The 3 Biggest Black Swans in Investing History

November 15, 2021

You can’t predict a black swan event—any more than Western ornithologists could have predicted the existence of black swans before Australia was colonized and the first black birds were discovered. But even if you’re in a relatively stable financial position, a black swan event can have catastrophic long-term impacts on your finances.

And if you’re not planning ahead, the consequences are even worse.

Here’s a look at some of the biggest black swans in investing history, what we can learn from the psychology of black swan theory, and how you can insulate your portfolio against the future.

What is a Black Swan Event?

A black swan is an event that goes well beyond what is normally expected of a situation and has potentially severe long-term consequences. Black swan events have three characteristics:

  1. The event is unpredictable
  2. The event has severe widespread consequences
  3. Afterward, people will rationalize the event as predictable (hindsight bias)

In other words, because black swans are so rare, they’re impossible to predict using normal statistical tools like a normal distribution. Such tools rely on large data sets (prior data would not exist for a black swan), and black swans are outliers that would likely be discarded anyway. Part of the problem is that we tend to statistically extrapolate based on observations of past events, which leaves us even more vulnerable to black swans.

Black Swan Theory, Human Behavior, and the Implications for Markets

This isn’t just an individual’s behavior. It’s a market-wide behavior, and it leaves entire systems vulnerable to black swans.

The reality is that humans are highly pattern-oriented. It’s how we make sense of an overwhelming world. But in the case of black swans, it leads us to believe that something could never happen simply because it has never happened before. And because we assume that something could never happen, we make market-wide decisions as though it won’t.

So when that seemingly impossible event happens, we’re completely unprepared for it, and the consequences are dire.

The Biggest Black Swans in History

To see this effect in action, it helps to take a look back at some of the major black swan events that shaped history.

The Asian Financial Crisis

The 1997 Asian Financial Crisis was a sequence of currency devaluations that kicked off in the summer of 1997 and spread across several Asian markets. It began on July 2, 1997, when the Thai government ran out of foreign currency. Since the government could no longer support the exchange rate (previously tied to the U.S. dollar) the government was forced to float the Thai baht. The exchange rate collapsed almost immediately. Two weeks later, the Philippine peso and Indonesian rupiah suffered similar devaluations, and the crisis spread across Asia.

As a result, Asian currencies plummeted by as much as 38%, and international stocks took a 60% nosedive. The International Monetary Fund and the World Bank stemmed some of the fallout, but the crisis still spread to the U.S., Europe, and Russia.

The causes are disputable, but one of the commonly cited culprits is the collapse of the hot money bubble. In the late 1980s and early 1990s, many South Asian countries achieved massive economic growth (8% to 12% GDP growth). They achieved this effect with high interest rates and fixed currency exchanges pegged to the U.S. dollar to attract hot money. However, that policy left corporations and the capital market exposed to foreign exchange risk.

The results were felt globally. For one thing, there were massive political repercussions, including anti-Western sentiment in Asia and international reluctance to invest in developing countries.

The Dotcom Bubble

The Dotcom Bubble was a rapid rise in U.S. stock equity valuations for Internet-based companies thanks to rapid growth in the 1980s and 1990s. The NASDAQ Composite Index, closely associated with the bubble, rose 582% from January 1995 to March 2000.

Unfortunately, many of these companies later failed, and many of them were significantly overvalued. So when several online and technology entities declared bankruptcy or faced liquidation, the NASDAQ tumbled 75% from March 2000 to October 2002.

Essentially, many of these companies didn’t have viable business models, but were involved in a high-growth industry that attracted interest from venture capital firms who didn’t do sufficient company analysis, industry analysis, or market trend analysis. Between the abundance of capital and the overwhelming media frenzy, companies were massively overvalued.

One result, among many others, was a sharp decline in the concept of investment of expectation, as well a crackdown on due diligence requirements.

The Great Recession

One of the biggest black swans in recent memory is, of course, the Great Recession. The Great Recession was a sharp decline in economic activity in the late 2000s, representing the single largest economic downturn since the Great Depression.

The trouble sprang from festering issues after the rebound from the Dotcom Crash. Employment rates were high, inflation rates were low, and financial institutions fell into financial complacency, making easy money available to individuals and businesses across the board. A big part of the problem was a significant relaxation on the standards for mortgage qualification, allowing individuals with poor or nonexistent credit to qualify for homes far beyond their ability to pay.

Once subprime mortgages began to default by the bucketful, lending giants buckled and crumbled without any income streams to replace all the loans they’d approved. In total, $10 trillion was wiped out of global equity markets.

As for the consequences, governments and consumers are still seeing the results in action. Governments cracked down on financial regulation, particularly guidelines on how much debt an institution could take on. At a cultural level, consumers now eye financial institutions with more distrust than ever, and millennial investors tend toward conservatism (having grown up in a world where everything their parents built vanished into thin air).

Investing to Protect Against the Future

What do these events teach us? In short, if you fail to plan ahead for catastrophes, you won’t insulate yourself against future market failure. Investing has to account for all sides, including the worst possible outcome, in order to protect against the eventualities of the future.

This is where alternatives can help insulate against the ebbs and flows of the market. And here at Masterworks, we’re on a mission to make blue-chip art investing accessible to regular investors like you so that you can hedge your portfolio against the market. Ready to get started? Fill out your membership application today to learn more.

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