What are Black Swan events and how to be prepared?

article by CryptoJelleNL

If you have been trading financial markets for any meaningful time, you will have probably heard the term "black swan event". Even though the name suggests as much, it has nothing to do with the animal. In fact, it is used to describe an unexpected event that significantly affects the markets. In this article, we dive into black swan events, history, and how you can protect yourself against them.

What is a Black Swan event?

In simple terms, a black swan event is a surprise event with significant - often negative - impact. The inventor of the term, a well known economist by the name of Nassim Nicholas Taleb, described the black swan with three key components: it has to be rare, have an extreme impact, and should be relatively obvious in hindsight.

A great example of this was how the markets reacted to the outbreak of the COVID pandemic. It took quite a while for the markets to price in the severity of the crisis, even though the virus had already spread significantly.

Black swan events are not limited to health crises though. For example, the sudden collapse of FTX is another great example of a black swan event, although this event was limited to crypto markets alone.

Why do Black Swan events happen?

Because of the unpredictability of a black swan event, the market tends to react aggressively when unexpected catastrophic news hits. As discussed, the black swan has three components:

• It is rare, or unlikely: Because of the rarity of such an event, market participants are caught by surprise - which induces emotional decision making.
• It has an extreme impact: To further the emotional reaction to the news, it should have an extreme impact, with clear consequences. The magnitude of extremity is often similar to the outbreak of a war, the collapse of a major bank, or natural disasters.
• It is easy to "predict" after the fact: Even though everyone is caught by surprise by a black swan event, a lot of market participants will rationalise the event after the fact. This is why black swan events rarely repeat - as the market will see the event coming.

All in all, the combination of rarity and extremity causes significant volatility in the markets. For example, the COVID-outbreak pushed the price of Bitcoin down by over 60 percent in less than a month. Extreme.

History of the term Black Swan event

While Nassim Nicholas Taleb popularized the term in the investing world, the idea of a black swan far predates his birth. It can be traced back all the way to the Roman empire, where a poet by the name of Juvenal wrote something as "a rare bird in the lands, and very much like a black swan" – note that back then, the people of Rome had never seen a black swan. They believed the animal did not exist.

Nevertheless, it was not until 2007 that Taleb brought the idea to markets, through his book "The Black Swan: The Impact of Highly Improbable".

In his book, Taleb also mentions several examples of black swan events:

• The rise of the internet
• The invention of the personal computer
• The September 11, 2001 attacks
• The fall of the Berlin Wall

Examples of past crypto Black Swan events

The most notorious and memorable crypto black swan was the sudden collapse of FTX, after the exchanges allegedly used user funds to take directional trades. When the news broke, users rushed to withdraw capital from the exchange, and markets crashed. To this day, FTX still owes billions of dollars to its users.

Another notable event was the collapse of Luna in May 2022. After a whale sold a large amount of UST, the capital pool that existed to ensure the stability of the stablecoin was drained, resulting in the depeg of UST. This caused a chain-reaction, which in the end resulted in the total demise of Luna, and a significant drop in Bitcoin prices as well.

How to prepare for Black Swan events?

Attentive readers will note that preparing for a black swan event is an oxymoron of sorts. After all, you cannot predict a black swan event. Nevertheless, there are a few strategies that can help you be prepared for the worst events.

One of these strategies is to use diversification to your advantage. By spreading your investment across multiple markets and instruments reduces the impact of adverse events on your portfolio. For example, the crash of Luna would affect you far less, if you had exposure to stocks as well.

Another popular strategy is to always have a portion of your portfolio available to react to such events. By keeping - for example - 10% of your portfolio in cash, you will be able to buy the dip on these significant crashes, allowing you to profit from the emotions of others. Sounds ruthless, but such is the way of the market.

Finally, it is important to remember that black swans rarely wipe out a market as a whole. Investors with a long time horizon often decide to hold through the carnage of a black swan, and wait for the recovery that follows.

For example, the collapse of Luna was still isolated to Luna, as the rest of the crypto markets eventually recovered. This brings us back to diversification - because if you were fully exposed to Luna, that black swan event would have completely wiped your portfolio.

Closing thoughts

Black swan events can be overwhelming and cause your portfolio to lose a lot of its value. Nevertheless, it is crucial to keep a level head, and to stay positive. The way you deal with the situation decides whether you survive the storm, or end up as one of the victims.

Understanding black swans, and why they happen is a great first step towards being prepared for them. To prepare for these hard-to-predict, catastrophic events, traders should exercise solid risk management, diversify across multiple markets, and always keep a portion of their portfolio in cash, to capitalize on the opportunity.

Good luck!

Author's Disclaimer: This article is based on my limited knowledge and experience. It has been written for informational purposes only. It should not be construed as trading or investment advice in any shape or form.

Editor's note: CryptoJelleNL provides insights into the cryptocurrency industry. He has been actively participating in financial markets for over 5 years, primarily focusing on long-term investments in both the stock market and crypto. While he watches the returns of those investments roll in, he writes articles for multiple platforms. From now on, he will be contributing his insights for Alpha Circle as well.

Check out his twitter: twitter.com/cryptojellenl

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