The “black swan theory” was popularized by option trader and mathematical statistician Nassim Taleb and is the idea that the world is shaped by extremely rare events that have severe impacts (good or bad) and are impossible to predict.
While Taleb’s idea is most commonly applied to the stock market, like the 2008 financial crisis when the market was cut in half, I want you to apply the idea to the rest of your life.
What unaffordable risks, no matter how small the possibility of happening, do you have in your life that have catastrophic consequences? Think about the worst-case scenarios: disability, bankruptcy, and even death.
Look at recent history and you’ll notice that black swan events happen all the time around the world. While the individual events themselves are unique (pandemics, wars, stock market crashes, etc.), together they are not as “rare” as we think. This is true in our individual lives as well.
If you’ve ever seen anyone lose a lot of money or their livelihoods due to catastrophes, you should absolutely learn from their mistakes and not repeat their fate. Being aware of unaffordable risks in your life is smart risk management.
Live to fight another day, so you can stay in the game of life and keep on moving forward. The worst feeling is losing years of valuable time that you will never get back.
Never Work For The Same Money Twice
Warren Buffet, one of the wealthiest investors of all time, lives by 2 very simple investing rules:
- Rule #1: Never lose money
- Rule #2: Never forget Rule #1
While these 2 rules seem obvious, too simple even, Buffet knows how easily they can be broken. As humans we let our emotions get in the way of acting logically. We are our own worst enemies when it comes to money and investing.
Be informed, whether in investing or in life, do your homework, understand the full risks of every decision you make (or don’t make), and don’t gamble away everything.
I’d like to expand Buffet’s philosophy with my own rule: Never work for the same money twice.
Think about the financial black swan events that have very small chances of happening but can destroy your financial life:
- A long-term injury that disables you from work while resulting in huge medical bills
- Your child gets into a car accident that results in a multi-million dollar lawsuit
- Getting a cancer diagnosis while you’re in between jobs
- Accidentally causing a fire that burns down your house
- Passing away and leaving a family behind without the main breadwinner
- Running out of money in retirement and giving up your lifestyle
While nobody wishes these financial black swan events to happen in their lives, the reality is they can happen to anyone, at any time.
While it’s okay to decline insurance in situations like buying a new phone because it’s cheaper to self-insure against a cracked screen in the long run, you most likely cannot afford to self-insure against these financial black swan events.
When there is a solution available (for a small price), not taking action and paying to properly protect yourself is the definition of being penny-wise and pound-foolish. Proper insurance is one way of using money wisely to protect the time you’ve invested and give you peace of mind for risks you cannot afford:
- Protect yourself from long-term injuries that disable you from work with proper long-term disability insurance
- Protect yourself from a multi-million dollar lawsuit due to your child’s reckless driving through proper auto and umbrella liability insurance
- Protect yourself from getting a cancer diagnosis while you’re in between jobs so you get the treatment you need with proper health insurance
- Protect yourself from accidental fires that burn down your house/apartment with proper homeowner’s/renter’s insurance
- Protect your family financially from your unexpected death with proper term life insurance
- Protect yourself from running out of money in retirement by investing early and buying an annuity that guarantees you a certain amount of income for life
Once you’ve achieved progress toward financial freedom, you’ll never want to risk the time and effort you spent building your richest life.
Remember. Never work for the same money twice.
Black Swans In The Stock Market
Let’s touch a bit on black swan events in the US stock market, which is a crash of 20% or more. The most recent example is the crash in early 2020 due to COVID-19 pandemic fears.
There is no reliable way to predict when these stock market crashes will happen, and we know that investors who try to time the market to get better returns, ironically get worse returns.
On the bright side, history has shown that after every single black swan event, the stock market has eventually rebounded and has relentlessly marched upwards to hit new highs.
Look at the chart below with the grey areas representing crashes in the stock market. In early 2020, the market crashed by 34% from its peak due to COVID-19 concerns, wiping out trillions of dollars in a matter of days. It took just 117 trading days for the market to fully recover.
At the time of writing, the S&P 500 is currently at ~4,600. That is ~36% higher than the highest level before the 2020 market crash.
Source: Refinitiv; New York Times
The Best Defense Against Stock Market Black Swans
The way to protect yourself from stock market crashes is to follow a proven investing style: long-term buy-and-hold investing, which is a favorite of Warren Buffet and Jack Bogle (founder of Vanguard).
If we invested in the stock market over 1-year, 5-year, 10-year, and 20-year periods, taking into account all the stock market crashes that have happened in the past, how would we do?
Source: The Measure of a Plan
While market crashes are painful in the short term, time heals all wounds and the crash becomes just a scar of the past. The annualized returns across 20-year periods are all positive (from 0.5% to 13.2%)… meaning you would have never lost money if you held on.
If history has shown that it’s almost impossible to lose money over a 20+ year period in the stock market, even with black swan events that you cannot avoid, why wouldn’t you adopt a long-term investing strategy where you are almost guaranteed to win?
You make money in the stock market by regularly investing and staying invested over long periods of time. A long investing horizon is the ultimate protection against crashes in the stock market and can make you rich.
Win The Game Once
Once you understand that financial black swan events exist in your life and know there are ways to eliminate that risk with money, it would be foolish to not take action.
You should not be afraid of every catastrophe that can happen, that’s not the point of this post. The chances of them happening are extremely small and hopefully never happen in your life.
But you should absolutely understand that they can happen and you can protect yourself against them. Smart risk management is being aware of the possibilities, not being scared of the unknown future.
More importantly, you can’t afford to lose all the time and effort you’ve spent building your freedom.
If you follow Buffet’s wisdom, you will only need to win the game of financial freedom once.
Then it’s on to accomplishing more important things in your life (like maximizing health, happiness, and dreams) to live the richest life possible.