COVID-19 and black swan events
Was the pandemic unpredictable? Or were the appropriate steps not taken to prevent the spread of coronavirus?
“As we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know.”
These words were famously uttered by Donald Rumsfeld, the former US Secretary of Defense, in the run up to the 2003 invasion of Iraq.
And though it may seem like sophistry, the final part of Rumsfeld’s remarks neatly describes the cause of a major problem that investors have to deal with — black swan events.
Black swan events are the result of unknown unknowns. They are things that happen without warning and have some sort of large-scale impact. It might be something that happens to you in your personal life or a major technological breakthrough that changes the entire global economy.
A short guide to black swan events
The theory behind black swan events was popularised by Nassim Taleb, a Lebanese author and ex-banker who spent most of his financial career trading derivatives.
His work in the financial services industry led him to write a book titled, unsurprisingly, ‘The Black Swan’, in which he argues that most areas of human activity, like the stock market, are influenced by rare, unpredictable events that have a big impact.
For example, Taleb has said that the collapse of the Soviet Union, the invention of the internet and the 9/11 terrorist attacks were all black swan events.
The third feature of black swan events is that, once they have occurred, they will be explained away by people insisting that they were actually predictable.
This may seem obvious but it contains one of the key ingredients of a black swan event — that they are retrospectively predictable but not prospectively predictable. You can look back at past data and try to explain why they happened but not look at current data to try and see when they will happen.
That being the case, Taleb wrote that people and companies should not attempt to figure out what or when the next black swan event will be. Predicting unknown unknowns isn’t easy, just ask Donald Rumsfeld.
Instead, Taleb has argued that businesses should always assume that a black swan event might happen and to either mitigate the effects that one could have or even seek to capitalise on them and make a profit.
And if you were wondering why they are called ‘black swan’ events, it’s because, for thousands of years, people thought there were only white swans. When Europeans finally made it to Australia, they found black swans there. Out of nowhere, an entire theory was proven wrong.
Is the coronavirus a black swan event?
Most people reading this may feel as though they are now living through the fallout from a black swan event.
Lockdowns, Zoom pub quizzes, people clad in surgical masks and the idea that we should all stand a couple of metres away from one another have now become a part of daily life when they would have seemed bizarre two months ago.
But there is a lot of debate as to whether or not the coronavirus really is a black swan event.
Taleb, who is still considered ‘the’ authority on the subject, has said that it is not. There is a good argument for this.
Prospective predictability
In late 2017, the Smithsonian Magazine published an article titled ‘Is China Ground Zero for a Future Pandemic?’
Without going into the finer details of the piece, it makes the claim that Chinese wet markets, where many different animals are kept together in unhygienic conditions, might lead to the creation of a virus “that could pass quickly through crowds of people in London and New York.”
Given that this is exactly what happened two years later, and that many other scholars had raised identical concerns previously, it’s hard to argue that our currennt pandemic was sudden or unpredictable. This is not to mention the fact that viruses similar to COVID-19 originated in China in 1957, 1968, 1997, 2002 and 2013.
The key thing here is that there was plenty of historical data to suggest that, at any given time, a virus originating from Chinese wet markets could spread across the world and steps would have to be taken to stop it.
As an example of this, we need look no further than Taiwan. Despite being geographically close to China, it’s government adopted policies to stop the spread of the virus as soon as it became obvious that it could spread between people. The country’s Ministry of Health specifically said that it had based its response on the 2003 SARS outbreak.
Taiwan now has the lowest number of coronavirus cases per million people of any country in the world over the past 50 days, with just under 90 per cent of all patients being people that returned from abroad.
Seen through this prism, to describe the coronavirus as a black swan event is to ignore all the warnings that scholars had issued years before any lockdowns began and to let governments off the hook for their collective failures to take meaningful steps to prevent the virus from spreading.
Alternatively, we may just be looking back in hindsight and making it seem as though this whole thing was predictable. You know, that thing Taleb says people do after black swan events take place. We’ll let you decide if that’s the case.
Black swan events and the stock market
If you’ve read this far then you might be thinking, ‘how do I protect my Freetrade portfolio from something that’s unpredictable?’
This is a tough question to answer. It’s hard to say what industries will be affected by a black swan event but a more diversified portfolio is more likely to be better able to withstand a crash.
Gold, for example, is popular with investors when the stock market does poorly, so having it in your portfolio might not be a bad option.
Holding stocks in businesses operating across a range of industries and geographies might help too. After all, a crash doesn’t necessarily mean that every single company in the stock market will perform badly, and some will fall in value less than others.
It’s also worth thinking about keeping some of your money out of the market. Even if we’re living through a period of low interest rates, it’s always good to have cash to hand in case any emergency bills crop up.
Equally important to all of these things is realising that investing is subject to all of the randomness and risk that flows through the world in which we live. Unless we reach some sort of Minority Report-esc dystopia, chaos and craziness are always going to be a part of our lives to a lesser or greater degree. Which is why….
When you invest, your capital is at risk. The value of your portfolio can go down as well as up and you may get back less than you invest.
This should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.
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