Black swan investing: is it possible to prepare for the unexpected

Simon Brett, head of investments at Parmenion Fund Research, looks at how the unexpected can affect investment opportunities.

The phrase a ‘black swan’ was coined by the Latin poet Juvenal, and at that point in time no-one had ever seen one. Seventeen centuries later, a Dutch explorer sailed up a river in newly discovered Australia to find to his amazement – a black swan.

The term was popularised in financial circles by Nicholas Taleb, a finance professor and former Wall Street trader, who used it describe an event which falls beyond the bounds of predictability and leads to unforecastable consequences. Hard, in fact impossible to predict, such instances include: a natural disaster such as the 26 December 2004 Asian tsunami, a coup d’état, the invention of the internet, or a terrorist attack – such as 9/11.

This year we have seen two examples of ‘Black Swans’ in the political upheaval in the Middle East, the so-called Arab Spring, and the Japanese earthquake. These have presented investors with difficult decisions around how to tackle a key issue: how can a portfolio be protected from the impact of the unpredictable, or at least cushion it from the immediate decrease in investment returns that follows any shock?

Political changes

Just as world economies started to show signs of recovery following the 2008 financial crisis, political changes in the Arab world and the Töhoku earthquake on 11 March 2011 have hindered an upturn in economic activity and recovery of world stock markets. While it is difficult, by definition, for a fund manager to plan for any type of unthinkable, unimaginable event, there is an increasing need for fund managers to try and plan more effectively their range of responses to such anomalies in building their investment strategy.

Case study

Taking the Japanese earthquake as a case study, from an investment standpoint the impact does not appear to have been as calamitous as first anticipated. This is assuming, of course, there are no long term effects from nuclear fallout. As might be expected, following the quake the forecasts for growth in 2011 were downgraded. However, the numbers predicted for Japan in 2012 are more optimistic as reconstruction will provide a fillip for Japan’s economy.

Although news headlines have focused on the colossal power of nature, human suffering and nuclear anxiety, the Japanese economy is recovering steadily from the catastrophic event and is not showing any long term signs of derailing the world economy.

The Japan earthquake also highlights the reality that when certain markets or economies are affected by a Black Swan, other areas and sectors can reap benefits. Consequently, should investors look to realign their portfolio following a ‘Black Swan’, it is key to remember that there will be areas of great opportunity just alongside others which should be completely avoided for a period of time.