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Beware Black Swans and Gray Rhinos

These phenomena pose real risks that investors should strive to avoid.

In a meeting with provincial leaders, Chinese President Xi Jinping warned the high-ranking officials about black swans and grey rhinos in the economy – unforeseen, improbable events with extreme consequences. These events can unfold throughout one’s investment journey. Learning to avoid or lower their associated risks is an important investment skill.

What are black swans and grey rhinos?

Black swans’ danger lies in their low probability, and hence low predictability, coupled with their catastrophic effects on investments. For example, the 2008 Global Financial Crisis was a once-in-a-century or even once-in-human-history event that had dire consequences in the economy. Fortunately, the crisis’s aftermath was quite properly managed; otherwise, its destruction to the economy could have easily surpassed the Great Depression of 1929.

On the other hand, grey rhinos are highly probable, high-impact, yet neglected threats. Investors ignore them precisely they’ve been predicted so often in the past, yet failed to come to pass – until they do. The debt bubble in China is the most-discussed grey rhino right now. Numerous experts have warned about it for a few years now, but it has still not burst. Nor has it brought about the dire consequences it is supposed to bring yet, though most experts still reiterate that it could.

Black swans and grey rhinos in investing

The scandal and subsequent bankruptcy of Enron Corporation was a typical black swan in investing. Enron was a major energy company, and it was quite impossible to fathom that such a reputable public business in which many institutional and pension funds had parked their money could engage in accounting fraud. Yet it did, and the scandal brought total losses to its investors.

Grey rhinos have even more examples in the stock market. Usually, they pertain to some persistent problems in an industry, such as the bad debt loads in Mainland Chinese state-owned banks, suspension of government subsidies in the auto industry, or trade disputes that plague export-sensitive industries.

Managing black-swan and grey-rhino risks

A common feature of the two risks is they are neglected or ignored, either because the chances are too small (for black swans) or the warnings are essentially deemed needlessly alarmist (for grey rhinos). The most sensible way to manage these risks is therefore to first acknowledge their presence. Then try to price for these risks, and ask yourself this question: Does the current market price for this reflect the black-swan and grey-rhino risks it carries?

If the try-to-know-it-all solution does not appeal to you, try this investment technique instead, more specifically for managing black swan risks: Buy a deep out-of-the-money put option for the stock you are holding. This approach is called a protective put, usually costs little, and can be likened to buying insurance. Say the current price of a stock you are holding is $70. You can buy a deep out-of-the-money put option at the strike price of, say, $35, which usually just costs you a few cents of option premium for a year of the exercisable period. You will then have the right to sell the stock at $35 within that year, thereby limiting your loss to only half of the investment. That might sound bad, but a black swan event that might completely wipe out the company. In that light, settling for half would absolutely be better than nothing.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.