NEW YORK (TheStreet) -- Those who don't learn from history are doomed to repeat it, but what can investors learn from the history of completely unpredictable events?
These kinds of events, dubbed "black swans" by Nassim Taleb, are unpredicted, come as a shock, have a massive impact and were then retroactively (and mistakenly) characterized as predictable. Recent examples include the rapid dissolution of the Soviet Union, 9/11, and the 2008 financial crisis (though some dispute this). Black swans can wreak havoc on any portfolio. Yes, they are unpredictable, but there are discernible traits common to different black swans that can inform investment strategies in a helpful way.
Best Practices for New Investors
There are three characteristics that define a black swan. First, it is an unpredictable and highly improbable event. Second, its consequences are massive. Third, after it occurs, people try to make it seem like it could have been predicted and should have been expected. While there are occasionally people who predict hard-to-predict events and warn of impending disaster, those voices are few and rarely headed.
In other words, forget trying to predict the next black swan. Instead, follow these five best practices to put yourself in a strong position to withstand whatever comes next.
1. Make sure you have a diversified portfolio. Avoid putting all your money in one place, one sector, or even in one country. For instance, you shouldn't have all your assets in the U.S. economy, but instead diversify and put some in foreign markets. Realize that owning a blend of tech and pharmaceutical stocks does not equal diversification. Owning only U.S. stocks usually doesn't, either.
2. Create a separate hobby portfolio. Some people enjoy investing as a hobby. But younger people in particular should have the bulk of their assets in a long-term diversified portfolio. If you're interested in taking risks, create a separate portfolio for yourself that you can experiment with. But don't play with all of your money. Keep some of it in very conservative, highly liquid investments for a rainy day; a rainy day will always come along.
3. Use solid fundamentals to fill your portfolio. Most investors are familiar with the revered price-to-earnings ratio, the price of a company divided by its earnings. Typically stocks in the S&P 500 trade around a 15 price-to-earnings ratio, which means they're valued at 15 times what they earn every year. But in times of critical importance, the conventional price-to-earnings ratio lags any index to the point of being useless as a value indicator. You might wonder, "How can price-to-earnings ratios be at record highs after stock prices have fallen? Why the lag?" Simple. Earnings fall faster than price. If you only use the price-to-earnings ratio to measure the markets' relative valuation, you're oversimplifying. Simple is good. Excessively simple is not so good.
A more accurate tool you can use is the Shiller price-to-earnings ratio. Yale Professor and Nobel Laureate Robert Shiller, author of the classic book Irrational Exuberance, popularized the ratio to better measure the market's valuation. The Schiller price-to-earnings ratio eliminates the fluctuation of the simple price-to-earnings ratio caused by variations of profit margins during the business cycle. It is calculated by taking the price of the S&P 500 and dividing it by the average annual earnings of the S&P ratio over the past 10 years, adjusted for inflation.
If we look at major peaks and bottoms in the Shiller price-to-earnings ratio (as shown above), we see that the peak during the dot-com bubble was at an all-time high -- above 44 -- in December 1999. Comparatively, the high in 1929 around the time of the stock market crash was 32.6, a distant second. The important takeaway is that the Shiller price-to-earnings ratio has identified secular bottoms before the market runs up, as well as tops before the market crashes. The current Shiller price-to-earnings ratio of the S&P 500 is 27.2, 63.9% higher than the historical mean of 16.6 -- an important number to keep in mind when taking a holistic look at your current portfolio.
4. Face the black swan reality. You should understand that bubbles and financial crises are inevitable, so that when they do occur you have prepared yourself emotionally and can respond rationally. You can analyze stocks and get into complex modeling, but at the end of the day, the future is a mystery.
5. Understand the black swan opportunity. "Buy low, sell high" is a cliché for a reason. Recognize that when the stock market crashes, that is the best time to buy stocks. It may feel counter-intuitive to spend more money when your portfolio is losing value, but this is the time to pick up good companies that will recover, for a low price.
Keep Calm and Invest On
We will always go through crashes. We will always overvalue stocks and then undervalue stocks and do it all over again. There's a famous quote by Charles Mackay that illustrates this truth: "Men, it has well been said, think in herds. It will be seen that they go mad in herds, while they recover their senses slowly, and one by one." Further evidence of this concept has been stated eloquently by business magnate Warren Buffet who noted, "Bad things aren't obvious when times are good. After all, only when the tide goes out do you discover who's been swimming naked."
There's no need to swim naked. Financial crises are hard -- if not impossible -- to predict. Past crises, however, can show us how to avoid falling victim to the next one. There is a false assumption that knowledge and timing are the best ways to get into the market. However, time in the market is more important than timing in the market. Don't analyze stocks to the point that you become paralyzed waiting for the perfect opportunity to arise. Use the best practices described above to create a solid emotional and financial foundation that can weather any storm.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.
Ankush "Koosh" Saxena is co-founder and CTO for TipdOff, a financial social network that connects individual investors and enables real-time access to stock tips, trades and advice from trusted friends and proven experts. In this role, he establishes the company's long-term technical and product vision while leading all aspects of the overall architecture and implementation of the platform. Prior to TipdOff, Koosh worked at Lockheed Martin and founded the startup Intreeka. He holds a master's in Electrical Engineering from the University of Southern California.