Do you know how to protect your portfolio from black swan events? They’re extremely rare, unpredictable, and severe, with consequences sweeping the globe. With widespread impact, a black swan is an unforeseen event beyond what is typically expected. Undoubtedly, Black Swan events can cause catastrophic damage to an economy.
And our inability to predict black swans matters because they can catch us off guard with their severe consequences. That’s why you must know how to protect your portfolio from Black Swan events.
Table of Contents
- Black Swan Events Introduction
- Examples Black Swan Events
- How Do People Prepare for Black Swan Events?
Black Swan Events Introduction
Is there a way to protect your portfolio from black swan events? An unforeseen occurrence, like a black swan, can damage our retirement portfolios and 401Ks, among other things. The best thing you could do is learn support and resistance to protect your portfolio or find an adviser who knows how to read stock charts.
What Exactly Is a Black Swan Event?
Coined by Nicholas Taleb, an economics professor, writer, and former trader, a Black Swan is an unexpected event that shocks the world with its impact and magnitude.
Black Swans rock the world to its core, stripping its occupants of their identity and leaving them uncertain of their next move. Shortly after, fear and panic set in, and the stock market crumbles.
One doesn’t have to look too far back in history for examples of Black Swan events. Classic black swan events include the 9/11 attacks, floods, droughts, and epidemics.
Take the Tsunami in Japan and the subsequent nuclear power plant accidents that followed. It can turn to swing trading on its head.
As a result, knowing how to protect your portfolio from black swan events is a good thing. Check out our trading service for more information.
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Examples Black Swan Events
Because events like this are improbable and unpredictable, humans develop a psychological bias or collective blindness towards them.
The very fact that we’ve developed a blindness to these rare but significant events makes them particularly dangerous.
For these reasons, we must always assume a black swan event is possible, whatever it may be, and plan accordingly. Our online trading courses give you the knowledge to trade in any market. One of the most recent examples of Black Swans in the market was the 2008 crash of the U.S. housing market. On Sept. 29/08, the Dow Jones Industrial Average fell 777.68%. Until March 16, 20,20, this was the largest single-day loss in Dow Jones history.
To make a long story short, it was a housing bubble. First, too many people took on loans and mortgages they couldn’t afford. Next, credit was extended to unqualified borrowers, which caused an increase in housing prices, the bubble burst, and houses came crashing down.
The time between late 2007 and mid-2009 was widely referred to as the “Great Recession,” It was the most significant economic slowdown since the Great Depression.
We saw the economy losing nearly 8.7 million jobs, with consumers cutting spending to a level not seen since World War II. Many experienced a rapid decline in retirement savings, on average, $100,000 per household, compounding unemployment and housing instability.
Unfortunately, those heavily invested in real estate and stocks saw the most significant losses to their portfolio.
1. Hyperinflation in Zimbabwe
In 2008, Zimbabwe had the worst case of hyperinflation in the 21st century. At this time, their peak inflation rate was more than 79.6 billion percent.
Not only is this inflation level nearly impossible to predict, but it can also easily weaken a country financially. Stock trading can come to a halt if a country is weakened financially.
2. The Dot-Com Bubble of 2001
The dot-com or Internet bubble of 2001 is another black swan event similar to the 2008 financial crisis.
During this time, America was enjoying rapid economic growth and increases in private wealth before the economy catastrophically collapsed.
Because the Internet was in its infancy, various investment funds invested in technology companies with inflated valuations and no market foothold.
Unfortunately, when these companies folded, their funds were battered, and the downside risk was passed on to the investors.
What resulted was a catastrophic collapse of the economy. And because the digital frontier was new, the collapse was nearly impossible to predict.
3. The COVID-19 Pandemic
Fears of the coronavirus disguised as a Black Swan Event have sparked panic in U.S. markets and abroad.
Until March 12, the 2,353-point drop in the Dow Jones was the worst single-day drop in history. That was until March 16, when the Dow fell 2,997.10 points.
These were the worst trading days in percentage terms since the “Black Monday” crash of 1987 when the Dow got a 22 percent haircut.
We’ve been discussing how to trade this in our live trading room. Sometimes, you need all the help you can get in such events.
How Do People Prepare for Black Swan Events?
- Here are some steps on how people prepare for black swan events:
- Map out supply chains and their risks.
- The unpredictability of Black Swans around the world.
- This means global companies can be vulnerable.
- Invest in safe havens like precious metals.
- Move your account to cash.
- Look for any sectors that are moving.
- Learn how to trade bearishly, like short selling, options puts, and spreads.
1. Diversify Your Portfolio
Because Black Swans are nearly impossible to predict, it’s essential to diversify your investments and spread your risk.
Diversification isn’t just a matter of holding numerous investments but investments that move independently or opposite from one another.
I am not a financial adviser, but one of the easiest ways to diversify your portfolio is with asset allocation funds.
In short, these are funds with a predetermined mix of stocks and bonds. A 60/40 fund, for instance, will maintain a 60% stock to 40% bonds or cash allocation.
You can also invest in a mix of mutual funds or ETFs. Because diversification is a personal choice based on personal preferences, you should consult a financial planner.
2. Hedge Your Portfolio
Another option you have to protect your portfolio is through hedging. Luckily, we have several hedging strategies to reduce our downside risk.
For example, you can buy a call option on the stock to protect a short stock position. The reverse scenario is also true; you can buy a put option on the stock to protect a long position.
Our old friends, re-balancing, ongoing monitoring, diversification, hedging, and so on, are less likely to let us down than models that are incapable of considering everything.
This should help smooth the curve if there is a sharp decline in stocks and help your portfolio weather the storm.
3. A Side Note For Day Traders
I am willing to bet money that most of you have never read the fine print in your broker’s terms and conditions. For the most part, it usually says something along these lines:
A regular stop loss will not always protect you, nor does it eliminate all trading risks. In most cases, when the price reaches your stop loss, your order is closed.
However, in case of slippage and price gaps, the amount your stop-loss is executed can be substantially worse than your actual stop-loss order.
Put in layman’s terms, it means that under ‘normal’ circumstances, your stop-loss order will work just fine. Unfortunately, when unexpected news or events happen, your broker can’t guarantee that your stop loss will be executed at the price you set.
During Black Swan events, it is likely and almost guaranteed that your stop-loss order will be executed after the trade has wiped out your whole account.
In some cases, you can end up owing your broker money. This is another reason why reading the fine print of the terms is so important.
On the plus side, some brokers offer guaranteed stop-loss orders. In these situations, they will always execute your order at the price you set it to. I suggest reading the fine print and picking a broker to give you a guaranteed stop-loss order.
You might say that such Black Swan events are infrequent, and you are right. But even to be on the wrong side of such an event once is one time too many.
In your trading career, such events are likely to happen, not only once. During times like these, exposure to such stock market shocks can lead to losses that wipe out a good portion of your portfolio.
For these reasons, protecting your trading capital and savings is important.