Black Swan Event - How to Guard Against it

Building a robust portfolio from savings to live a comfortable post-retirement life, or to even help you retire early, is one of the key objectives for every individual. Savings can be increased through two routes: by boosting your income or moderating your expenditure.
But sometimes, no amount of savings is enough to tide you through unpredictable situations – situations that have an immensely adverse impact on your investment portfolio.

What is a Black Swan event?

A Black Swan event refers to an occurrence that is extremely hard to predict, or an outlier, and one that normally has a huge negative impact.
 

The Black Swan theory was popularised by Nassim Nicholas Taleb, a former derivates trader, first in his 2001 book ‘Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets’ and then in ‘The Black Swan: The Impact of the Highly Improbable’ in 2007. The latter was picked by British newspaper The Sunday Times as one of the 12 most influential books since the second world war.
 

A black swan – the bird – in itself is not a rare bird. It is a type of swan that is native to Australia and is a symbol of the region of Western Australia. However, the use of the phrase to describe something rare dates back nearly two thousand years to the Roman empire when it was thought that such a bird did not exist.
 

The notion of a black swan being a non-existent creature remained true as recently as 16th century England. It was finally in the late 1600s that Europeans became aware of a black swan.
 

Was the COVID pandemic a Black Swan event?

The most recent example of a Black Swan event is the COVID-19 pandemic. A virus that broke out in a province of China very quickly spread across the world with such deadliness that governments were quickly forced to shut down entire countries, bringing economic activity to a standstill.
 

The prevent a total an utter economic collapse because of the nationwide shutdowns, governments and central banks around the world had to take drastic measures. And while these measures helped somewhat, they did not provide complete insulation. The S&P 500, for instance, was down a third by the last week of March 2020 after hitting an all-time high on February 19. As such, stock market investments were hit significantly and investors’ portfolios would have lost a lot of money.
 

Are Black Swan events becoming more frequent?

The COVID pandemic has been widely described as a once-in-a-century event, with the last such comparable incident being the influenza outbreak of 1918. However, Black Swan events that have a huge negative impact on economies and financial markets across the world have been occurring rather regularly in recent years.
 

Before COVID, the Global Financial Crisis of 2008 had a huge impact on asset valuations across the world. Then there was the attack on the World Trade Centre on September 11, 2001. Not much before that was the bursting of the so-called dot-com bubble, the Asian financial crisis of 1997, and Black Monday in 1987, when global stock market losses were in trillions of dollars.
 

More recently, Russia’s invasion of Ukraine in February 2022 has also been likened to a Black Swan event given its impact on global supply chains and commodity prices. Wars, after all, are not a normal event.
 

Is your portfolio safe from Black Swan events?

Preparing for a Black Swan event and its consequences on your investment portfolio is inherently difficult. After all, these events cannot be predicted and can originate in any corner of the world. They could impact one asset class or just a few or several of them. Interest rates could be raised or reduced to tackle their economic consequences.
 

How does one even go about preparing a portfolio that is resistant to a global macroeconomic disaster when one does not know what sort of a catastrophe it will be and when it will hit?
 

Thankfully, two of the most important aspects of financial planning go a long way in de-risking your portfolio against Black Swan events. The first is building a contingency fund made up of liquid assets. Such a fund, be it equal to six months of your expenses or a year’s worth, will be largely indifferent to what is happening in the broader financial markets. Imagine Rs 5 lakh deposited in your savings bank account. While the rate of return on these funds will be fairly low compared to other investments, it will remain protected even in the unlikeliest of events – the bank going bankrupt. Why? Because funds up to Rs 5 lakh in a savings account is insured in India by the Deposit Insurance and Credit Guarantee Corporation.
 

A second and well-known method to make your portfolio robust to risks is to diversify your investments across asset classes and sectors. This reduces vulnerability to volatile financial markets and any particular category of instrument at any given point in time.
 

Is portfolio diversification the only solution? 

Diversifying your portfolio is the easiest way to reduce its vulnerability, although it is not guaranteed to prevent losses.
 

The extent of diversification can also vary from person to person. Some may go as far as investing internationally, which is an example of geographical diversification.
 

However, more sophisticated investors can opt to ‘hedge’ their portfolios. Of course, a well-diversified portfolio acts as a natural hedge as its various components behave counter to each other and respond differently to changes in economic situations. For example, if an unexpected crash in US demand forces the Federal Reserve to resort to a heavily easy monetary policy that weakens the US dollar and hurts the performance of an individual’s dollar-denominated investments, the gold component of the portfolio could provide a cushion by providing higher returns in such a situation.

But more active hedging techniques, such as put and call options to protect long or short position, can also be used. However, only those who are well-versed in the workings of these derivatives and the financial markets should participate in them.