Nassim Taleb, in his book, explains a Black Swan event as one that a) is unexpected and b) carries extreme impact. The coronavirus pandemic is a Black Swan event considering that it was not predicted, and it has led to a virtual shutdown in a large part of the world.

In the investment world, such events pose a challenge. Preparing for bubbles is different. There are some indicators or markers that would signal to the keen observer that prices have significantly moved higher than fundamental values. Here, the investor can vary the exposure levels to participate and later protect oneself from such bubbles. But how does one prepare for something that is difficult to predict?

One can buy insurance through hedging. However, being hedged against all kinds of risks, all the time will adversely impact returns.

Common characteristics of market crisis

There may not be a way to anticipate Black Swan events, but there are ways to navigate them and use them to our advantage (carefully). Market crashes historically have some common characteristics:

Investors are gripped by fear and predict a wide range of forecasts about the market (some of them extremely bearish). Unfortunately, the reigning pessimism will push people to assign high probability to extreme outcomes too. (Fear of further loss, herd mentality)

Growth premium falls. Valuations crash to historic lows. Creative valuation methods are exposed. (Negative feedback loop)

High uncertainty will lead to investors giving unduly high importance to short term movements. (Myopic loss aversion)

Correlations rise and hence diversification may not help much. Investors take cash calls. (Liquidity preference)

Good news is ignored. Participants overreact to bad news. (Cognitive dissonance, confirmation bias)

Market crash affects economic activity adversely. (Reflexivity)

Credit markets get impacted. Financial institutions may shy away from lending. Credit spreads rise Leveraged companies under serious threat. (Risk off)

New money stops moving into equity. Panic leads to redemptions or exits. (Risk off)

Headlines and sentiment will be negative. (Narratives)

Once investors know the behavioural cycle of the market, they have an edge that can help them take advantage of the crash. They can buy into the pessimism, hold the investments through the long term and sell into euphoria. The seeds of wealth are sown during bad times and the fruits of the effort are harvested during good times.

Handling the Swan

Once you understand the market cycle and are convinced to take advantage of the crash, there are two important questions to address: How to invest?

And What to invest in?

How to invest: Handling duration blindness

One of the most difficult problems an investor faces in handling black swan type crisis is duration blindness. Since there is no precedence of such an event, it is difficult to estimate the time the crisis will last for. The investor can use various estimates from experts but make room for the errors in forecasting too. It is extremely rare to catch the exact low of the market while investing.

Hence it is better to stagger the investment over a significant period of time. Selection of this time frame is subjective. However, it is better to keep a longer duration so as to accommodate a margin of safety in terms of timing too.

What to invest in: Handling portfolio selection

During a market crash, the frothy valuations get almost eliminated and sub-standard businesses are penalised heavily. The investor is in given an opportunity to choose from a wide variety of businesses that have come to attractive levels. To create a robust portfolio, one must follow some basic principles:

Stay within the circle of competence: Typically, in these markets, investors run a screener to check which stocks have corrected the most in the fall. Being anchored at the 52-week high or all-time high prices, one is tempted to dive into businesses that one may not have tracked earlier. Not knowing what you are buying (irrespective of valuation) makes you vulnerable to losses. Stay within the stock universe that you understand well.

Avoid companies with high financial leverage: Leveraged companies can often run into liquidity troubles. These businesses have to survive the downturn to make money for the investor.

Also, in an environment where quality companies are available at attractive valuations, there needs to be very high payoff to move into riskier stocks. Unless, the earnings trajectory is fairly visible, dabbling with high debt companies can be avoided.

Buy robust business model, cash rich, high RoCE companies: During a bull market, even companies with fragile businesses or weak balance sheets or negative cashflow profiles are able to raise money based on a concept or an idea. A lot of zombie companies continue to survive due to easy money conditions.

After a crash, investors who have burnt their fingers in such stocks, will shift to companies that have a robust growth-oriented business model, good management and strong balance sheet. Healthy cashflows and RoCE are a mark of a good business. Scalability, brand franchise and good leadership are other important characteristics to choose a company.

To sum up, Black Swan events are unexpected, high impact events. Investors can take advantage of these events by understanding the fundamentals and behavior of a market crash. However, it is important to a) be humble and stagger the investments over a reasonable time frame and b) be meticulous in picking up good quality businesses.

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Ways of the Black Swan and how to handle it in investing - Economic Times