How to Protect Your Portfolio From the Next Unexpected Market Crash

If you were to try to predict which event might be the catalyst for the next financial crisis, would you choose a) a war over South China Sea islands, b) a global debt crash, c) a collapsing Chinese economy, or d) none of the above?

The best answer, according to the Black Swan theory, is "d) none of the above."

This theory was created by Nassim Taleb, a statistician who wrote a book about it in 2007. He explained that a "Black Swan" event is something that has a catastrophic effect on markets, and is also almost impossible to predict.

Too often, we rely on what's happened in past markets to predict what will happen in the future, says Taleb. But the stock market is unpredictable, and the past can't foretell the future. So we underestimate the chances of an unprecedented event happening.

The 2008 global economic crisis showed that Taleb was right. It was the thing that no one predicted that made the biggest splash. Nowadays, "experts" often use his theory to predict the "next Black Swan." 

But that is a contradiction in terms. A Black Swan event is devastating because no one can see it coming. Few can prepare for it or lessen its shocking effects.

There are several unexpected and unprecedented Black Swans in recent memory -- the terrorist attacks of 9/11, the Southeast Asian tsunami of 2004, the financial crisis of 2008, the Fukushima tsunami and nuclear disaster of 2011, and the collapse in oil prices of 2015.

After the fact, however, people like to say that they saw it coming, that it was obvious. This is called "hindsight bias," or the "knew-it-all-along effect." This causes us to think that if something like that ever happens again, we will recognize and prepare for it.

But thinking that way misses the point of the Black Swan theory.

To explain further, Nassim Taleb uses the example of a Thanksgiving Day turkey. In preparation for the holiday slaughter, turkey farmers get their birds extra plump by feeding them more.

"Consider a turkey that is fed every day," Taleb writes. "Every single feeding will firm up the bird's belief that it is the general rule of life to be fed every day by friendly members of the human race 'looking out for its best interests,' as a politician would say."

"On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief."

The turkey's Black Swan event is its head on the chopping block.

This is how Taleb charts the bird's feelings:

The bird is fed daily by the nice farmer, and its happiness increases. It could not possibly predict the final outcome because it is something that has never happened before.

The comments of Tsuneo Futami shed light on the matter. He was a nuclear engineer and director at Fukushima Daiichi, the site of the 2011 Fukushima disaster, in the late 1990s. "We can only work on precedent, and there was no precedent," he said. "When I headed the plant, the thought of a tsunami never crossed my mind."

Like Taleb's Thanksgiving turkey, Mr. Futami and his fellow safety experts didn't plan -- and, by definition, couldn't plan - for an unprecedented Black Swan event. Instead, they relied on what had already happened in the past to develop the safety design. (That said, some nuclear power experts had flagged the plant's earthquake-related dangers.)

For investment portfolios, Black Swan wisdom calls for remaining wary and informed. Don't base decisions on recent past events. Even in calm times, think about how an extreme event could affect you. But keep your balance and don't allow fear to paralyze you. After all, Black Swan events are rare, and if you worry too much you could miss out on a solid investment opportunity.

Consider these basic protections that should be built into every portfolio -- for optimists and pessimists alike:

Diversify:Own assets in a variety of industries and countries, and own a range of assets, such as cash, real estate, gold, bonds, and stocks.

Hedge:Make sure your portfolio holds assets whose prices usually move in opposite directions, or independent of each other.

Buy quality:Focus on owning quality businesses, not just stocks. Go by this famous advice from Warren Buffet: "Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years."

Don't over-leverage:Don't borrow too much to invest or you may make your Black Swan losses worse.

Stay flexible:Keep some cash available to take advantage of unexpected investment opportunities. This will allow you to "buy when there's blood in the streets."

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Kim Iskyan is the founder of Truewealth Publishing, an independent investment research company based in Singapore. Click here to sign up to receive the Truewealth Asian Investment Daily in your inbox every day, for free.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.