A Black Swan event is a once-in-a-lifetime occurrence in human history that was unprecedented and unforeseen at the time. Domain experts (and, in rare situations, laypeople) can usually conclude: “that was bound to happen” after assessing the surrounding context. Even if certain variables differ (such as the event’s timing, location, or precise type), similar occurrences are likely to have had similar outcomes in the past.
The moniker “Black Swan” comes from the (Western) notion that all swans are white because they are the only ones that have been identified. Willem van Vlamingh, a Dutch explorer, spotted black swans in Australia in 1697.
This was a once-in-a-lifetime (scientific) occurrence that forever altered zoology. Following the discovery of the black swan, it seemed logical that black swans must exist, just as other creatures of all hues were known to exist. In retrospect, the surrounding context (i.e., observations about other animals) seemed to infer the Black Swan hypothesis, which was later confirmed by empirical evidence.
Nassim Nicholas Taleb first proposed the hypothesis of Black Swan events in 2007. Wikipedia and Black Swans Explained both have more information.
Detecting and analyzing Black Swan events can help us understand why certain events occur repeatedly throughout history and what impacts they have.
Vital Points
- Black swans are highly unusual occurrences that frequently have significant negative implications.
- A black swan occurrence cannot be foreseen in advance, although it may become clear after the fact.
- Standard forecasting methods and investment models can both fail to foresee black swans and enhance vulnerability to them by spreading risk and providing false security.
Backstory
The term “black swan” is derived from a Latin idiom; the earliest recorded use is in the 2nd-century Roman poet Juvenal’s description of something being “rare avis in terris nigroque simillima cygno” in his Satire VI (“a rare bird in the lands and very much like a black swan”). The black swan was thought to be extinct at the time the phrase was developed. The metaphor’s significance stems from its comparison to the frailty of any system of thought. When one of the essential postulates of a set of conclusions is invalidated, the entire set of conclusions can be thrown out. The sight of a single black swan in this situation would be the undoing of any system of thought’s logic, as well as any reasoning that resulted from that logic.
In 16th century London, Juvenal’s remark was used as a proclamation of impossibility. The Old World assumption that all swans must be white stems from the fact that all ancient chronicles of swans said that they had white feathers. A black swan was either impossible or non-existent in that environment.
In Western Australia, however, Dutch explorers headed by Willem de Vlamingh became the first Europeans to encounter black swans in 1697. The term was eventually repurposed to refer to the potential of a seeming impossibility being disproven. According to Taleb, in the 19th century, John Stuart Mill coined the term “black swan logical error” to describe falsification.
Nassim Nicholas Taleb discussed black swan events in his 2001 book Fooled By Randomness, which was about financial events. His book The Black Swan, published in 2007, expanded on the metaphor to include occurrences outside of the financial markets. Almost all great scientific breakthroughs, historical events, and creative achievements, according to Taleb, are “black swans”—unpredicted and undirected. As instances of black swan occurrences, he cites the advent of the Internet, the personal computer, World War I, the breakup of the Soviet Union, and the September 11, 2001 assaults.
Bottom Line
It is possible to predict financial markets, but their accuracy is as much a function of luck and intuition as it is of talent and sophisticated models. Too many black swan events can occur, rendering even the most sophisticated models useless. This isn’t to say that modeling and forecasting can’t or shouldn’t be done. However, we must also rely on instinct, common sense, and simplicity.
Furthermore, investment portfolios should be designed to be as crisis- and black-swan-proof as possible. Diversification, continuous monitoring, rebalancing, and other tried-and-true methods are less likely to fail us than models that are inherently incapable of taking everything into consideration. In fact, the most reliable prediction is that, at least in part, the future will continue to be a mystery.
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