How to Protect Yourself From Highly Improbable but Deadly Events

A Black Swan event is a term introduced by Nassim Taleb, a Lebanese American statistician, in his book The Black Swan: The Impact of The Highly Improbable. It describes an event that is hard to predict but yet carries such powerful consequences – that can be both good or bad –  that no one can disregard it.

As investors, it is worth understanding this concept and how it may impact our decision-making while investing.

Examples of Black Swans

Some recent examples of black swan events include unpredictable incidents like the March 2011 Japanese Tsunami, the 2003 SARS outbreak in Singapore, and the 2008 and 2011 Mumbai bombings in India.

normal distriubtion curve

Source: University of Houston Website

If we place the probability of such events happening on a normally-distributed probability curve, those events – the Black Swans – would lie on the edge of the curve at the +3 / -3 standard deviation marks or beyond and thus would be considered as outliers.

And, it is their status as ‘outliers’ that leads to most people turning a blind eye toward such events. It thus becomes a self-fulfilling prophecy as the greater the element of surprise, the more deadly the consequence as people just generally do not prepare well enough for events that they deem highly unlikely to occur.

To a certain extent, we can also argue that bubbles are a form of black swan events, with the most recent being the Global Financial Crisis of 2007-2009 and the penny stock crash involving Blumont Group  (SGX: A33)Asiasons Capital  (SGX: 5ET), and LionGold Corp  (SGX: A78) back in October this year.

Although some investors might be able to spot the formation of these bubbles, it would have been very difficult to predict when exactly these bubbles will implode, making such occurrences black swan events (as you can’t tell when they’ll happen)

Foolish Bottom Line

Nassim Taleb has shown how the use of complex modeling in the financial markets is inadequate when trying to avoid black swan events. So, what we can do instead, is to rely more on our common sense and diversify our investments.

Each time Warren Buffett invests, he would be asking himself a basic but profound question: “What is the worst case scenario?”  This simple question might just possibly save us a fortune if we place the consideration of risks at the forefront of our investing activities.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.