Investing Using the Black Swan Theory

In 2004, the author and thinker Nassim Nicolas Taleb published a book called "Fooled By Randomness", in which he identified certain events as Black Swan events.
These events are loosely defined as something that is so rare and unpredictable that no one is prepared for it. There are actually three components to a true Black Swan event, as Taleb outlines:

"What we call here a Black Swan (and capitalize it) is an event with the following three attributes. First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme 'impact'. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable."  -Nassim Nicolas Taleb

Examples

A perfect example of a Black Swan is the 2001 terrorist attack on the United States. This event was completely unpredictable, impacted millions of people, and, in hindsight, many people rationalized that it *should have been* predicted based on known factors.

In financial terms, a terrific example of a recent Black Swan event is the 2008-2009 recession based on the housing collapse. While a very few hedge funds reliably predicted the disaster, the majorit of investment advisors, credit rating agencies, and government officials were all taken completely by surprise.

A Black Swan event can be either positive or negative, depending where you are standing. For example, if you suddenly won the Publisher’s Clearing House sweepstakes, that would likely be hugely beneficial for you.

On the other hand, you may have seen much of your home value disappear during the housing crash and recession. That was an extremely negative Black Swan event for millions of people, as they watched their hard-earned equity go up in a puff of smoke.

Prediction

Black Swan events are, by their very definition and nature, pretty much impossible to predict, so it’s not easy to invest utilizing this theory.

A couple of scenarios do come to mind, however.

Perhaps you know of a company that is doing well in the stock market, that is very popular with investors, and whose share price is relatively high. Perhaps you believe that something very bad will be happening to that company – its accounting is fraudulent, or its “wonder product” will turn out to be far from wonderful. In that case, you could either sell the stock short, or take out put options contracts on the company. In either of those scenarios, if the price of the company falls precipitously, you will make a lot of money.

A second way to profit from a Black Swan event is by investing in a small start-up, getting in when the stock sells for very little, and then waiting until the company gets acquired by a larger company. In a case like that, the value of your shares could double or triple overnight. Again, options could be useful in this scenario, because using the leverage inherent in an options transaction magnifies the potential gain.

Biotech and pharmaceutical companies are fertile hunting ground for Black Swan events. A small biotech company with one product in the pipeline can explode in value if they announce excellent clinical trial results, or if the FDA approves their drug.

A website named Intrade.com offers what is called a prediction market. You can actually place bets on whether certain events will or will not happen, and you can make money (or lose it) based on those bets. Right now you can bet on the winners of the Academy Awards, and who will be elected the next Pope. There is actually a huge range of events you can bet on, including climate and weather, earthquakes, political events, and all kinds of other situations.

The problem with most investing based on Black Swan theory is that, even if you are right on the fact that something will happen, your timing may be wrong. Even if you believe 100% that a certain company will have to declare bankruptcy and its stock will be worthless, you may not be right on the timing and you may end up losing your money as your options expire worthless or your short position goes so badly against you that you hit a margin call.

If you want to try to make a killing on a Black Swan event, be sure to limit your losses, and to allow such risky trades to comprise only a small part of your overall portfolio.