What happens to a portfolio in a Black Swan event?

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Black Swan Event is a term coined by Nassim Nicholas Taleb in his book "The Black Swan" to describe an event that is:

• Rare and Unpredictable: These events are outliers, meaning they lie outside the realm of regular expectations because nothing in the past can convincingly point to its possibility.
• Severe Impact: When a Black Swan event does occur, it has an extreme impact, often altering the course of industries, economies, or societies. 
• Retrospective Predictability: After the fact, people will concoct explanations for the occurrence of the event, making it seem explainable and predictable, though it was not predictable beforehand.

Characteristics of Black Swan Events:

• Low Probability: Before the event happens, it's considered to have a very low probability of occurring, if considered at all.
• Disproportionate Consequences: The effects are significantly larger than the cause would suggest. Small triggers can lead to massive outcomes.
• Human Nature to Rationalize: Our tendency to seek patterns and explanations                  leads us to rationalize these events post hoc, creating narratives that suggest they could have been foreseen.

Examples of Black Swan Events:

• The 2008 Financial Crisis: Few predicted the scale of the global financial meltdown, which was triggered by the collapse of the U.S. housing market and led to a worldwide economic recession.
• The COVID-19 Pandemic: The global spread of the novel coronavirus in 2020 was unexpected in its scale and impact, leading to economic shutdowns, millions of deaths, and a profound change in how societies operate.
• The Dot-com Bubble Burst: The rapid growth and subsequent collapse of internet companies in the late 1990s and early 2000s were not anticipated to happen so suddenly or with such impact.

When we talk about stock market crashes, we often focus on the recovery afterward. However, it's crucial to understand the immediate impact these events had on investors' portfolios. Let's break down the losses for a hypothetical $1,000,000 stock portfolio during the significant downturns around 1999-2000 (Dot-com Bubble), 2008 (Global Financial Crisis), and 2020 (COVID-19 Crash), focusing solely on the months of the crashes:

Dot-com Bubble (1999-2000)

• Peak to Crash: The Nasdaq Composite, heavily invested in tech stocks, peaked in March 2000. From its peak to the end of 2000, it fell approximately 39%.
• Impact on $1,000,000 Portfolio: Assuming this portfolio was heavily weighted towards tech stocks or similar to the Nasdaq's performance:
  • Loss: $1,000,000 * 39% = $390,000
• Time Frame: From March 2000 to December 2000.

Global Financial Crisis (2008)

• From Peak to Bottom: The S&P 500, a broader market indicator, reached its peak in October 2007 and hit its trough in March 2009, but the significant part of the fall occurred in 2008. By the end of 2008, the S&P 500 had declined by about 38.5%.
• Impact on $1,000,000 Portfolio: Assuming the portfolio mirrored the S&P 500's performance:
  • Loss: $1,000,000 * 38.5% = $385,000
• Time Frame: From October 2007, with the steepest declines from September to December 2008.

COVID-19 Crash (2020)

• Rapid Decline: From its peak in February 2020, the S&P 500 saw a rapid decline, hitting a low in March 2020, dropping around 34% from its high.
• Impact on $1,000,000 Portfolio: Assuming the portfolio's performance was similar to the S&P 500:
  • Loss: $1,000,000 * 34% = $340,000
• Time Frame: From February to March 2020.

Summary Table:

Crash Period

Peak to Trough Decline

Loss on $1,000,000 Portfolio

Time Frame of Major Decline

Dot-com (1999-2000)

39%

$390,000

Mar 2000 - Dec 2000

Financial Crisis (2008)

38.5%

$385,000

Sep 2008 - Dec 2008

COVID-19 (2020)

34%

$340,000

Feb 2020 - Mar 2020

Note: These calculations assume the portfolio's composition closely matched the indices mentioned or was heavily concentrated in the sectors most affected by these crashes. Real losses could vary based on individual investment choices, sector allocations, and timing of investments.

These figures illustrate the potential damage a major market crash can inflict on an investor's wealth in a short period, underscoring the importance of risk management strategies, like diversification and hedging, which can be crucial in protecting one's investments during such tumultuous times.

Portfolio Composition:

• 70% Stocks ($700,000)
• 30% Treasury Bonds ($300,000)

Dot-com Bubble (1999-2000)

• Stocks Impact: As previously noted, stocks (assuming a tech-heavy portfolio) lost about 39% from March to December 2000.
  • Stock Loss: $700,000 * 39% = $273,000
• Treasury Bonds Performance: During this period, treasury bonds actually performed well as investors sought safety, with long-term treasury bonds gaining around 16% in 2000.
  • Bond Gain: $300,000 * 16% = $48,000
• Net Portfolio Impact:
  • Total Loss: $273,000 (Stocks) - $48,000 (Bonds) = $225,000 (22.5% loss)

Global Financial Crisis (2008)

• Stocks Impact: The S&P 500 fell by about 38.5% by the end of 2008.
  • Stock Loss: $700,000 * 38.5% = $269,500
• Treasury Bonds Performance: Treasury bonds saw gains, with long-term Treasuries up by about 20.1% in 2008 as investors fled to safety.
  • Bond Gain: $300,000 * 20.1% = $60,300
• Net Portfolio Impact:
  • Total Loss: $269,500 (Stocks) - $60,300 (Bonds) = $209,200 (20.92% loss)

COVID-19 Crash (2020)

• Stocks Impact: The S&P 500 declined by roughly 34% from February to March 2020.
  • Stock Loss: $700,000 * 34% = $238,000
• Treasury Bonds Performance: Treasury bonds again provided a buffer, with long-term Treasuries gaining approximately 13.5% in the first quarter of 2020.
  • Bond Gain: $300,000 * 13.5% = $40,500
• Net Portfolio Impact:
  • Total Loss: $238,000 (Stocks) - $40,500 (Bonds) = $197,500 (19.75% loss)

Summary Table:

Crash Period

Stock Losses

Bond Gains

Net Loss on $1,000,000 Portfolio

Net Loss Percentage

Dot-com (1999-2000)

$273,000

$48,000

$225,000

22.5%

Financial Crisis (2008)

$269,500

$60,300

$209,200

20.92%

COVID-19 (2020)

$238,000

$40,500

$197,500

19.75%

Note: These figures are approximations based on historical performance data of major indices and treasury bond returns. Real-world outcomes for individual investors can vary due to specific bond maturities held, reinvestment strategies, and other factors like interest rate changes.

Including treasury bonds in a portfolio notably mitigated the losses from these stock market crashes, demonstrating the value of diversification and the role of bonds as a safe haven during market turbulence. This not only reduces potential losses but also aids in managing risk, which is vital for long-term investment strategies.