If you asked someone six years ago what a "Black Swan" was, they would likely look at you a little funny and say, "It's a swan that's black… assuming there is such a thing." I likely would have said the same thing. However, since Nassim Nicholas Taleb's book by that name came out in 2007, the term has entered the popular lexicon—at least in the financial field.
A Black Swan is an event that occurs very rarely and is difficult to predict. As a result, it catches people off guard, and often has drastic and dire consequences. Black Swans actually happen more frequently than we realize. The Japanese tsunami and Hurricane Katrina are two examples we can point to in a non-financial sense that were catastrophic and, to some extent, unpredictable. However, to those who study these types of events, it really shouldn't have been shocking that a large tsunami would hit Japan at some point or that a hurricane would travel through the Gulf of Mexico and hit Louisiana. These are events that may not be predictable from a timing point of view, but we can be fairly certain that they will happen again at some point. With enough accurate data, we can even create a loose framework of how often an event will occur within a longer period of time.
Moving to a financial context, an example of a Black Swan would be another huge crash in the stock market. We don't know when it will happen, but it's very likely that it will happen again in our lifetime—maybe even a few more times. Another thing to consider is that, not unlike earthquakes, the longer the period of time between these events, the more severe they likely will be!
So what should you do with the knowledge that at some point the stock markets could potentially plunge 20%, 30%, 40% or even 50% like in 2008/2009? The obvious answer is that you should protect yourself… but how?
Unfortunately, most financial pundits talk about the day's "hot stocks" or "hot sectors" to the neglect of one of the most important factors when it comes to investing—asset allocation. More than 90% of the volatility (risk) of your portfolio's return is based on its asset allocation. If your portfolio was entirely invested in stocks during the market crash of 2008/2009, then its value was likely down about 50%. If it was all invested in bonds, it was most likely actually up in value. If it was all invested in commodities, it was down, but not as much as if it was all invested in equities. As you can see, it's important to make sure your asset allocation is correct before a Black Swan hits.
As a financial advisor, one of the most important things I do is ensure my clients are suitably protected against financial volatility, given their life goals and risk tolerance. This is not to say that organizing our clients' financial lives and showing them how to save on their taxes isn't important. It is, but a well-balanced portfolio is clearly one of the fundamentals of a good financial plan!
In a future post, I'll be covering asset allocation in more detail, including how to make sure you have the right allocation to match your goals. Come back soon.