The black swan theory and Silicon Valley Bank: everything that investors can’t foresee, but should consider
The black swan theory is a concept proposed by the Lebanese-born financial writer and researcher Nassim Nicholas Taleb that describes rare and unpredictable events that have a major socio-economic impact.
The term “black swan,” used to designate these events, comes from a 17th-century historical fact. At that time, Europeans were only familiar with white swans, but on exploratory expeditions to Australia they discovered the first black swans, a variety considered non-existent up to that point.
The theory argues that, although certain events are unknown and unpredictable, they can have significant social, political, and economic consequences and should therefore be considered in decision-making.
The market response to such events is usually panic, as Alberto Matellán, chief economist at MAPFRE Inversión, explains. “Investors sell positions and flock to the safest assets, which are traditionally cash and US or German treasuries. This explains why, in the presence of black swans, there are near vertical price declines in things like equities,” he says.
This is what’s happened, for example, with the bankruptcy of the Silicon Valley Bank (SVB), which is causing sharp falls in stock markets on both sides of the Atlantic, with fears spreading that the ghosts of the 2008 financial crisis have returned to haunt us through contagion in the rest of the sector. As a result, the Federal Reserve (Fed) has had to launch an emergency funding plan for US banking.
For an event to be considered a “black swan,” it must meet the following characteristics:
- It must be unexpected
The event cannot be something foreseen by analysts or something that has happened before. It must be improbable, meaning there is no evidence that it will happen and that it will surprise analysts and the market. If there were any likelihood of it happening, financial agents would take steps to protect themselves, so it would not take the market by surprise.
- It must have a major impact
The event must have a significant influence on the world economy or world politics.
- It is predictable in retrospect
After the event occurs, there must have been factors or signs that could have been used to foresee the event. However, these signs were not evident before the event occurred, and they can only be identified after the fact.
In these situations, the chief economist at MAPFRE Inversión insists that people should avoid panicking and should analyze the impact of the black swan event — which is often not as acute and long-lasting in markets as it can be at other levels — with a “clear head.” “In the long run, the investor who holds the position, in most cases, ends up better off than the one who sells. The latter, in order to improve their position, should look to buy right at the minimum,” he points out.
21st century black swans
The past 23 years have seen major events (generally negative) that have changed history and the political and economic trajectory of the world. All of them share a factor of surprise in that no one expected them to shake our society to its core:
- September 11, 2001, when a terrorist group hijacked several planes and crashed them into the Twin Towers in New York, an unanticipated event that changed the course of history.
- The global financial crisis of 2008, which had a massive impact on the world economy and took many experts by surprise.
- The COVID-19 pandemic, which emerged suddenly in 2019 and spread rapidly around the world, causing enormous damage to public health and the global economy.
Will it ever become possible to predict these events?
Scientists at Stanford University have developed a method to anticipate black swan phenomena, which can be used in different fields: economics, politics, health, etc.
After examining long-term data from three ecosystems, the scientists found that variations in different biological species are statistically equivalent. This finding suggests that there are universal processes that anticipate such extreme events. The effects they have on the markets and share prices may be more difficult to predict.
In any case, Matellán stresses that investors almost always need to have a part of their portfolio earmarked for protection, which can be smaller or larger depending on each investor. Despite this, he warns that this can be “costly” in monetary terms if done with derivatives and is almost always so in terms of psychological effects or incentives.
“Highly prudent investors undoubtedly see how, when times are good, others do better, which often leaves them under pressure to increase their appetite for risk,” he says.
On the other hand, there are also portfolios that bet directly on black swans. According to Taleb’s theory, since black swans reliably occur from time to time despite being unpredictable, they are “a way to make a lot of money quickly.”
This strategy requires a lot of financial and — most of all — psychological strength, since it is based on taking many small, constant losses in order to make “a huge profit” at some point down the road.
“In any case, for the average investor, the risk of black swans is combated in two ways: the first is to save regularly, as this allows you not only to have a more stable investment track record, but also to cushion the blows of any downturn, black swan or not; the second is professional advice, as this is the only way to ensure that the risk profile of the portfolio is best for each investor,” concludes Matellán.