Is There a Way to Predict or Avoid Black Swans?

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Investing comes with risk. That shouldn’t be a surprise to anyone, but many investors think that simply diversifying a portfolio eliminates the majority of risk they’re taking on. Unfortunately, risk comes in many different shades and flavors.

Experienced investors know all-too well the many different types of risk that comes with investing in the stock market. There’s foreign exchange risk, geopolitical risk, industry risk, technology risk and much more to contend with. While diversification can help mitigate some of these risks, there’s one that’s hard to defend against – systemic risk.

The Unknown Unknowns

Systemic risk is a type of risk that affects entire markets, making diversification nearly useless as a risk avoidance tool. General market corrections are a common type of systemic risk that come naturally in the cycle of the stock market, but the most dangerous is called a black swan.

Black swans are unpredictable events that have a major impact on the markets and/or the economy as a whole. The idea was developed by Nassim Taleb, who researched past black swan events, such as the advent of the personal computer, the fall of the Soviet Union and the attacks on September 11th, 2001.

But the nature of these events, unpredictable and sudden, makes them hard to prepare for. Even if one takes into account every imaginary scenario, one cannot prepare for the unknown. If, for example, a a scientific breakthrough in a new type of energy made oil and gas irrelevant, the markets would undergo massive chaos as investors bail out of the energy industry.

Regression analysis and prediction models can only help spot trends and take from historical data. But designing a portfolio that accounts for all possibilities is not only virtually impossible, it’s counter-productive. Standard portfolio designs take data and make macroeconomic predictions and invest accordingly. This design allows for the maximum potential for profits while reducing unnecessary downside risks. But risk isn’t completely eliminated.

In fact, the only real way to avoid something like a black swan would be to avoid being invested at all – in which case, there’s no possibility of loss, but none of gain either.

While it might be nearly impossible to accurately predict a black swan occurrence, the good news is that you really don’t need to worry about them. Because they’re random happenings that affect entire markets, you won’t be alone when disaster strikes. More importantly, though, is that markets do recover from black swans. The sub-prime financial crisis in 2008 crippled the markets for a while, but just one year later, stocks were climbing once again. As an investor, staying in the markets and holding on even through downturns ensures you take advantage of all the upside gains the subsequent recovery has to offer.