Made popular by his book “The Black Swan: The Impact Of The Highly Improbable” (Penguin, 2008), Nassim Nicholas Taleb, investor and Professor of Risk Engineering at New York University, is credited for cementing the term black swan into the vocabulary and minds of investors worldwide.
The historical reference of the black swan dates back centuries to when it was widely believed that all swans were white and that very idea of a black swan was utterly absurd. This belief was proven wrong when explorers actually discovered black swans in Australia. The parallel takeaway: unexpected surprises can – and do – occur at any time.
What is a Black Swan?
Black swan or black swan events describe rare events that are hard-to-predict, come as a shock, have a large impact on society, history, technology, and finance. Black swan events are often accompanied by the human reaction of after-the-fact rationalization that they were, in hindsight, predictable.
Black swan events can be either good or bad. An example of a good black swan event would be the development of the smartphone, while an example of a bad black swan event would be the Viet Nam War or the events of 9/11. Other bad black swan events include natural disasters such as El Nino that cannot be measured using scientific methods.
See our recent post on the black swan event of Donald Trump’s run for president.
Taleb claims that people develop a “collective blindness” to these events, though by their nature of being outliers, they are dangerous. No computer program can forecast it.
Fearful of further losses following the 2007-2009 financial crisis many investors began to seriously think about how they could protect their portfolio against another possible black swan event as well as how they could use these downturns as potential profit opportunities.
This demand gave rise to several special investment products designed to capitalize on black swan-related market declines. Money management firms began offering institutional investors an array of tactical asset allocation funds, absolute return funds, long/short funds, tail risk strategies, option hedging strategies, and other black swan strategies, which subsequently became more accessible to individual investors.
And while it remains difficult to hedge out the risks of unknown events, investors can take an important and logical step to help protect their portfolio – by using diversification.
Portfolio diversification as protection against black swan events
The goal of diversification is to maximize portfolio returns through investment in different places, sectors, or countries, and using different financial instruments that would each react differently to the same event.
One way to introduce diversification into a portfolio is through managed futures. Managed futures are specifically designed to make money in both up and down markets and their performance is not dependent on the business cycles. Some of the best years for managed futures have occurred during bear markets or recessions.
Managed futures can be used to invest in global volatility tied to black swan events; from a plunge in crude oil prices as a result of natural disasters to the volatility of currency prices related to major global political events.
While diversification does not guarantee against loss, it is the most crucial component of reaching long-term financial goals while minimizing risk against unknown events.
Black swans are inevitabilities that cannot be forecasted with even the most complex computer model; they are events outside of any investor’s control. However, preparing and protecting a portfolio against wild market swings that result from black swan events – and even profiting from these events – IS within an investor’s control.
For more information on how you can help protect your portfolio from black swan events using diversification and managed futures, visit RMB Group at www.rmbgroup.com.
The RMB Group
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