By Robert C. Klemkosky

We have always been curious about what happens next. Attempting to predict the future has been an ancient human trait, using oracles, fortune tellers, nature, gods, mystics and others.

Because the source of risk is an uncertain future and the chance that a future event might happen with adverse consequences, if we could predict the future we would eliminate uncertainty and risk.

While many people think of risk as a bad four-letter word, unfortunately an economic system needs risk. If individuals and corporations did not bear risk, there would be no economic growth. Thus risk is an essential part of any economic or financial system.

In finance we use past empirical data and models to try to control risk, sometimes successfully, sometimes not.

The primary way to control risk in finance is by diversification within an asset class such as stocks, or across asset classes, such as stocks, bonds, commodities and real estate. In many countries, anyone with a fiduciary responsibility has to adhere to the prudent man rule which is to not expose investors to excessive risk.

This works fairly well if risk is normal, meaning that events fall within our range of expectations, both positive and negative. What is more difficult to manage are events that occur outside our range of possible expectations.

These would be rare, unpredictable, and extreme events that could be catastrophic and are referred to as black swan events.

The term is attributed to Nassim Taleb in his best-seller titled “The Black Swan: The Impact of the Highly Improbable.”

To quote his book: “Before the discovery of Australia, people of the Old World were convinced that all swans were white, a belief completely confirmed by empirical evidence.” Obviously seeing a single black swan in Australia repudiated the confirmed belief that all swans are white and showed limitations to our learning from empirical observations and experience.

Black swan events are thus high risk and are sometimes referred to as tail events and tail risk. This is a statistical term referring to the left tail of a normal distribution (bell-shaped curve).

The far left tail of that curve would represent rare events that have a very low probability of occurring, and thus unpredictable. Usually these events result in returns that are at least three standard deviations from the mean, meaning that there is less than a .13 percent probability of occurrence.

Black swan events can be man-made (9/11 terrorist attacks), natural (earthquakes and hurricanes), systemic (financial crisis of 2008) or government induced (wars, inflation and depressions).

Since these events are outside our realm of expectations, their impact is impossible to predict, especially their impact on the financial markets. During black swan events, uncertainty increases and investors’ tolerance for risk goes down and risk aversion goes up.

Investors thus require a higher return for owning a financial asset so asset prices come down. Sometimes there is panic selling. Since these events are rare and unforeseen, investor perceptions usually change more than reality.

Another problem with black swan events is contagion or the spreading of risk. We don’t know how things are interconnected and what the potential impact will be, short term or long term.

The 9.0 earthquake and resulting tsunami in Japan were outside their realm of expectations and forecasts, resulting in a nuclear disaster and mass destruction of lives and property. Who knows what the final impact will be.

While the two can’t be compared directly because of the human element, the financial crisis of 2008-2009 was also a black swan event that was outside our realm of expectations. Very few thought the subprime mortgage market could nearly collapse the financial markets of the world with dramatic finance and economic consequences.

While unpredictable, one thing you can predict is that there will be more black swan events in the future with unpredictable consequences. History may not be much of a guide in predicting the next black swan event or its consequences.