What Is a Black Swan Event?
Black Swan events are rare and unpredictable events that can pose a great threat to the health and security of the market. Trader Nassim Nicholas Taleb normalized the term via his book, The Black Swan. As mentioned Black Swan events can cause serious damage to the economy worldwide and even the use of extreme methods and prediction tools cannot prevent such an event. Additionally, those of which who rely on standard forecasting methods may fail to see an oncoming Black Swan event which subsequently increases vulnerability due to the false security a false prediction may give. To give one an idea of what a Black Swan event is examples may include the 911 bombings, World Wars, Natural Disasters, etc.
Understanding a Black Swan
Nassim first wrote about the idea of a Black Swan Event in 2007 prior to the 2008 market crash where he states that Black Swan events are virtually impossible to predict due to their rarity. Nassim describes Black Swan events as something that is explained and talked about as if they were predictable. However, Nassim recognizes that these events have substantial consequences as mentioned previously. He states that it is crucial for people to always be expecting the occurrence of a Black Swan event as a possibility as to prepare so that in the event one does occur you as an investor are prepared. One of the ways to be prepared can be via diversification which is the act of having investments in a large variety of stable assets as this offers financial protection if a Black Swan Event were to occur.
Nassim states that for Black Swan events standard applications of probability and prediction do not work due to their reliance on both large and previous sample sizes that do not apply to such rare events by its very definition. Even overestimating and using past events/statistics to predict when or if a Black Swan will occur does not work and can even make investors more vulnerable to them. Most of the time after Black Swan events we as a collective often look to explain said event and how we could have predicted it but in hindsight, this does not help us predict future Black Swan events.
What is a Black Swan Event in the Stock Market?
In the market, Black Swan events can be seen as a market crash that exceeds six standard deviations (Six Sigma) which makes it rare in hindsight. In addition to this some say that security prices will be fat-tailed or skewed and subsequently, Black Swans are more frequent than public information leads us to believe.
Why Do They Call it a Black Swan Event?
The reason these events are called Black Swans is simply the following. White Swans in the wilderness are quite common yet Black Swans are very rare therefore these events are referred to as Black Swans. However, some say the story goes that Black Swans were thought to never exist until one was found, leaving the precedent that something we thought to never exist or be extremely rare may be quite common.
What Is a Gray Swan Event?
Grey Swans are deviations of Black Swans that are rare but still more probable than Black Swans. However, unlike Black Swans, they can be better prepared for due to their lower rarity and rate of occurrence.