Black Swan in the Stock Market: What Is It, With Examples and History

Definition

A black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences.

Black swan events are extremely rare and unpredictable, going outside of normal expectations. They are characterized by their potentially severe impact and the widespread insistence that they were obvious in hindsight.

One frequently cited example of a black swan event was the housing market crash of 2008, which led to the Great Recession. Other examples include the COVID-19 pandemic, the terrorist attacks of Sept. 11, and the hyperinflation crisis in Zimbabwe.

Key Takeaways

A black swan is an extremely rare event with potentially severe consequences.
It cannot be predicted beforehand, though after the fact, many falsely claim it should have been predictable.
Black swan events can cause catastrophic damage to an economy by negatively impacting markets and investments, but even the use of robust modeling cannot prevent a black swan event.
Reliance on standard forecasting tools can both fail to predict and potentially increase vulnerability to black swans by propagating risk and offering false security.
The term was popularized by the book The Black Swan by Nassim Nicholas Taleb.

Understanding a Black Swan

The term was popularized by Nassim Nicholas Taleb, a finance professor, writer, and former Wall Street trader. Taleb wrote about the idea of a black swan event in a 2007 book prior to the events of the 2008 financial crisis. Taleb argued that because black swan events are impossible to predict due to their extreme rarity, yet have catastrophic consequences, it is important for people to always assume a black swan event is a possibility, whatever it may be, and to try to plan accordingly. Some believe that diversification may offer some protection when a black swan event does occur.

Tip

Taleb later used the 2008 financial crisis and the idea of black swan events to argue that if a broken system is allowed to fail, it actually strengthens it against the catastrophe of future black swan events. He also argued that conversely, a system that is propped up and insulated from risk ultimately becomes more vulnerable to catastrophic loss in the face of rare, unpredictable events.

Taleb describes a black swan as an event that:

Is so rare that even the possibility that it might occur is unknown
Has a catastrophic impact when it does occur
Is explained in hindsight as if it were actually predictable

For extremely rare events, Taleb argues that the standard tools of probability and prediction, such as the normal distribution, do not apply since they depend on large population and past sample sizes that are never available for rare events by definition. Extrapolating, using statistics based on observations of past events is not helpful for predicting black swans, and might even make us more vulnerable to them.

The last key aspect of a black swan is that as a historically important event, observers are keen to explain it after the fact and speculate as to how it could have been predicted. Such retrospective speculation, however, does not actually help to predict future black swans as these can be anything from a credit crisis to a war.

Black Swans and the Housing Market Crash

One of the most oft-cited examples of a black swan event was the housing market crash of 2008. It occurred shortly after the 2007 publication of The Black Swan, and it ticked all of the boxes in Taleb's description: Prior to the crash, it was impossible to calculate the probability that the housing market was in a bubble, despite the serious economic consequences. After the bubble popped, many experts produced post-facto rationalizations to explain why the collapse had been inevitable; yet only a handful of economists and asset managers had seen it coming.

Other Examples of Black Swan Events

A black swan is any event that seems highly unlikely before it happens, but in retrospect seems to have been nearly inevitable. This definition is inherently subjective, but these are some examples that are often cited as black swan events:

Hyperinflation in Zimbabwe: Also in 2008, Zimbabwe had the worst case of hyperinflation in the 21st century with a peak inflation rate of more than 79.6 billion percent. An inflation level of that amount is nearly impossible to predict and can easily ruin a country financially.
Tech Bubble: The dotcom bubble of 2001 is another black swan event that has similarities to the 2008 financial crisis. America was enjoying rapid economic growth and increases in private wealth before the economy catastrophically collapsed. Since the internet was in its infancy in terms of commercial use, various investment funds were investing in technology companies with inflated valuations and no market traction. When these companies folded, the funds were hit hard, and the downside risk was passed on to the investors. The digital frontier was new so it was nearly impossible to predict the collapse.
Collapse of LTCM: As another example, the previously successful hedge fund Long-Term Capital Management (LTCM), was driven into the ground in 1998 as a result of the ripple effect caused by the Russian government's debt default, something the company's computer models could not have predicted.

COVID-19 Pandemic: A more recent example could be the emergence of the COVID-19 virus that caused a pandemic in 2020, disrupting markets and economies around the world.

What Is a Black Swan Event in the Stock Market?

A black swan event in the stock market is often a market crash that exceeds six standard deviations, making it exceedingly rare from a probabilistic standpoint. Some have argued that stock prices are "fat-tailed" and that such events are, in reality, more frequent than the statistics would let on.

Why Do They Call It a Black Swan Event?

A black swan is considered to be rare, since most swans are white. In fact, the story goes that black swans were thought once to not at all exist, until finally one was discovered. The lesson is that what we think are very rare events may be more common than previously thought.

What Is a Grey Swan Event?

A grey swan event is an outlier that is more probable than a black swan. As a result, people can better prepare for and hedge against a grey swan than a black swan.

The Bottom Line

A black swan event is a consequential occurrence that is almost impossible to predict, yet after the fact seems to have been inevitable. Such events can prove highly disruptive to the stock market, where investors spend millions trying to predict unpredictable events.