman Brothers and the 2008 financial crisis stands out as one recent example; the bursting of the dot-com bubble in 2000 to 2001 and the “Flash Crash” of May 2010 are others.

What Is a Black Swan?

A black swan event is unlikely, an outlier; is extremely difficult to predict (although we tend to think we should have predicted it, after the fact); and carries extreme impact.

The term was popularized by Nassim Nicholas Taleb, a finance professor, writer, and former Wall Street trader, in his 2007 book The Black Swan: The Impact of the Highly Improbable.

According to Taleb, Dutch explorers who traveled to Western Australia in 1697 were the first Europeans to see black swans. Previously, they’d assumed all swans were white.

A metaphor was born. The black swan “illustrates a severe limitation to our learning from observations or experience and the fragility of our knowledge,” Taleb wrote in an excerpt of his book that was published in the New York Times in 2007.

Why Do Black Swans Happen?

Good question. Although no single factor led to the 2008 crisis, for example, an abundance of cheap and easy credit plus “irrational exuberance” fueling the boom in housing and other asset classes likely played a part.

But here’s the thing about black swans: The reasons behind them often appear obvious only years later, when we’re still sweeping up the wreckage. But in reality, nobody really knows the causes.

“Few people saw that [2008] crisis coming, or, more specifically, very few people understood the catalysts behind why that crisis was bound to happen,” says Pat O’Hare, chief market analyst at Briefing.com. “Even the Federal Reserve missed the warning signs brewing in the housing sector, and, more importantly, in the derivatives market for mortgage debt."

“There were complex financial transactions leading up to the crisis, yet it all sounded so simple after the calamitous fact why the financial system basically collapsed as a result of it.”

Broadly speaking, the reasons for black swans lie deep in the human psyche, according to Taleb.

The central idea of Taleb’s book, he wrote, concerns “our blindness with respect to randomness, particularly the large deviations: Why do we, scientists or non-scientists, hotshots or regular Joes, tend to see the pennies instead of the dollars? Why do we keep focusing on the minutiae, not the possible significant large events, in spite of the obvious evidence of their huge influence?”

Are There Black Swan Warning Signs?

By definition, a black swan event is nearly impossible for anyone to see coming. Bunkering up a portfolio strategy around your expectation for an impending black swan is probably ill-advised, some experts say.

Still, investors can keep an eye on indicators such as Treasury yields or the CBOE Volatility Index (VIX) for signs of escalating concern among market professionals. The VIX, known as the “fear gauge,” often spikes higher during periods of market or political turmoil around the world. More recently, the VIX conveyed a calm picture (trading around 11 to 12 in mid-July).

Another potential warning sign is volatility skew, which measures the implied volatility (IV) of out-of-the-money put options versus the IV of out-of-the-money call options. The CBOE SKEW Index (SKEW), which some refer to as the black swan index, measures the probability of outlier events, or down moves, of two to three standard deviations.

The SKEW’s value typically ranges from 100 to 150, although it has broken above and below that range (the index rose above 153 in June 2016 after the UK voted to leave the European Union). According to the CBOE, a SKEW value at or close to 100 indicates a “normal” market (meaning the market views the likelihood of a black swan event as low).

A SKEW at 115, for example, suggests a 6% risk of a black swan event occurring; at 135, that risk rises to 12%. In mid-July, the SKEW hovered around 130.

How Might You Protect Yourself?

For investors seeking to guard against volatile, uncertain markets, if not a black swan event, there are a few ways to establish more of a “defensive” posture—such as buying U.S. Treasuries, a traditional safe haven, O’Hare said.

But although Treasuries are traditionally a good defensive investment, that market is currently “richly priced,” O’Hare cautioned. “The stock market isn’t the exclusive domain for a black swan event.”

Buying index put options, or allocating a larger portion of a portfolio to gold or cash, are other approaches. And consider good, old-fashioned diversification: avoid having too many assets in one particular stock, sector, or market.

It’s important to stay level-headed. Recognize that randomness is everywhere and that black swans can happen anywhere.

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