What is a “Black Swan” event and how could it affect your retirement plans?
“Go ask your portfolio manager for his definition of “risk,” and the odds are that he will supply you with a measure that excludes the possibility of the Black Swan-hence one that has no better predictive value for assessing the total risks than astrology (we will see how they dress up the intellectual fraud with mathematics).”– Nassim Nicholas Taleb, author.
In his bestselling book, “The Black Swan: The Impact of the Highly Improbable,” former Wall Street trader and author Nassim Nicholas Taub describes what has become known as “Black Swan Theory.” Taleb observed that “the cycles of risk-taking in the economy as following a pattern: stability and absence of crises encourage risk-taking, complacency, and lowered awareness of the possibility of problems.”
As defined by Taleb, black swans are occurrences that no one could have possibly predicted. They can turn out to be positive in some cases. However, many times, these dramatic events are catalysts for severe economic downturns. Some black swan events have resulted in the loss of billions of dollars in accumulated wealth. Black swan events that changed the course of history include the terrorist attacks of 9/11 and the Fukushima nuclear meltdown. These two occurrences were unanticipated, and both had a devastating impact on the global economy. Markets around the world tumbled. Millions who were getting ready to retire were shocked to see their portfolios lose as much as 50% of their value.
The “Dotcom” Crash of the early 2000s is another occurrence classified as a black swan. This crash was not exactly out of the blue since many economic experts had warned about overvalued dot.com stocks, but it had a devastating effect on the stock market. During that crash, nearly one trillion dollars worth of stock value evaporated. The NASDAQ lost 78% of its value!
The most recent example of a black swan event, one which triggered worldwide economic and social upheaval, was the financial crisis of 2008. This meltdown of world financial markets saw one of Wall Street’s oldest and most prestigious companies, Lehman Brothers, file for bankruptcy. Nearly 25,000 Lehman employees suddenly found themselves without work.
The problem with black swans is that when they are over, and life has returned to normal (more or less), hindsight bias takes hold. This bias leads many to believe that with more information and better analytics, we could have predicted the black swans. As Taleb points out, this is not the case. Black Swans are black swans because we never see them coming.
So, what does this mean for the average retiree or pre-retiree? How can you possibly prepare for the unknowable future? Does leaving Wall Street mean that you might miss a positive black swan event and the resulting unanticipated gains?
The best advice I have for safeguarding yourself is to acknowledge that they will happen. As is the case with earthquakes, tornadoes, and natural disasters, predicting black swans with any degree of certainty is impossible. What is certain, though, is that they will occur at least once in your lifetime.
When you acknowledge this fact, then you can look into your portfolio and begin the process of reducing your exposure to risk as much as possible. Reducing risk exposure is particularly critical if you are five years or less from retirement. Products and strategies exist that could potentially shield your wealth during a black swan event and help you sleep better at night.
