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The Black Swan Theory 

CHESTA CHOPRA /   DECEMBER 24, 2022   

Today, we have events that may be classified as known knowns, known unknowns, and unknown knowns.What about the unknown unknowns? Although the probability of such incidents  occurring is very low, many times they tend to have a significant impact.

    magine yourself as a chicken. Sometimes you would wonder why your owner takes such good care of you. You keep waiting and imagining that one day your owner will kill you, but it never happens, so you stay on high alert. As the years go by, you come to understand that your owner loves you more than he does any of these other hens and that he would never treat you unfairly.  The fact that another day has passed is more proof that the next one will not be your last. But in the end, you end up on someone’s dinner plate. Imagine the chicken's feelings of betrayal as it was being led to that dreadful area of the farm. The chicken's confidence in its owner was, ironically, at its strongest during its execution, given the days of proof. That last day completely altered the bird’s existence. This situation is an instance of ‘Black Swan.’

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Black Swan is a metaphor defining a rare, unexpected and unpredictable event that goes beyond what is generally accepted of a situation and has a significant impact on both the society and world.

Black Swan is a metaphor defining a rare, unexpected and unpredictable event that goes beyond what is generally accepted of a situation and has a significant impact on both the society and world. They are normally characterised by the following events: first the observer will find the event unexpected, second the event will have a significant impact on society and third after the incident occurs, people will rationalise it as being predictable (known as hindsight bias). Given that there is no reliable evidence that can forecast the event's occurrence in the future, these events are very challenging to anticipate. 

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Illustration via Pinterest

It's interesting to note that Black Swans were thought to not have existed at the time the word was first used.

It's interesting to note that Black Swans were thought to not have existed at the time the word was first used. It gets its name from the way the Roman poet Juvenal described something in his Satire VI in the second century, "rara avis in terris nigroque simillima cygno" (a rare bird in the lands and very much like a black swan). Dutch explorers were the first Europeans to notice black swans in Western Australia in 1697. As a result, the phrase came to signify the potential for demonstrating that an apparently improbable event was actually highly likely.

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Illustration via Pinterest

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However this theory was popularised by a Lebanese-American essayist, statistician and a former Wall Street trader, Nassim Nicholas Taleb, who wrote a book titled ‘The Black Swan’ in 2007. In his book, he expands the meaning of Black Swan events which were essentially restricted to financial markets to include all significant historical events from scientific breakthroughs, artistic accomplishments and historical occurrences as ‘Black Swans’.

 These events were unexpected occurrences that our limited understanding of the past could not have predicted. 

These events can be further divided into negative and positive black swan events. A negative black swan event is one that has a significant long-term impact and has a negative outcome. An example is  the 2008 financial crisis which led to the largest bankruptcy filing in history.  Although no one genuinely anticipated the company to fail, the economic effects were devastating, and scholars now contend that warning signs had been raised before the catastrophe occurred. The historic Lehman bankruptcy thus fulfils all the criteria for a negative Black Swan event. Another instance of a negative black swan event is the Zimbabwe hyperinflation.

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Illustration via Pinterest

According to research (Hanke S. and Kwok A, 2007), Zimbabwe saw the worst hyperinflation of the 21st century in 2008, with a peak inflation rate of more than 79.6 billion %. A country's finances can quickly be destroyed by inflation of such magnitude, which is very hard to anticipate. Meanwhile, a positive Black Swan event such as the development of the internet, has the potential to generate a massively beneficial outcome. People would have never been able to imagine being able to access any kind of information, watch movies or stay in touch with their loved ones over just a click in a million years. The advantages of using the internet are numerous and get better every day.

According to Investopedia, a Black Swan event in the stock market is mostly a market drop that exceeds six standard deviations, making it statistically unlikely.

Black Swan events are frequently described in terms of the stock market. According to Investopedia, a Black Swan event in the stock market is mostly a market drop that exceeds six standard deviations, making it statistically unlikely. In the market, some claim that stock prices are ‘fat-tailed’ and that these occurrences are actually more common than the data would indicate. These events are unpredictable and also cause huge losses in the stock market as well as in the economy, investors suggest a few ways in which they can be avoided. According to Viraj Desai (Director, Portfolio Manager, at TD Ameritrade Investment Management, LLC), purchasing index put options or allocating a larger portion of a portfolio to assets that have historically been regarded as ‘safe havens’ like gold or cash are some options. Good, old-fashioned portfolio diversity is also a smart idea which will help in risk management, even while asset allocation and diversification may not completely remove the chance of experiencing investment losses.

An alternative perspective according to Desai is that opportunities will always exist with risks and potential black swan catastrophes. Black swans frequently generate opportunities to take a contrarian stance as many investors flee the market. While, as has also been seen in the past, it's difficult to forecast a  black swan, individuals who weren't completely

unprepared may have opportunities to add low-priced assets to their

portfolios and possibly benefit if and when the market recovers. Taleb

in his book contendsthat it is impossible to forecast Black Swan events

because of their high degree of improbability. So, the best defence

against a negativeBlack Swan event is to create strong systems that

can significantly reduce the risk of it happening. Thus, to conclude

in Taleb’s words,“The problem with experts is that

they do not know what they do not know”.

via Tradebrains.in

Illustration via Tradebrains.in

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Keywords 

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Black swan events, Lehman Bankruptcy, Zimbabwe hyperinflation, 'fat-tailed' stock prices, Nassim Nicholas Taleb, positive and negative black swan events

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References

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The views published in this journal are those of the individual author/s and do not necessarily reflect the position or policy of the team behind Beyond Margins, or the Department of Economics of Sophia College for Women (Autonomous), or Sophia College for Women (Autonomous) in general. The list of sources may not be exhaustive. If you’d like to have the complete list, email us at beyondmarginssophia@gmail.com

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