In investment terms, black swans are seemingly random, large-scale events that the markets don’t see coming until it is too late. The phrase is borrowed from 16 th century philosopher David Hume, who used the example of the emergence of black swans in Australia as proof that we cannot be certain of anything.

In recent years, the phrase has become a widely used term for any random event in the financial markets that investors should be prepared to respond to, due to their widespread negative consequences. In this extract from the Modern Wealth Management blog, we take a look at these events — and how to trade them.

What are black swans?

You don’t have to look far to find an example of a high-profile black swan event. The financial crisis of 2008 following the collapse of Lehman Brothers, caught most of the banking system unaware, and according to Saxo’s chief economist Steen Jakobsen, the financial sector is still only in the early stages of deleveraging balance sheets. Another was the 1991 Iraqi invasion of Kuwait, which prompted the first Gulf War.

Hume used black swans to draw attention to a fundamental flaw in his contemporaries’ wrong-headed conclusions. By comparison, financial black swans are far more damaging, because investors can stand to lose a lot more than their pride if they get hit with a black swan.

Mr Jakobsen said that it is impossible to predict these events, although he did say that he expects to see a fundamental shift in the role the Middle East plays in energy supply, with the US expected to become self-sufficient over the next ten years.

What do they mean for investors?

Black swan events can either be a disaster or an opportunity for investors, and sometimes both. The financial crisis of 2008 is a case in point. The biggest losers in that instance were the banks, but many investors who swooped to buy up shares when they were at their most depressed after the crash have since reaped the rewards.

Nassim Nicholas Taleb, author of The Black Swan, says that investors who have thought cautiously about their investment strategy are best placed to deal with it. Taleb notes that investors can position themselves to profit from a black swan by keeping the majority of their investments very safe, while betting a small proportion on speculative market opportunities, such as an unexpected fall in share prices.

For example, the principle behind the core-satellite investment strategy is to keep the vast majority of ‘core’ investments ultrasafe, with long-term horizons. A small proportion of funds are then re-invested in shorter-term, speculative market opportunities.

The micro-economy will always compensate for the macro mistakes, explained Mr Jakobsen. The individuals and companies react logically to crisis.

Potential black swans for 2012?

In the wake of the 2008 financial crisis, Saxo Bank came up with its own list of outrageous predictions for 2012. While not intended as forecasts in anyway, Mr Jakobsen believes they are an under-recognised probabilities that — if fulfilled — would fundamentally alter the way investors approach markets.

Here is a selection from Saxo’s ten outrageous predictions for 2012.

1) Wheat prices to double. This prediction comes out of a combination of factors, such as wheat being the worst performing crop in 2011 and the world population continuing to grow.

2) An unannounced candidate becomes US president. An ongoing economic downturn and a perceived lack of firm action on the part of the current incumbent Barack Obama may have created the perfect conditions for an unlikely candidate to take advantage of this year’s election.

3) Apple Inc stocks plummet by 50% following a 2011 high. Facing increased competition from competitors like Samsung and Google, the underlying presumption here is that Apple will be unable to maintain its market share.

Although it is unlikely that any of these were to come true, if just one or two did then it would mean huge changes.

How can you benefit?

Black swan events often develop on an international scale, so investors need to have a very strong understanding of global economics to stand any chance of making the most of them.

At the extreme, someone trying to gain an advantage from a perceived black swan event can’t really prepare at all, because they are impossible to spot.However, anyone actively investing in the market has some basis for their decisions. Making the most of a black swan requires you to understand how fallouts in one area will impact others, so they can respond to them when they do occur.

Reassuringly, markets have tended to recover from black swan events in the past. I also think everything in life mean-reverts, and as such I believe US first, Europe second will see a revival which will be good for the imbalances of the world, explains Mr Jakobsen. History teaches us that economies self-heal despite macro and political mistakes.

The latent danger for any investor who relies solely on market black swans for returns is whether they will actually happen at all. If the market continues to behave as expected, then people who bet on the inevitable appearance of a black swan could end up losing a lot of money without any return.

Additionally, investors need to know how to respond when confronted with a black swan, wherever it crops up in the market. And because it could, potentially, take on any form, having a broad, deep understanding of international markets is key. This makes deciding when to make a move during a perceived black swan event particularly difficult, requiring strength of conviction to make decisions while others are making money by doing the opposite.

It’s counterintuitive to most other approaches and, most importantly, human nature, claims Investment U Research analyst Jason Jenkins. Taking all those little daily dings in the market while waiting for something to go bad could be overwhelming and demoralising.

Investors taking a long-term view will argue that black swan events only have short-term consequences. To a certain extent, they are right. Historically, all market crashes are followed by a rebound. But then people used to believe all swans were white, too.

This is part 16 of a series powered by Saxo Bank’s Modern Wealth Management team.