Defending Your Portfolio Against Black Swan Events
The 2011 tragedy of the Japanese earthquake and tsunami once again highlighted an occurrence where a seemingly unpredictable, disruptive event, often referred to as a Black Swan event, affects the global economy.
The origin of the term “Black Swan” dates back to a time in history when swans were believed to be only white in colour. A black-coloured swan was seen as an impossibility. More recently, former Wall Street trader Nassim Nicholas Taleb redefined a Black Swan event to be an outlier outside of the realm of regular expectations that has an extreme impact, but after the fact becomes explainable through rationalization and as a result of human nature.
A look back over time shows that Black Swan events occur fairly frequently — the 9/11 terrorist attacks in 2001 and the collapse of Lehman Brothers in 2008 are recent examples. They may have a significant short-term impact on the financial markets, but oftentimes do not create any long-lasting effects. However, these events often result in much discomfort causing investors to hastily react. In hindsight, after these Black Swan events are over and things have returned to normal, the simple act of staying-the-course emerges as one of the more viable defenses.
As Black Swan events are inevitable, are there any pre-emptive measures that can be taken? Here are some practical investment tactics that you might consider to help minimize the effects of Black Swan events when it comes to your investment portfolio.
Diversifying — Diversification across different industries, geographies and asset classes is an excellent way to protect against Black Swan events. A diversification strategy may extend to include other elements, such as types of risk. As examples, investing in bonds with varying maturities may be one way to manage interest-rate risk. Inflation-protected investments may help to manage purchasing-power risk.
Rebalancing — If the share price of one of your equity holdings has gone up so much that its value makes up a large proportion of your overall portfolio, it may be a good time to consider selling to restore balance. By selling high (and buying low), the basic idea is to ensure that appropriate diversification is maintained through balanced allocations.
Upgrading — More speculative holdings may be replaced with shares of larger, more established companies to form the basis of your portfolio as these companies may have greater stability and be better able to withstand a downturn.
Dollar Cost Averaging (DCA) — DCA helps to separate emotions associated with turns in the market from investing decisions. Engaging in the practice of buying at regular intervals, regardless of market conditions, generally lowers the overall cost of shares purchased over time as a greater number of shares are purchased when prices are low and fewer shares are purchased when prices are high.