What is a Black Swan Event?

Nassim Nicholas Taleb is the author of The Black Swan,one of the most influential books of the past 50 years. The book is concernedwith randomness and uncertainty, and our chronic inability to accurately fathomand measure these phenomena. According to Taleb, a Black Swan event is one thatis unpredictable yet has wide-spread ramifications. This article is about how we can define a Black Swan event.

Nassim Nicholas Taleb is the author of The Black Swan, oneof the most influential books of the past 50 years. The book is concerned withrandomness and uncertainty, and our chronic inability to accurately fathom andmeasure these phenomena. According to Taleb, a Black Swan event is one that isunpredictable yet has wide-spread ramifications.

More specifically, a Black Swan event has to have thefollowing three characteristics: 1) it was not predicted, meaning it came as asurprise (to the observer), 2) the event has a huge, widely-felt impact, and 3)even though the event was not expected or predicted, human nature causes theobserver to believe that the event was perfectly predictable and foreseen.

The financial crisis of 2007-2008 is a perfect example of atypical Black Swan event. It fits the first criteria because most people didnot expect such an event to occur. In fact, before the crisis hit, many peoplepointed to the fact that housing prices had not declined on a national levelfor decades, as if the fact that this hadnt occurred meant that it was notpossible for it to occur. The crisis obviously fits the second criteria ofhaving a huge impact, as we are still trying to climb out of the hole thecrisis created. And the crisis fits the third criteria, as many people who didnot predict the financial crisis came out after the crisis occurred and claimedthat the decline in housing prices was perfectly predictable. In fact, manypeople have been angry with politicians, regulators, and business executivesfor not preventing the crisis, when these same people had no idea themselvesthat a crisis was coming.

The third criteria for a Black Swan event, that the eventbecomes predictable only after it occurs, is probably the most interestingfrom a psychological perspective. Its certainly a contradiction that an eventbecomes predictable only after it occurs, but it seems to be indicative ofsome naturally occurring biases, including the hindsight bias (i.e. hindsightis 20/20).

As mentioned above, the financial crisis of 2007-2008 is aprototypical Black Swan event, and it is also the event that really shot NassimTaleb into popularity. In fact, in the book, which was published before thecrisis hit, Taleb mentioned that he would never invest in Fannie Mae andFreddie Mac because they seemed to be sitting on top of a timebomb with all ofthe mortgage-backed securities they had on their balance sheets. Of course, thevalue of these securities fell through the roof, Fannie and Freddie requiredmassive bailouts, and Taleb ended up looking like a prophet.

Taleb spends a lot of time in his book going over thepotential dangers of negative Black Swan events and how to avoid them, but healso points out that there are positive Black Swan events, and you shouldmaximize your exposure to these. For example, the explosive growth of both thepersonal computer market and the internet were both positive Black Swan eventsthat no one foresaw, had a massive impact, and were thought to be predictableonly after they happened.

Asprotection against negative events, Taleb developed his barbell strategy,where you ignore stocks in the middle, invest most of your assets in ultra-safeinvestments like T-bills, and then invest a small portion of your portfolio inassets that offer a huge payoff if they pan out, such as out-of-the-moneyoptions or very-small-cap stocks. This barbell strategy can protect you fromnegative Black Swan events while still giving you exposure to positive ones. Infact, Talebs hedge fund earned a massive return in 2008 using just such a strategy.