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Besides a hit movie about ballerinas (or something), a Black Swan event in the financial world is any bad, unexpected event that nobody saw coming. The term comes from an old folk saying that there’s no such thing as a black swan, which people believed with 100% certainty until they accidentally stumbled on them in the wild.
Black Swan events are supposed to be rare, but lately we’ve been seeing them pretty frequently for some reason. In only the past decade, we’ve had Brexit, the oil crash, and, oh yeah, a tiny little thing called The Great Financial Crisis. Black Swan events, and the subsequent market crashes that follow are, lets face it, scary as fuck. But it’s in those market crashes that you truly discover whether you can hack it as an investor. You can stare at spreadsheets and charts all day, but it’s your reaction to that first market crash when you’re down tens of thousands of dollars that earns your place at the table of the rich.
That being said, while it’s scary to deal with a market crash, it’s really not that complicated.
Understand That the World’s Not Going to End
This is kind of an absurd statement but really really important to understand. Every time (and I mean every time) a Black Swan event happens, the media fills with screaming pundits shouting about how “it’s different this time!” They did it for Brexit, they did it for the oil crash, and they were doing it really really loudly during the housing crash of 2008/2009. Clearly we’re still here, so they’ve been wrong every single time.
The reason why they do this is that Black Swan events are, by their very nature, unpredictable and impossible to forecast. That nasty surprise makes people question every single thing they believe in, and when they do that they panic.
But here’s the thing: any form of investing requires a certain amount of optimism. You have to believe that the world’s not going to end. But even getting up and going to work every day requires you to believe that. If you truly believed that the world’s about to end, then no investing strategy makes sense for you, because what good is money if we’re all dead? The only thing that makes sense in that scenario is to take all your money, blow it all on cocaine and hookers, and go have orgies until we all get crushed by a flaming meteor.
So now operating under the assumption that the world’s not going to end, your first and best defence from Black Swan events is to build your portfolio using index ETFs. The reason why is that Black Swan events, by their very nature, can’t be predicted ahead of time. You don’t know whether it will take out all health care stocks, or the oil sector, or maybe even cause a bank to collapse. So if you buy individual equities, it’s entirely possible for a Black Swan event to cause all your companies to go bankrupt. But with an index like the S&P500, it’s impossible for the ETF to go to zero unless all companies go bankrupt.
And of course, since we’re operating under the assumption that this won’t happen (because it’s impossible to invest at all in that scenario), this gives your portfolio a natural “floor.” It may drop by 50% but it will never drop by 100%.
The second safeguard against Black Swan events is not to hold your entire portfolio in equities. Some percentage of it should be held in fixed income like bonds, because when equity markets plummet, bonds go up as money flees towards safety. So by holding some of your portfolio in bonds, two things happen:
- Your portfolio doesn’t drop as much as the overall market
- You make sure you have some money available to buy into the storm
Now the big question we keep getting in our inbox is “What should my allocation be?” The problem is that there’s no one correct answer for everyone. Many of our fellow FI-ers like Jeremy from GoCurryCracker.com and Justin from RootOfGood.com are 90% to 100% in equities. That’s way too cowboy for me. Personally, I’d never go above 75% and right now we’re still sitting on a 60%/40% equity/fixed income split.
To people who are just starting out, I tell them to start with 50%/50%. Sure it might be conservative given their timeframe, but in my view the asset allocation isn’t nearly as important as surviving that first Black Swan event. If you can make it out of your first market crash without panicking, then you can increase your equity exposure to something more aggressive.
And finally, the most important part of surviving Black Swan events is to rebalance. Because you have a portfolio made up of index funds with some fixed income, when the next market crash happens, your equity portion will shrink while your fixed income will rise. A 50%/50% portfolio may for example become 40% equity/60% fixed income. When this happens, you need to sell 10% of your fixed income and buy equities until your asset allocation is back to its target.
Whether you can do this is what earns you the right to sit at the table with the other rich people. It’s not easy, believe me. When we were in the middle of the 2008/2009 market crash, every single instinct was telling me to dump everything and run. But we didn’t, and as a result we didn’t lose money in the biggest financial crisis of our generation.
Surprisingly, surviving that crash had the effect of inoculating us from fear. Because we followed this strategy and survived 2008, every time a new market panic happens we just shrug and say “Yeah, yeah. The world is ending again. Whatever.” and do the exact same thing: ignore the media and rebalance. 2008 was a once-in-a-generation event, so no other crash we’re going to see down the road is going to be worse than that. And because we survived 2008, we know we’ll survive all the others.
Crashes Are Normal
Market crashes happen. Black Swan events happen. That’s just a normal part of investing. But by accepting that and knowing what to do when it inevitably happens, you can survive them like we did.
And also note that this strategy is assuming that you’re in the accumulation part of your journey. Surviving Black Swan events after you’re retired and relying on your portfolio for your living expenses (like us) is slightly different, and is known as Sequence-of-Return risk. We will be covering that in next week’s Investment article.