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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.
Index
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%.
Fixed Income
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.
Rebalance
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.
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Very well written article. looking forward to seeing what you have to say in your future article about re-balancing during retirement.
not sure how detailed a response you can give, for someone who’s invested in ETF’s and trying to minimize buying/selling, how frequently would you recommend rebalancing during a perceived black swan event? afterall, noone really knows how big or bad it could be. do you try to time it? or do you aim for only rebalancing during your regularly planned dates (I’m thinking quarterly for myself based on costs)
Yeah when I did it during 2008, I was using e-series mutual funds which have no transaction costs, so I was doing it every two weeks (timed with my paycheck). With ETFs, I wouldn’t do it more than quarterly to avoid the commissions (though apparently Questrade only charges for sells, so if you can do your rebals with cash buys only, you could do it more frequently without incurring any cost).
All awesome advice. Stay optimistic, and realize that (usually) it really is not different this time around.
I do think some big bad events can be predicted (i.e. – Canadian housing crisis that Garth has been blogging about for years) but, generally, you don’t really know what to short, or how to short it, or how the bad event might spread to other segments of the economy. But, there are rare occasions when you might know what NOT to buy, and what to stay away from (i.e. – $1.4M SFH in Vancouver).
As always, awesome stuff. Do you ever read JL Collins? I think you guys might be cut from the same cloth.
Thanks! And Garth doesn’t predict a housing crash, but he has been saying houses are stupidly overvalued for some time and for people to stop going all in on it. It’s a subtle difference.
And yes, I have JL Collins’ book right here in front of me! Expect a review coming up!
Good points raised.
Near the bottom of the financial crisis I remember people saying stay clear of the markets and so on, it will be cut in half again or maybe worse the whole system might collapse and cash would be king. I suggested to those that were the most bearish, that if they truly believed that, then their cash (or in another instance, their gold holdings) would also be totally useless and perhaps they should instead find a hidden and defendable shelter and stock it with non-perishables and ammo.
I knew myself as the nerdy type I wouldn’t survive the aforementioned doomsday scenario, so I piled money into the markets and ended up funding a travel sabbattical for two years and strangely enough by shrugging off the market blips during that time have returned with a bigger portfolio than I left with.
Don’t fear the black swan. Just adapt accordingly.
I’d like to think I could hold my own in a bunker/doomsday scenario. An Air Force buddy of mine took us shooting in Virginia and he said and I quote “Hey, you’re not too bad for a Canadian…”
Of course, unless the invading hordes consist of stationary paper targets and blocks of thermite, my skills may not be directly transferable…
If the time comes, you can be chief of bunker defense. I’ll provision the craft beer and devise the system to keep it cold. Wanderer and my better half can quickly launch apps that send the herds in the other direction pokemon style.
Although, this is starting to sound like a lot of work. Might be easier just to sail off to a relaxed pace island and drop anchor.
Oh, your way sounds MUCH easier. Let’s do that.
I’m on the trailing edge of the (US) Boomer generation you (so rightly) deride. Got similar pressures, bought into them, then mostly got out as the tides turned locally. Still not going the “rent” route, since my wife (Chinese, first-generation immigrant) drank the wrong Kool-aid and is still merrily entrapped in the Boomer dream.
Looking forward to whatever other descriptions elicit the “No. — Legal Department” picture and caption.
Obligatory writerly idea: a humor book collecting these descriptions, each lovingly illustrated with the same trailing black frame and caption. This isn’t as extreme as “What Men Know About Women” (trade paperback, standard start- and end-matter, blank pages for content) but the vein’s still worth mining ….
Rebel Boomers like you are a rare breed…like a purple unicorn. You guys rock!
And I love your humour book suggestion! Now to get through this pile of emails and messages, so we can get started on that….
Nice article, well written.
I need a bit more humor in my writing.
I like your point on rebalancing a portfolio after black swan events, smart indeed.
Thanks, Rudy!
Good advice until… “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.” <– Either I need to tune my irony detector, or you don't understand Black Swan events:
http://www.goodreads.com/book/show/242472.The_Black_Swan
There are many scenarios that could unfold to create a much larger crash. Some are on mankind's radar, most are not. Our inability to predict them doesn't mean they won't happen (hence, Black Swan events).
I hope you were either being ironic, or using a Stoic mindset when defining "worse". A Stoic might say "a greater crash in stocks is indeed possible, but I will see it as an opportunity / test / lesson rather than a loss". We can't predict Black Swan events or lack thereof, but we can control how we perceive and react to them.
And that’s why we structured the portfolio so that it generates 3.5% of dividends & fixed income. That way we don’t have to sell if a Black Swan even were to happen again. In addition to this, we have a cash cushion that covers 3-5 years of living expenses and are flexible to move anywhere where the cost of living is low (eg Southeast Asia, at $22K/year). The point of life is not to never take any risks. It’s to have backup plans to mitigate risk.
What do you guys think of the current trade war outlook? Over the last 7 months I’ve lost 15% of my portfolio and looks to reach 20% soon. Seems like there is no end to the sell off. I did a mistake putting a huge chunk of my savings into mutual funds, wish I came across your blog and knew about index funds earlier on. Not sure how much more I can stomach losing, I’m close to withdrawing half my portfolio into fixed deposit to stop the bleeding.
By doing that, you will be locking in the losses. If you can’t stomach only a few months of stock market corrections, investing it’s not for you. This is the long game, you need to think in terms of years not months. Read this series to understand how buy and hold investing works and how to build a portfolio to withstand downturns: https://www.millennial-revolution.com/invest/why-most-people-lose-money-in-the-stock-market/
You guys obviously didn’t read any of Nassim Nicholas Taleb’s books, because your definition of a Black Swan event is wrong (impossible to predict, massive impact – positive or negative) and your investment advice is also wrong, or at least not in line with Taleb’s recommended “Barbell” approach.