Black Swan Event

A black swan event is a very surprising and rare event that is beyond the realm of normal expectations. Such an event is very hard to predict, since it is an outlier in the data series and nothing in the past points to the possibility of its occurrence. However, the event has an extreme impact. In other words, a black swan event is an unexpected event of large magnitude; the bankruptcy of Lehman Brothers in 2008 serves as a good example.

Black Swan Theory

The black swan theory was developed by Nassim Nicholas Taleb and presented in his books, for example in “The Black Swan” published in 2007. The term “black swan” originates from the past belief that all swans must be white since nobody has ever seen swans of different colors. Thus, the black swan had been presumed not to exist. However, in the 17th century explorers discovered black swans in Australia, which negated the whole theory.

In finance, one of the most famous examples is the collapse of Long Term Capital Management as a result of the ripple effect caused by the Russian government debt default - an event the company’s models could not have predicted. Similarly, the Great Recession had been presumed ‘impossible,’ since such a large crisis had not happened since the Great Depression.

Black Swans and Gold

The practical implication of the black swan theory is that investors should learn how to deal with bad black swans events. Since these events are unknowable and unexpected, and they impact financial markets, the best idea is to have long positions in assets whose prices increase during systemic crises. This is why gold is a hedge against black swan events. The yellow metal does not perform well when the economy runs smoothly and risk-aversion is very low, but it shines during economic turmoil. You can think of gold as insurance, which does not generate huge profits during normal times, but rather protects the investors’ wealth against unlikely but serious events (like financial crises).

The best example that gold serves as a hedge against black swans is the last financial crisis. As you can see in the chart below, stocks (and other standard financial assets) drastically fell after the Lehman bankruptcy and suffered huge losses in 2008, while gold ended that year with a modest gain.

Chart 1: Gold prices (yellow line, right axis) and S&P500 Index (blue line, left axis) from 2007 to 2009

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