“The Central idea in Black Swan is that rare events cannot be estimated from empirical observations since they are rare,” said Nassim Nicholas Taleb.
From time to time, our financial markets are jolted by unexpected events that cause widespread panic, mayhem and monetary losses, leading to huge erosion of investor wealth. The 9/11 terrorist attacks, the 2008 global financial crisis, the 2016 Demonetization and the 2020 COVID-19 epidemic are some such events that spring to mind. Could anyone predict at least one of these unexpected “black-swan” events, if not all of them?
Forget ordinary investors like you and me, not even one among the very best in the business could correctly predict these events.
Then what helps these Super investors such as Buffett, Peter Lynch, Seth Klarman among others not just survive these “black swan” events, but profit from these whereas the common man is often left bleeding with deep financial wounds and massive portfolio losses.
Readers of the the Asterix comic series will know of a character called Getafix, the wise old man of the small Gaul village and the only person in the whole village who knew the secret recipe to brew the “magic potion” that gave the ordinary Gaulish villagers their superhuman strength to fight the Romans.
Likewise, I had wondered if there was a magic potion that ordinary investors could gulp down to actually help them protect their portfolio from the financial calamites unleashed by these deadly black swan events.
Luckily, the answer is a resounding YES and unlike in Asterix, the recipe for the brewing the magic potion to protect your portfolio from these black swan events is no secret at all. Through their books, interviews, share holder letters, the investing greats have been kind enough to share their wisdom
The magic potion: Key ingredients
Before we learn about the recipe, let us first understand the two key ingredients of the magic potion: “study of “financial history” and “human psychology”.
Study of our Financial History and Human Psychology
History never repeats itself, but it does often rhyme. Our financial history is littered with manias, panics, and bubbles.
And if you care enough to study each one of them – be it the Tulip mania of the 16th century or the housing bubble of the 21st century or the great depression of the 1930’s then you will find out that the cause that triggered the mania or panic may be different each time but the key underlying reason that causes our stock markets to swing wildly from Euphoria to Depression & vice-versa are the twin human emotions of “FEAR” & “GREED”- Fear of losing money & Greed for making more money.
Once the panic strikes then the gems left behind by the fleeing public will be picked up the wise investors armed with the knowledge gained by study of our financial history and human psychology that once the initial fear dissipates, the same public will soon come back looking back to buy back the very same gems they had abandoned earlier and at a much higher price!
Take a look at COVID-19 Epidemic. If you felt this was a unique and a rare event which had never ever happened before then here are some facts mics from our history:
-Plague of Justinian (Egypt) in the 5th century is estimated to have killed a 100 million people in the Roman Empire.
-Black-death epidemic in the 13th century is estimated to have wiped out at least 30 percent of the Europe’s population.
-There were many more epidemics like the Plague of Milan (1630 AD), the great plague of London (1665 AD) and many more.
More recently, we have seen epidemics like SARS, Avian Flu, Swine Flu, MERS, EBOLA and ZIKA. COVID 19 was not the first and won’t be the last. The question is: Do they derail the equity markets forever?
The pattern of the effects of pandemic on equity market is the same: Initially the stock market crashes, as investors flee due to “fear of losing money”. After a while, as we humans as always find an antidote for the epidemic, the investors shed their fear of losing money and the greed for making more money takes over.
The +21.51 percent gain and +39.96 percent gains with 6 months of the outbreak of SARS in 2003 and H1N1 in 2009 respectively are just two examples.
Was it any different during COVID-19? Absolutely not.
The markets initially panicked on the outbreak of the pandemic. The fear of losing money caused the market to fall as low as 28000 and gradually as we found the antidote the fear gave way to greed propelling the market to 61,000 levels now.
Recipe for the Magic Potion
Calmness + Courage + Cash = Success in Crisis
The study of our financial history and human psychology will help us with the supply of the first two components of the magic potion equation: calmness and courage. That leaves us with the third and crucial part – Cash.
You can be as cool as a cucumber and as courageous as a wild cat but without any capital to be deployed when the crisis unfolds, you will be as effective as a toothless tiger on a hunt.
When the financial markets are experiencing the proverbial blood bath and the whole market is on a big “fire sale,” to convert the crisis into an opportunity, you need a meaningful amount of capital, else you will be left twiddling your thumbs in sadness on being unable to display your courage and apply your knowledge.
Black Swan Investing Fund
This fund should be used only during the Black Swan events and to ensure there is a meaningful amount of capital, one should allocate at least 20 percent of their investment capital. Use this money to jump into equity markets and pick up good bargains when the equity market fall sharply, like it did as soon as Covid-19 pandemic was declared in March 2020.
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