Black Swan Events Are Coming. Here’s How To Be Ready

As the world becomes increasingly complex and volatile, we’re likely to see more of the impossible-to-predict, hugely disrupting so-called black swan events. So the challenge for you is to get comfortable expecting the unexpected and take steps to protect your portfolio – even from the kinds of threats you can’t actually see coming.

What are these mysterious “black swans”?

Well, the term was popularized by Nassim Nicholas Taleb, in his 2007 book, Black Swans: The Impact of the Highly Improbable. But its centuries-old origins stem from a time when the Western world believed all swans were white – simply because no one had ever seen otherwise. That is, until the late 1600s, when living, breathing black swans were discovered in Australia, and voilà: the highly improbable had become reality and those long-held beliefs had shattered. You could describe these events another way: imagine being a Thanksgiving turkey, well-fed and living the good life until one fine November day, things take a sharp, unforeseen turn.

Taleb’s theory of black swan events describes how stridently unforeseen events can happen, 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 core criteria:

Eye-popping rarity. These events sit way outside our normal expectations, generally because nothing in the past gives a solid hint as to their possibility. They’re the very definition of “unpredictable”.

Monumental impact. When they do occur, these babies are game-changers.

Hindsight bias. Post-event, a lot of people don their “I knew it” hat. Spoiler alert: they didn't.

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’re not just unlikely scenarios or debatable outcomes, like the dotcom bubble burst, Brexit, or the Fed’s latest bold rate hikes. If those events are “known unknowns”, black swans are the wild card “unknown unknowns” – the ones that people didn’t see coming. And when they happen, the impact is seismic.

So why does this all matter?

Black swan events can unleash tidal waves of change, rippling through economies, societies, and, of course, through your carefully curated portfolio. They serve as stark reminders of our world’s complexity and the limits of our own knowledge and predictive capabilities. Here are a few lessons you can take from these birds:

Acknowledge there are more things you don’t know than you do know. Instead of fearing the unknown, aim to manage what’s within your control, and be prepared for what you can’t control.

Challenge what you think you know. Continuously question your assumptions and consider where the blind spots in your logic might be.

Don't get hung up on historical data. Just like the Thanksgiving turkey, it’s risky to read too much into past events and presume the status quo will hold.

Beware of narratives. We love creating neat stories to wrap our heads around complex situations, but reality often refuses to be boxed into our oversimplified tales.

Don’t put all your faith in models. Sure, traditional models can be very useful a lot of the time, but they can’t foresee black swan events. They often assume a normal distribution, and underestimate the probability and impact of extreme outliers.

How can you protect your portfolio?

Let’s face it, you’ll neither be able to identify nor time the next black swan event, so there’s little point in trying. Instead, brace yourself for its impact. That means focusing on building a robust – or what Taleb would call “antifragile” – portfolio that can survive shocks and unpredictable events. Here’s how you can armor up:

Stress-test your portfolio. Periodically assess your portfolio under extreme scenarios (using a tool like portfolio visualizer, for instance) to gauge how well you’d fare in worst-case conditions. That means managing your leverage wisely, capping your maximum losses (by having stop-losses in place, for instance, and of course by avoiding positions where your losses are unlimited, like selling options), and steering clear of overconcentration in any single asset. Sounds simple, I know, but you’d be surprised how many hedge funds have blown up by not respecting those simple rules.

Spread your bets. If you can’t predict black swans, you probably won’t be able to correctly forecast the future, given how important they are in shaping it. To reduce the need for making precisely accurate predictions, make sure you own assets that can weather different macroeconomic climates, so not just stocks, but also gold, Treasury bonds, and bitcoin. If you’re unsure where to start, have a look at my previous insight here.

Consider insurance-like “tail hedges”. Depending on your risk tolerance, you may want to explore spending some money on options that could act like an insurance policy if things go wrong. Implementing a strategy like the 1x2 or a put-spread on a stock or credit index could help offset some losses in the rest of your portfolio in the face of a black swan event. But, keep in mind, those strategies don’t come cheap and they will eat into your returns most of the time. Another drawback: they tend to rapidly lose their gains after the event has passed, so you’ll need to plan when to take your profits. Nonetheless, a small allocation to such asymmetric payoffs might make sense.

There are also some black swan ETFs out there, like the Amplify BlackSwan Growth & Treasury Core ETF (ticker: SWAN; expense ratio: 0.49%), which holds US Treasury bonds to finance call options on stocks. That being said, they don’t always work as intended and can be quite expensive to hold over the long term.

Last, but not least, you could consider focusing on the bright side. Yes, black swans sound like a harbinger of doom, but they also bring opportunities. As Taleb rightly points out, some major scientific or technological leaps have come from these unpredictable events. Most breakthroughs aren’t planned but are stumbled upon, often because of a black swan event. So, with that in mind, a small exposure to assets like bitcoin or tech stocks, which could hugely gain from such events, may make sense.