Brexit – Should It Be Considered A Black Swan Event?

*Discussing black swan events and why I believe “Brexit” is now part of that group.*

The black swan theory is used to describe events that come as a surprise, have a major effect and are often inappropriately rationalised after with the benefit of hindsight. In this blog post I am going to explain why I think the 2016 Brexit referendum should be considered a black swan event.

What is a black swan event?

The term was popularized by Nassim Nicholas Taleb, a finance professor, writer, and former Wall Street trader. Taleb wrote about the idea of a black swan event in a 2007 book prior to the events of the 2008 financial crisis. Taleb argued that because black swan events are impossible to predict due to their extreme rarity yet have catastrophic consequences, it is important for people to always assume a black swan event is a possibility, whatever it may be, and to plan accordingly.

He later used the 2008 financial crisis and the idea of black swan events to argue that if a broken system is allowed to fail, it actually strengthens it against the catastrophe of future black swan events. He also argued that conversely, a system that is propped up and insulated from risk ultimately becomes more vulnerable to catastrophic loss in the face of rare, unpredictable events.

Taleb describes a black swan as an event that 1) is beyond normal expectations that is so rare that even the possibility that it might occur is unknown, 2) has a catastrophic impact when it does occur, and 3) is explained in hindsight as if it were actually predictable.

For extremely rare events, Taleb argues that the standard tools of probability and prediction such as the normal distribution do not apply since they depend on large population and past sample sizes that are never available for rare events by definition. Extrapolating using statistics based on observations of past events is not helpful for predicting black swans, and might even make us more vulnerable to them.

Our inability to predict black swans matters because they also can have such severe consequences. Inconsequential events, regardless of how unpredictable, are obviously less interesting.The last key aspect of a black swan is that as a historically important event, observers are keen to explain it after the fact and speculate as to how it could have been predicted. Such retrospective speculation however, does not actually help to predict black swans.”  – Investopedia.

Examples of black swan events.

  • The 2008 global financial crisis initially caused by sub-prime mortgage lending.
  • The “Dot-Com” bubble caused by over excessive speculation on internet companies.
  • The crude oil crisis in 2014 initially caused by a rapid growth in emerging economies slowing down whilst supply increased.
  • The asian financial crisis in 1997 caused by the unsustainable rapid growth in asian economies which lead to losses greater than 70% in currencies and stocks in those markets.

This is going to seem controversial but I personally believe that the UK deciding to leave the European union in 2016 is a perfect example of a black swan event. I will use the 3 rules as given by Nassim Taleb to explain.

Firstly, the idea of the UK leaving the European Union was never really discussed since they first joined the EU way back in 1973. For over 40 years, we had been one of the major members of the EU and therefore, when the original referendum was announced back in 2016, it was definitely  beyond normal expectations and so rare that even the possibility that it might occur is unknown.

Secondly, the initial Brexit referendum back in June 2016 and the subsequent fallout since has had a catastrophic effect on all parts of the financial markets. The initial reaction was a huge sell-off on the Pound leading to a near 14% drop in the value of the GBP over the following 6 weeks. Since then, there has been increased volatility on all indices and currencies linked to Brexit discussions and it is estimated that Brexit has cost the UK economy £66 billion so far and we are still yet to leave the EU at the time of writing this (January 2020).

The chart above shows the value of the GBP vs USD during the 3 months either side of the initial Brexit referendum in 2016.

And thirdly, in hindsight, it appears all of this has been for nothing. It is now nearly 4 years since the initial Brexit referendum and we are still yet to leave the European Union. Since then, we have had general elections, sent different politicians to Europe countless times and brought multiple deals to the houses of parliament for discussion. All of which has left us in exactly the same situation as when we started. 

You can read my previous blog post discussing Brexit, the initial referendum results in 2016 and my conspiracy theory behind it all by clicking on the link below.

https://diaryofafinancekid.com/2019/03/21/brexit-money-making-masterpiece/

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