What Is a Black Swan in Finances?

A "black swan" is an event with a very low probability of occurring that produces catastrophic results when it occurs. Retired New York University professor and former derivatives trader Nassim Taleb popularized the term in his book of the same name: "The Black Swan: The Shock of the Highly Improbable."

He describes that a black swan has three properties: high unpredictability, potentially serious consequences, and being predictable in hindsight.

What is a black swan?

Nassim Taleb's three properties of black swans suggest:

They are outliers in the sense that their probability of occurrence is well outside the normal expectation range.
When they occur, they produce significant impacts.

We tend to see clear explanations for them after the fact, which we call hindsight predictability.

Willem de Vlamingh discovered black swans in Australia in 1697. Since no black swan had been previously observed, Europeans believed that all swans were white.

The Roman satirist Juvenal even referred to a black swan to describe something as incredibly rare, much like the modern phrase "When pigs fly."

How a Black Swan event works

The general premise of the black swan theory is that unpredictable events can have serious economic or financial consequences on markets. Importantly, events can be unpredictable due to the accumulation of similar and repetitive experiences.

According to Taleb, the problem with the black swan in its original form is this: "How can we know the future, given [our] knowledge of the past?"

In other words, how can we draw general conclusions from our specific experiences when we have not experienced all that there is? Just because we've only seen white swans doesn't mean there aren't black, pink, or any other colors.

Taleb illustrates the overconfidence in past experiences with the example of a turkey being raised for Thanksgiving. Throughout the turkey's life, it is fed daily, creating the expectation that it will, in fact, be fed the next day.

Each day the turkey is fed, the belief is reinforced until the day before Thanksgiving, when "it will incur a belief revision."

This is a simple and easy to understand illustration of the black swan phenomenon. When we keep experiencing the same things, like seeing only white swans or being fed every day, we tend to believe that this will be our experience in the future.

Sometimes it takes a dramatically different and unexpected experience to change established beliefs.

Black swan event example

To illustrate the other principles of the black swan events (significant economic impact and hindsight predictability) we will consider some examples.

Subprime Mortgage Crisis of 2008

The subprime mortgage crisis that began in 2008, also known as the Great Recession, led to one of the worst economic periods in American history since the Great Depression. It shows all three features of a black swan.

It was unexpected: Policy makers, especially at the Federal Reserve, were largely unaware of the subprime crisis. In fact, Alan Greenspan, chairman of the Federal Reserve at the time, later said in an interview with David Rubenstein: "You cannot have a crisis of this nature that is not a surprise."

It had a significant economic impact: the unemployment rate doubled during the Great Recession, reaching 10%. There were also about 3.8 million foreclosures between 2007 and 2010, which occurred as a direct result of the sharp decline in the housing market and its domino effects.

It's predictable in hindsight: the Great Recession has been studied and discussed in depth. It is now clear to most economists and even the occasional interested observer that lax credit policies in the subprime market were the main cause of the mortgage crisis.

These policies included making loans to less creditworthy borrowers, often with adjustable-rate mortgages, and securitizing these loans for resale in increasingly opaque arrangements.

One lesson to be learned from the black swan theory is that there are always unknowns that can affect financial markets.

Therefore, it is prudent to take fundamental precautions by diversifying your investments and maintaining a suitable asset allocation for you that is designed to withstand the ups and downs of the market.

We hope you enjoy watching this video about What Is a Black Swan in Finances?

Source: Rocking Finance

 

Did you find this post useful or inspiring? Save THIS PIN to your Finances Board on Pinterest!

Ok, That is all for now…
If you enjoyed this article please, Share and Like it. Thanks.
See you in the next post, Have a Wonderful Day!