Financial markets are filled with opportunities and risks. To manage risks, investors, institutional and retail traders develop and test various strategies. However, there are threats that cannot be foreseen.
An extremely rare and unpredictable event that can severely impact the financial markets is called a “black swan” event. We’ve seen multiple cases when financial markets were caught completely off-guard. For example, Dot-com Bubble Burst, 9/11 Attacks 2007-2008 Global Financial Crisis, and the very recent Covid-19 pandemic.
How can companies and individual traders prepare for such events? Are there any opportunities that arise from market crashes? Let’s delve into more details and try to learn more about how unpredictable events pose risks to financial markets and what we can learn from them.
The Examples of Black Swan Events
There have been multiple black swan events in the history, and are likely to keep occuring in the future. Some of the notable ones include:
- Dot-com Bubble Burst (2000) – in the early 2000s, excessive speculation and overvaluation caused massive declines in internet-based companies’ stock valuation. This decline caught many investors off-guard.
- 9/11 Attacks (2001) – The terrorist attack on New York trade centers caused a massive drop in stock prices and increased market volatility immediately.
- Global Financial Crisis (2007-2008) – the collapse of major financial institutions led to severe recession, and job losses.
- Swiss Franc De-pegging (2015) – The Swiss national bank made an unexpected decision to remove the Swiss Franc’s peg to the Euro, which resulted in a speedy appreciation of the Franc. This massive currency pair move caught many traders off guard that were on the wrong side of the trade.
- COVID-19 Pandemic (2020) – the global pandemic caused shutdowns and many businesses were forced to change their practices and move to online work. The pandemic increased market volatility.
The Impact on Financial Markets
It should be noted that black swan events can have different impacts on different market participants. Investors that purchase and keep assets long term are more vulnerable to such events, because they aren’t actively participating in the markets and are mostly unable to react quickly. In addition, investors don’t make money when markets are crashing.
On the other hand, black swan events can be incredibly profitable for market speculators. Speculators that trade utilize leverage and use CFDs (Contracts for Difference) for market speculation, can go long or short, which makes it possible to make money when markets are falling.
Black swan events are terrifying for passive investors. However, for investors that are looking for opportunities, they offer opportunities. Unpredictable events often drag stock prices down, making shares extremely cheap for other investors. For long term investors, money is made when they can buy assets cheap and wait for their prices to hike. When asset prices drop significantly, panic selling starts and assets become unusually volatile.
One can argue that the current financial system is faulty and black swan events are needed to refresh the markets every now and then. Thanks to excessive money printing, more and more resources are poured into financial markets and financial bubbles get inflated. Black swan events are like shock therapy as they expose vulnerabilities, challenge conventional wisdom, and compel stakeholders to reevaluate their practices, which leads to more resilient and firm financial systems.
Black Swan Events and Risk Management
Investing in financial markets is risky in itself. There are specific risks in stock investing, there are FX trading risks, and managing those risks is one of the biggest challenges.
Black swan events by their definition cannot be predicted. And it’s best to stop wasting efforts to do so. Instead, companies and individuals can prepare for such events. Companies have various strategies that guide them through such difficult times, for instance, they keep an emergency fund, monitor early warning signs, and diversify their risks. Similarly, individual traders and investors can prepare themselves. For example, some traders put all their savings in one company, or in crypto, which doesn’t mean it is a bad investment, it means that they are more vulnerable to specific risks. There are multiple investment vehicles such as real estate, stocks, bonds, physical precious metals, agriculture, and entrepreneurship.
Key Takeaways
To sum everything up, Black Swan events pose threats and opportunities for financial market participants. Such events are impossible (Or at least very hard) to predict and prepare for. What smart risk managers do instead of spending efforts on predicting, is preparing for emergency situations and by creating emergency funds and diversification. Black Swan events crash financial markets, however, they are also seen as shock therapy by investors, as these events help identify weak chains in the modern financial system.