Understanding Black Swan Events and Their Impact on the Stock Market

This article is dedicated to "black swan events" – rare and complicated global events that were difficult to predict and perceive, with a major effect, but are rationalised with the benefit of hindsight.

The black swan theory

The "black swan event" metaphor describes an improbable event with a major impact that is difficult to predict – both the event itself and its consequences. Examples of such events in the US are the Great Depression of 1929, the financial crises of 2008 and 2014, and the terrorist attacks of 11 September 2001 commonly known as 9/11.

The tradition of calling such global events "black swans" was introduced by American economist and mathematician, and former trader, Nassim Taleb, in his book "The Black Swan: The Impact of the Highly Improbable", published in 2007.

It should be noted that the theory of uncertainty in life and the economy was formulated by Taleb already in 2004 in his book "Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets".

What are the main signs of a black swan event?

For an event to be called a black swan, it must have the following three main characteristics:

1. The event is fully unpredictable.
2. Its consequences are tremendous, and the global impact is immense.
3. Rational explanations appear post-factum only.

What leads to a black swan event?

To understand the theory better, Nassim Taleb suggests determining the factors that influence our readiness to face complicated global issues:

• Confirmation error. This means we see random fragments of the picture and in attempting to make it whole, we make hasty and superficial conclusions instead of looking deeper into the situation
• Distortion of narratives. This means we create our own meanings for the invisible fragments of the picture in an attempt to understand what is happening
• Neglecting the black swan event. This means society tends to behave as if black swans do not exist
• Issue with hidden evidence. This means we make partial, superficial, and not always true conclusions from previous global issues, and try to predict the future based on the distorted picture of the past

How black swan events impact financial markets

Basically, the influence of black swan events on the world of finance is negative: as a rule, it leads to financial markets falling. Stock indices, stock quotes, crude oil, and precious metal prices – all of these head downwards.

As Nassim Taleb states, one of the ways to smooth out the repercussions of a black swan event is to accept its inevitable emergence and develop a detailed and realistic plan of action. For example, banks carry out stress tests from time to time to check on their ability to manage crises.

However, black swan events are not necessarily always associated with crises and catastrophes. Some of these impactful events have had a positive effect on humanity, our lives, and world history: the first human space flight, the creation of the Internet, and the development of new medicines and bionic prosthetic devices.

Moreover, there are successful companies that not only kept their business afloat in times of crisis, but remained the leaders of their segments: Alphabet Inc. (NASDAQ:GOOGL), PayPal Holdings Inc. (NASDAQ:PYPL), Airbnb Inc. (NASDAQ:ABNB), and more.

How to stay safe from a black swan event

• Diversify your investment portfolio
• Prepare a financial airbag
• Keep a part of your money in protective assets
• Hedge risks
• Control your income and expenses

Summary

A black swan event is an improbable event that cannot be predicted beforehand, nor can its consequences. As a rule, it has a negative impact on financial markets. It must be noted that these events have three main characteristics: they are unpredictable, global, and can be rationally explained only after they have happened.

The author of the term "black swan" and the theory of uncertainty and randomness in the economy is Nassim Taleb, an economist, mathematician, and former trader.