Do you know how to protect your portfolio from black swan events? They’re extremely rare, unpredictable, severe with consequences sweeping the globe. With widespread impact, a black swan is an unforeseen event that is beyond what is typically expected of a situation. Without a doubt, 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 it’s essential you know how to protect your portfolio from Black Swan events.
Table of Contents
- Do You Know How to Protect Your Portfolio From Black Swan Events?
- How Do People Prepare for Black Swan Events?
Do You Know How to Protect Your Portfolio From Black Swan Events?
- Is there a way to know how to protect your portfolio from black swan events? An unforeseen occurrence, like a black swan, can do a lot of damage to our retirement portfolios, 401Ks among other things. The best thing you could do is learn support and resistance to protect your portfolio, or make sure to find an adviser that 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 by both its impact and its magnitude.
Black Swans rock the world to its core, they strip its occupants of their identity, leaving them uncertain of their next move. Shortly after that, fear and panic sets in and the stock market crumbles in it’s wake.
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, or events such as floods, droughts and epidemics.
Take the Tsunami in Japan and the subsequent nuclear power plant accidents that followed. It can turn swing trading on it’s 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.
We Are Blind Towards Black Swans Happening
Because events like this are so 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 make 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%. Up until March 16 of 2020, this was the largest single-day loss in Dow Jones history.
To make a long story short, it was a housing bubble. First off, too many people were taking 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 the house came crashing down.
As a matter of fact, 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; which compounded unemployment and housing instability.
Unfortunately, it was those heavily invested in real estate and stocks saw the most significant losses to their portfolio.
Hyperinflation in Zimbabwe
Along the same token, 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 is nearly impossible to predict, but it can also easily cripple a country financially. Stock trading can come to a halt if a country is crippled financially.
The Dot-Com Bubble of 2001
The dot-com or Internet bubble of 2001 is another black swan event that has striking similarities 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 were investing in technology companies with inflated valuations and no market foothold.
Unfortunately, when these companies folded, their funds were walloped, 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.
The COVID-19 Pandemic
Fears of the coronavirus disguised as a Black Swan Event have sparked panic both in U.S. markets and abroad.
Up until March 12, the 2,353-point drop of the Dow Jones was the worst single-day drop in history. Well, that was until March 16, when the Dow fell 2,997.10 points.
These were the two 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 events like this.
How Do People Prepare for Black Swan Events?
- Here’s 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.
- The 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.
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 holding investments that move independently or opposite from one another.
I am by no means 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% socks 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 very personal preferences, you should consult with a financial planner.
Hedge Your Portfolio
Another option you have to protect your portfolio is through hedging. Luckily, we have several hedging strategies available to us to reduce our downside risk.
For example, to protect a short stock position, you can buy a call option on the stock. The reverse scenario is also true; to protect a long position, you can buy a put option on the stock.
Our old friends, re-balancing, ongoing monitoring, diversification, hedging, and so on, are less likely to let us down than models that are fundamentally incapable of taking everything into account.
This should help smooth the curve if there is a sharp decline in stocks and help your portfolio weather the storm.
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 protect you at all times, 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 laymen’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.
Suffice to say, 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. Which 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. My suggestion is to read the fine print and pick a broker that will 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 the course of your trading career, such events are likely to happen, and not only once. During times like these, being exposed to such stock market shocks can lead to losses that wipe out a good portion of your portfolio.
For these reasons, it’s important to take precautions to protect your trading capital and your savings.