Understanding Black Swan Events in Financial Markets

“It ain’t what you don’t know that gets you into trouble, it’s what you know for sure that just ain’t so”
Mark Twain

Introduction

Prior to the late 17th century, the term ‘black swan’ was used by Europeans to mean something that was considered impossible or non-existent. After all, every swan they’d ever encountered was white, and why believe in something you’ve never seen? It was therefore a surprise for Willem de Vlamingh, a Dutch navigator exploring Australia in 1697, when he discovered Cygnus atratus (‘mourning swan’), swans with black plumage. Rather than having never existed, black swans simply hadn’t been observed… until then.

More recently the term has been adapted by investors to describe sudden, unpleasant market shocks that few see coming. The 2008 Financial Crisis, the Dot-Com crash, Black Monday, and other well-known market disturbances have all shared this quality: that they seem perfectly rationalisable, even obvious after the fact, but are difficult to predict ahead of time.

These costly reminders that financial markets are predisposed to unwanted shocks invite difficult questions for investors, like “What haven’t we considered?”, “What don’t we know?” and “What’s lurking around the economic corner?”.

While Black Swans are incredibly difficult to predict due to the multitude of factors responsible for their occurrence, it feels to many that circumstances in 2025 lend themselves to potentially severe market movements, and this has been epitomised by the decline in benchmarks like the S&P 500 over recent weeks and months. Some of those causes include:

– President Trump: Impossible to predict and often contradictory to both established norms and his past self, the U.S. president has a history of increasing market nervousness and is likely a catalyst for Black Swan events compared to his Oval Office predecessors. As is widely known, geopolitics is enduring a sustained period of heightened tension both economically and militarily (though many examples such as the Ukraine war pre-date Trump’s second term), and this creates opportunities for Black Swan events to crop up in the financial markets, whether that be via energy shortages, trade wars, the disestablishment or emergence of political allegiances, or a single post on Truth Social.

– A major banking crisis: The current size and trajectory of U.S. debt are considered unsustainable by many, if not most, analysts. The explicit default of the U.S. government on its debt would inevitably send economic shockwaves around the world. Indeed, when Standard and Poors downgraded the credit rating of the U.S. Treasury¹ (an indication for the first time that the U.S. might not be fully reliable in repaying its debt) in 2011 stocks plunged in value and investors led to safer assets (including, ironically, U.S. debt, illustrating the irrationality of market participants in a panic).

– The rise of artificial intelligence: AI is likely the most transformative technology of the 21^st century so far, and certainly the most important technology to have seen such exponential improvement the last decade. The potential downstream effects of AI are many and unknown. Large shifts in the employment markets, downward pressure on salaries, the potential for exponential rates of growth in scientific advances, an explosion in disinformation, cyberterrorism, and a fundamental change in warfare could all cause Black Swan events.

– Energy market disruptions: For decades markets have been dependent upon the trade routes established during post-war globalisation. As nations’ energy requirements increase, either their exposure to the risk of overdependency on foreign states increases or the necessity for renewable alternatives increases (nowhere is this more apparent at the moment than in Germany, which is rushing to find alternatives to dependence on Russian oil). Both exposures could predispose markets Black Swan events.

– Climate related disasters: The frequency and severity of natural disasters has increased alongside rising global temperatures, which have the potential to disrupt global trade or disrupt supply chains.

– Miscellaneous unforeseen risks: When the container ship ‘Ever Given’ blocked the Suez Canal in March 2021 global trade was severely disrupted for several days. Random events like this can cause markets to plummet and the downstream effects are largely unknown.

While Black Swan events can’t be avoided for any investor exposed to reasonable levels of market risk, their impact can be proactively mitigated. There are measures (discussed further on) that alleviate the potential downside of such an event, but it’s also perhaps more important for investors to understand the psychological shortcomings that all human beings experience that allow Black Swan events to ‘sneak up’ on us. Some of these are listed here:

– Hindsight bias: Past Black Swan events appear obvious in the rear-view mirror, which can give the impression that future Black Swan events will be obvious in advance. Investor’s make the mistake of thinking that they’ll ‘be ready’ for the next Black Swan event, but their unpredictability is their defining characteristic. Investors should vigilantly keep an open mind about not knowing what they don’t know.

– Confirmation bias: Whilst Black Swan events are unpredictable, there is sometimes evidence for their potential approach in advance of them happening, as written about brilliantly in Michael Lewis’ The Big Short², the true story of how a small group of Wall Street traders were able to profit from the financial crisis in 2008. However, most investors avoid such warning signs (even if they have the technical expertise to notice them) or downplay their relevance because they’re looking for information that aligns with what they already ‘know’ to be true. To counteract this natural bias, investors should consistently look out for information that contradicts what they believe to be true and evaluate it as objectively as possible.

– Overconfidence bias: Put bluntly, people overestimate their ability to understand market trends and underestimate the potential for circumstances to catch them off-guard. The consequences of a Black Swan event are more severe for those who confidently place ‘bets’ on specific companies or strategies thriving into the future. Again, an investor remaining openminded about their own limits is important when considering exposure to Black Swan events.

