How To Navigate Through A Black Swan Event

Black swan events are the new normal if you listen to the news, especially the financial press. There is always something out there that is going to take down the financial markets and the rest of the world, and sometimes bad things actually happen. Then Financial Crisis absolutely crushed the markets. So did the Great Depression and 9/11. And yes, some people predict downturns. But even a broken clock is right twice a day.

But by definition black swan’s are rare and unpredictable. The only way to protect yourself from the truly unpredictable is to set up shop in your own off the grid fallout shelter and never come out, but that is just no way to live. Similarly, always expecting the imminent collapse of the financial markets is no way to invest. The real return on cash in the mattress is the inflation rate, in reverse.

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Black swan event and markets

So how do you invest knowing we have these black swan's lurking about ready to spring on us as soon as a virus in China spreads, or dictator in North Korea or Iran pops off a missile, or the latest worry, an elected leader tweets?

One old school answer is you patiently wait through it, allowing time for the market to recover. There is absolutely a lot of validity in that approach. Markets have always recovered, eventually. However, it is tough to wait it out if you have expenses to pay now, and Murphy’s Law, and economics, dictates that you will likely need money when the market is down.

There is also another old school answer, the Benjamin Graham / Sir John Marks Templeton approach. You wait and invest at the point of maximum pessimism. The market is after all, very efficient at taking money from inpatient investors and giving it to patient ones. Value investing still makes sense, even in the era of the market bull being dominated by a small number of tech stocks, aka FAANG. However, if you missed investing in the last market bottom back in 2009 and have been waiting ever since for the next big correction, when exactly are you going to be able to get back in at a bargain?

However, is there possibly another answer, a more contemporary strategy to dealing with black swans?
One is from the institutional world made famous by David Swensen, guru chief investment officer of the Yale Endowment. It argues that investors should include more real estate, private equity, and venture capital in their portfolios.

Black swan events and portfolio management

But what percentage of a portfolio should be made up of these alternative investments?

The most recent information released by Yale on their endowment shows just 16.5% of their portfolio is allocated to equities, and 84% of that was to foreign equities.

However, if you look at the most recent numbers, Yale’s Endowment only returned 5.7% net from July 1, 2018, to July 1, 2019. The ten-year return of 11.1% trailed the return of the US stock market by a whopping 3.6% annually. To be fair, the Yale Endowment is an income portfolio, paying more than a third of all of the university’s expenses; and the drag from 30% of the portfolio being in cash, bonds, and absolute return investments is substantial, but maybe the Endowment Model has drawbacks as well.

So what should you do now? How do you invest prudently with a black swan event out there ready to spring out of the blue, the stock market at highs, bond yields low, a flat yield curve, etc., etc.? How do I allocate today?

Conclusion

I do all three.

The Endowment model offers good returns, stability and income. I allocate there, with the income constantly providing more cash, initially to reinvest and eventually to live off of. Then I invest in the stock market, diversified and globally, adding when the total market or a sector I believe in corrects and hold through any subsequent corrections where I likely will be buying again.

There are times to sell off equities, but that will be based on someone’s specific situation, and best to be done when the market is high, like now. And don’t forget taxes. Never forget taxes. The best way to increase returns is still to avoid taxes so you keep more of your own money, but that is a discussion for another day. For more on how to defer capital gains taxes, please see my earlier post on ValueWalk.

Please note that there are special rules & risks associated with alternative investments & not every investor will be eligible or suitable to invest in alternative investments. Many alternative investments place limitations on who may purchase them based on a person's income & assets & some may only be available to accredited investors. Alternative Investments often include a high degree of risk.

Black Swan Events: 9 Recent Events That Changed Finance Forever via Visual Capitalist

Almost every market participant out there has at least one horrific war story on a crash that profoundly affected their portfolio or world view.

For example, one unnamed stock broker I know had himself and his clients in a soaring gold stock called Bre-X in 1997. There was way less connectivity at this time, and this person was on a trip to Vegas for some sun and fun. Staying at Caesar’s Palace, he went out for a short while as the stock was trading near its highs of $286.50 per share.

When he got back to the hotel, he found out that news had already spread quickly: during a due diligence test, mining company Freeport had twinned seven drill holes, finding not even a trace of economic gold. The deposit was not real, and panic swept the market. His hotel phone had been ringing off the hook for three hours but he missed all the calls. Shares plummeted 83% that day, but he was already too late to get out of the stock.

It’s easy to rationalize the series of events that led to the fall of Bre-X in hindsight, but at the time many traders and experts like this broker were caught by surprise. A company worth around $4.5 billion basically went to zero almost overnight as its claim of 70 million ounces of gold vanished into thin air. That’s a “black swan”, and this one in particular changed the mining and finance industries forever.

Black Swan Events: 9 Recent One That Changed Finance Forever

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The following infographic comes to us from Call Levels, and it highlights nine other recent “black swan” events that will have a lasting impact on how investors approach markets.

These events range from the Asian financial crisis of 1997 to the more recent Brexit panic that occurred in June 2016.

Note: we are aware that some of these may not meet the “technical definition” of black swans, but they do meet the more colloquial meaning used today by many people in the markets.