Insight: Black Swan Theory

While not directly a portfolio construction theory, the Black Swan Theory serves simply as a warning. The term “black swan” comes from a Latin expression popular in 16th century London to describe impossibility. Up to that point in time, all observed swans had been white. But on a Dutch expedition to Western Australia, explorer Willem de Vlarningh discovered black swans on the Swan River. Eventually, “Black Swan” referred to a logical fallacy, meaning, “If one doesn’t know about something, it’s therefore impossible.”

In his 2010 book, Black Swan Theory, Nassim Nicholas Taleb describes the Theory of Black Swan Events as events that are completely unpredictable, revolutionize the venue in which they occur and are rationalized by hindsight after the fact, as if they were not a surprise. Examples include Black Monday in 1987, the sub-prime melt down, and the collapse of Enron.

Modern Portfolio Theory, Behavioral Economics, and Post Modern Portfolio Theory help shrewd investors navigate the financial waters to their advantage, but they are not fool proof. Extreme outliers of probability, Black Swans, do and will occur. To be a wise investor is to be well-prepared, using a risk level appropriate to you, so that when a Black Swan comes along, your portfolio lives to fight another day.