– Recency bias: “There haven’t been any market shocks for some time, so why would there be one now?”. Humans consistently favour information obtained recently over older information³ regardless of the information’s actual relevancy. The recent past is often (successfully) used as a predictor for the near future, a perceived predictability which Black Swan events consistently prove to be less than absolutely reliable.

– Narrative fallacy: “David Hasslehoff’s music brought down the Berlin Wall”, “The Great Depression was caused by the 1929 stock market crash”, “World War 1 began because the Archduke was assassinated”. Humans consistently construct simple, elegant, post-hoc ‘causes’ for events which were, in reality, the result of many interwoven, complicated factors. Black Swan events are almost always the result of chaotically complex systems behaving in ways that haven’t occurred before and constructing manageable stories about how and why they happened after-the-fact leads to a belief that they can be predicted in the future.

Investors have a range of tools that can be used to potentially mitigate the impact of Black Swan events when they do happen, and several of them are listed here:

– Diversification: The only ‘free lunch’ in investing. Holding a mix of assets across multiple asset-classes reduces reliance on any single company, asset, industry or region. Put another way, putting all an investor’s eggs into one basket can increase their exposure to the fallout of Black Swan events. Niche markets are more susceptible to large crashes than large, diversified markets. Investors looking to hedge the risk of Black Swan events should look to diversify their holdings.

– Investing in defensive assets: Defensive assets are those which are less impacted when downward (‘bear’) markets rear their head. For example, the utilities and consumer staples equity sectors tend to outperform the overall market during extreme downturns. Many investors are reluctant to invest in these areas when markets are performing well and are instead drawn to the often more attractive return profiles of other sectors, like technology.

– Stress testing: Simulating extreme scenarios is common practice in investment finance and can be used to assess a portfolio’s exposure to extreme events. Whilst these are often hypothetical scenarios, it’s also possible to analyse how a current portfolio would’ve performed during historical crises (though this is rarely a perfect analysis as many current investable assets didn’t exist at the time of historical market crashes). As part of our ‘Insight Report’ comparative portfolio analysis reports that we provide free of charge to clients on request, we model a range of different historic scenarios and provide an overview of how a portfolio might have hypothetically responded to these, if the scenarios were to play out similarly today.

– Reducing the duration of fixed income portfolios: It is widely understood that the value of bonds and bond portfolios move inversely to movements in interest rates, and their sensitivity to such movements is measured by a characteristic known as duration. Lowering the duration of the fixed income assets a portfolio holds reduces exposure to interest rate movements. Investors who are nervous about Black Swan events can reduce their duration such that their bond investments will be less impacted if they occur.

ebi’s investment philosophy has long prioritised a common-sense approach to portfolio construction, including broad global diversification across markets and industries. We believe that it’s better to seek to deliver performance broadly aligned with global markets (enhanced by the inclusion of market factors, which historical evidence shows deliver premiums on market returns over long time horizons), rather than pick concentrated investments that we think will do well, and seek to actively trade these over time.

Alongside this, we opt to tilt our bond portfolios to a shorter-than-market duration, reducing interest rate risk within our portfolios compared to the wider market. This is a strategy that has served our investors well, particularly following the rapidly rising interest rate environment experienced over recent years.

Together, we believe this focus on a simple but well-tested (using historical data and scenario analysis) long-term strategic asset allocation, broad global diversification, and shorter-than-market-duration bond exposure, leads to potentially more optimal outcome for our investors, and less space for any black swans that may be lurking in the shadows to do damage to our clients’ portfolios, including through the risk of end-investor knee-jerk reactions to emerging market events as and when they occur.

Although we maintain our buy-and-hold philosophy and encourage all investors to not react hastily to news headlines, we nonetheless keep a very close eye on financial news. We will be sure to keep you updated as markets continue to evolve, and keep a keen ear out for the faint sound of flapping wings.

Duration is an estimate and can change over time due to factors such as changes in interest rates, market conditions, and the bond’s remaining time to maturity.

The price of shares and investments and the income derived from them can go down as well as up, and investors may not get back the amount they invested. Past performance is not a reliable indicator of future results.

1 BBC News [https://www.bbc.co.uk/news/world-us-canada-14428930]
2 Michael Lewis’ ‘The Big Short’ [https://www.michaellewiswrites.com/#the-big-short]
3 Recency Bias [https://www.investopedia.com/recency-availability-bias-5206686]

Disclaimer

We do not accept any liability for any loss or damage which is incurred from you acting or not acting as a result of reading any of our publications. You acknowledge that you use the information we provide at your own risk.

Our publications do not offer investment advice and nothing in them should be construed as investment advice. Our publications provide information and education for financial advisers who have the relevant expertise to make investment decisions without advice and is not intended for individual investors.

The information we publish has been obtained from or is based on sources that we believe to be accurate and complete. Where the information consists of pricing or performance data, the data contained therein has been obtained from company reports, financial reporting services, periodicals, and other sources believed reliable. Although reasonable care has been taken, we cannot guarantee the accuracy or completeness of any information we publish. Any opinions that we publish may be wrong and may change at any time. You should always carry out your own independent verification of facts and data before making any investment decisions.

The price of shares and investments and the income derived from them can go down as well as up, and investors may not get back the amount they invested.

Past performance is not necessarily a guide to future performance.

Blog Post by Jonathan Simpson, MSci
Investment Support Analyst at ebi Portfolios

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