Black Swan Events in the Alternative Investment Market

Masterworks
November 15, 2021

Black swans aren’t just everyone’s favorite ballet villain or a psychological thriller with Natalie Portman. Black swan is also a common term in finance.

And it can have a significant impact on your investing strategy. Just look at the COVID-19 pandemic, which some finance scholars debate calling a black swan event.

When it comes to black swans, alternative investments are not completely spared. But alternatives may be able to help you hedge against black swans. Here’s what investors should know.






What is a Black Swan?

First introduced and popularized by Nassim Nicholas Taleb in his 2001 book Fooled by Randomness, a black swan is an extremely negative event which is impossibly difficult to predict. It goes well beyond what is normally expected of an event and has the potential for severe long-term consequences.

According to Taleb, black swans have three defining attributes:

  1. The event is unpredictable
  2. The event results in severe and widespread consequences
  3. Afterward, people rationalize the event as predictable (hindsight bias)

In other words, black swans are defined by their rarity, severity, and stubborn postmortem insistence that the event was obvious.

Understanding Black Swans

What makes a rare event so significant for finance? According to Taleb, because black swans are almost impossible to predict yet have such dire consequences, it is vital to always assume that a black swan event is an imminent possibility and plan accordingly.

Ironically, Taleb released an updated version of his book in 2007, shortly before one of the characteristic black swan events of a generation: the 2008 Recession.

To Taleb, the catastrophic fallout of a black swan can be a good thing (if we’re smart about it), and the 2008 Recession is a perfect example. If broken systems are allowed to fail and we learn from what went wrong, we can strengthen the system against the possibility of similar black swans in the future.

History of Black Swan Theory

Taleb’s choice of terminology—black swan—is a telling example of how black swan theory works. It refers to the story that Westerners once believed swans were only white simply because they had only ever seen white swans before—at least until they colonized Australia and discovered black swans for the first time.

While the discovery was a surprise to ornithologists, the story illustrates the severe limitations of learning from experience, as well as the fragility of knowledge. As Taleb noted, all it takes is one black bird to invalidate millennia of confirmatory observations of white birds. Statistically speaking, the appearance of a single black bird is impossible to predict with the usual tools since these tools rely on large data sets (which would have consisted solely of white birds) and there is no preexisting data for a rare event (like the first sighting of a black swan in Australia) even though the black bird exists in the world.

In other words, what you don’t know is way more important than what you know, and even if you use your knowledge to prepare for every eventuality, a single black swan event (what you don’t know) can lay all your careful planning to waste.






Black Swans and Human Behavior

As a species, humans excel at pattern recognition. Or rather, we sidestep constant sensory overwhelm by breaking our world into recognizable patterns that are easy for the brain to recognize without wasting extra processing power. This works well for events and activities we encounter every day, like putting on socks, or driving to work.

However, it also means that we rely too much on patterns, leaving us susceptible to bias as we assume our patterns will always hold true. No one would have predicted the meteoric rise of the Internet, or World War I, or 9/11. They were outliers, and because such things had never happened before, we assumed based on historical data that they wouldn’t. But they happened anyway, and they changed the world forever.

This is what makes black swans so dangerous. Because we assume that such events will not or cannot happen, we develop a collective blindness to them. And when the events happen, we’re completely unprepared to handle the fallout—with dire consequences.

Black Swans, Alternative Investments

This brings us to alternative investments and black swan investing.

For savvy investors, alternative investments have long been used to offset the constant ebbs and flows of the conventional market. Art or gold, for example, can be used as value stores that retain their value regardless of changing economic conditions. This also makes them incredibly useful for black swan investing.

What is Black Swan Investing?

Black swan investing is a philosophy predicated entirely on the existence of black swans and the need to prepare for them.

A black swan investor would not buy options based on predictions of the market moving one way or the other. Instead, they buy on both sides of the market, always buying out-of-the-money options, assuming that a catastrophe will happen on one side or the other. That way, they have options to protect themselves against a failure on either side. The idea is that because black swans are unpredictable, there’s no use trying to attain unattainable knowledge—you’re better off assuming the market could go either way.

Basically, think of black swan investing as a form of hedging—but against massive, catastrophic rarities rather than a standard buy and sell.

Alternatives and Black Swan Investing

This is where alternative investments can help.

The driving concept at the core of black swan investing is to insulate yourself against an unknowable catastrophe by spreading your options across the market. That way, your portfolio is more highly protected, no matter which way the wind blows.

Alternatives are useful in this regard because they’ve long been used as a means of hedging against the stock market. This makes them a useful tool to insulate your portfolio against sudden dips on either side of the market.

Investing for the Future—Whatever the Future May Hold

When it comes to black swans, alternative investments can be incredibly useful. So if you’re ready to insulate your portfolio against the future (whatever the future may hold) it’s time to get started with alternatives.

That’s where we can help. Here at Masterworks, we make blue-chip art investing accessible to ordinary investors so that you can take advantage of an asset class that’s outperformed the S&P 500 by 180% from 2000 to 2018. With expert research in partnership with Citi Bank and Bank of America, we identify high-growth artist markets with the highest potential risk-adjusted returns. Then, after we authenticate multi-million-dollar artwork, we allow members to purchase shares in art. All you have to do is collect dividends when we make a sale. Sound good? Then fill out your membership application today to learn more.







Masterworks
Masterworks is a fintech company democratizing the art market. Our investors are able to fractionally invest in $1mn+ works of art by some of the world's most famous and sought-after artists.