Until they were discovered in Western Australia, black swans were mythical creatures, like unicorns.
The metaphor was applied by Nassim Taleb in his 2007 book The Black Swan: the impact of the highly improbable to describe events that are unexpected, significant and hard to predict.
Common parlance goes one step further and regards such events as impossible to predict, thereby providing a convenient excuse to investors who see the value of their portfolios plunge due to an abnormal event.
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On closer examination, however, the excuse wears thin.
The biggest crashes in recent history were foreseeable
Most so-called “black swan” events, it turns out, should have been obvious, were predicted in the public domain, or could be foreseen by those who had the right contacts.
For example, the pandemic caused global equity markets to drop by a quarter in early 2020. But if it was such a shock to the world, why are there so many epidemiologists? Why had the UK government organised the construction of a major vaccine manufacturing centre in Oxfordshire in 2018?
History and science fiction are full of pandemics; books of warning have been written; and Bill Gates lectured about the risk in 2014. And some took action at the time. Bill Ackman, manager of Pershing Square, bought protection for his portfolio in early 2020 when stories were surfacing but complacency reigned.
What about the “great financial crisis” of 2008 which caused equity markets to more than halve? In his book The Big Short, later turned into a film, Michael Lewis showed that there was a group of investors who knew exactly what was going on in the US housing market. They also knew the consequences for the financial securities financing it, for the banks behind the securities – and hence for the whole financial system.
At the time, few would have heard from or of these highly eccentric characters operating on the outer fringes of financial markets. Most of us, however, were well aware that holes were regularly appearing in bank balance sheets which had to be filled by emergency fund-raising – notably the Bank of England’s rescue of Northern Rock in September 2007, shortly before Wall Street hit its peak. Some of us even worried about what would happen if investors stopped plugging the holes.
What we didn’t foresee was the chain reaction which spread through the financial system, the fallibility of central banks and governments, and the political fall-out. There was a mass of evidence of serious problems but we assumed it would somehow be sorted out benignly.
Market bubbles and busts – was 1987 a black swan?
Few claim that the collapse of the technology, media and telecoms bubble at the millennium, when markets also halved, was a “black swan” event; investors had been carried away with optimism about the future and with disdain for the old economy. They jumped the gun on the new economy and wrote off the old too easily.
But the 1987 crash, when markets fell by a third in a week, was clearly a shock. Was it a “black swan” event? Markets had risen 50% earlier in the year so were clearly over-extended. Many expected a bear market before long, but thought that there was a bit more to go for or assumed that, with stop-loss sell orders in place, they would have time to get out.
Greed overcame fear. There hadn’t been a crash for nearly 50 years so investors had forgotten how markets can plunge in a panic.
Geopolitical black swans are less common than you might think too
Those who were caught by surprise by Iraq’s invasion of Kuwait in 1990 hadn’t been reading the research reports of Hoare Govett’s oil analyst, who had been warning of a military build-up on the border for a couple of weeks. This, too, was no “black swan”.
The collapse of the Berlin Wall the previous year was a major surprise to nearly everyone, but shouldn’t have been. A friend, returning from a trip to Poland some years earlier, had told me exactly how it would be triggered.
The communist party’s allies, who were assumed to be their stooges, were waiting, he said following conversations with subversives in Warsaw bars, to switch sides when the opportunity arose.
Solidarity’s success in the 1989 election for the third of the seats which the government permitted to be contested, gave them that opportunity. The dominoes of Eastern Europe quickly fell, with the Russians under Gorbachev, predictably, not intervening.
The consequence for markets has been significant, though there have been many twists to the story. The suppression of the Tiananmen Square protests in 1989 was not a surprise and seemed at the time to be a major setback for globalisation.
The subsequent evolution of the Chinese economy along broadly capitalist lines has arguably been a true “black swan” development, previously assumed to be impossible under a “communist” government .
Other examples of supposed “black swans” that were, in fact predictable, stretch back through the Falklands war in 1982 via the 1973 Yom Kippur war and the subsequent oil shock, to earlier examples. Perhaps the best is the outbreak of the first world war in August 1914.
Professor Niall Ferguson’s historical research has shown that this was a total shock to financial markets. Until Austria’s ultimatum to Serbia in late July, investors were unconcerned. A month later, most markets closed to avert the greatest crash of all time, some never to reopen.
Yet there is plenty of evidence that tensions in Europe had been increasing since 1908, that treaties were unravelling and militarism was on the rise almost everywhere.
The point is not that the war was a greater shock than we now believe – but that investors were blind to the risk of it. As Ferguson’s latest book, Doom, shows, investors and people in general do not see disaster until it is staring them in the face. Equally, they are blind to seismic changes for the better.
Calm markets encourage investor complacency which feeds back into calm markets until reality dawns and panic sets in. It’s not that the investment world is short of Jeremiahs warning of disaster around the corner all the time. But investors, riding the long-term uptrend of markets, have learned to ignore them.
Most of the time, that is right. Every now and then, though, disaster really does threaten and, for the watchful, can be seen coming. Reliance on the “black swan” excuse for missing the evidence suits the professional fund managers – but it is expensive for their clients.
Max has an Economics degree from the University of Cambridge and is a chartered accountant. He worked at Investec Asset Management for 12 years, managing multi-asset funds investing in internally and externally managed funds, including investment trusts. This included a fund of investment trusts which grew to £120m+. Max has managed ten investment trusts (winning many awards) and sat on the boards of three trusts – two directorships are still active.
After 39 years in financial services, including 30 as a professional fund manager, Max took semi-retirement in 2017. Max has been a MoneyWeek columnist since 2016 writing about investment funds and more generally on markets online, plus occasional opinion pieces. He also writes for the Investment Trust Handbook each year and has contributed to The Daily Telegraph and other publications. See here for details of current investments held by Max.
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