If you have been following the financial news lately, you will probably have heard people talking about a potential ‘black swan event.’ They are usually referring to the Coronavirus. But, what’s all this about black swans?
The phrase ‘black swan event’ became popular in the 2000s when option trader Nassim Nicholas Taleb wrote a book called The Black Swan. Taleb’s book sold three million copies and spent almost a year on the New York Times bestseller list. It remains a great read – and not just when it comes to economics.
In the world of finance, a black swan event gets its name from the fact that, before Europeans arrived in Australia, no one in Europe had ever seen a black swan. Because no one in Europe had ever seen one, black swans were simply thought not to exist. This became a firm belief – “I have never seen a black swan, which proves that black swans do not exist” – rather than a more accurate and humble observation – “I have never seen a black swan, but that does not prove anything, because I know there are a lot of things I have not seen.”
In investing, the term refers to something that people believe will never happen just because it has not happened so far… until it does happen, at which point it looks obvious. Perhaps the most famous black swan event was the Global Financial Crisis, which essentially stemmed from a collapse in domestic American house prices in the late 2000s. Because house prices had traditionally risen, many people came to believe that house prices simply could not fall. People took on larger mortgages and lenders lent money to people who could not afford the long-term repayments. Basically, everyone was banking on prices continuing to rise so that the loans could be refinanced. Financial engineers even started packaging up what were known as ‘sub-prime loans’ as AAA-grade investments, again based on the belief that borrowers never defaulted on their loans and so these packages were “as safe as houses.”
And then… the black swan flew into view. People did start defaulting on their home loans. One thing led to another and world economies took up to a decade to recover. In hindsight, it all looked very logical – if people can’t afford their loan repayments they won’t repay their loans. Just because many people had never seen house prices fall did not mean that they could not fall.
So, why are people talking about black swans again? Well, some people are wondering whether the Coronavirus might become another black swan event. When you stop and think about it (ie, in hindsight), the idea that in this age of globalisation a virus will spread quickly around the world makes complete sense. But there is a concern that world financial markets have not ‘priced in’ the risk of a health event that makes it harder for people and things to move around the world. People have therefore been too optimistic and that optimism might mean that share markets are overpriced.
Only time will tell if this is the case. Basically, everything will depend on the extent to which the virus affects world economies. And no one has ever proven themselves very good at predicting things like that (except in hindsight!)
What we do know is that share prices go down quite often. In fact, about a third of price movements tend to be negative, as a long-term average. Last year, and in the first weeks of 2020, the market soared. This can lead people to forget that prices fall sometimes, as well.
As professional advisers, this is something we never forget: markets move in both directions, up and down. Our advice is always to accept the key lesson of the black swan: rare things happen. More formally, this is known as ‘risk management’ and it is the key element of any successful investment plan.
If you would like to discuss how to effectively manage your own financial risk, please do not hesitate to get in touch. We will gladly help you arrange things so that you do everything you can to avoid mistakenly thinking that there is no such thing as a black swan.