How to counter Black Swan events

PR when put together presents for Public Relations, a wing of the communication strategy of a corporate or country to give a positive picture. When used separately the connotations could be as diverse as Pandemic and Recession, that's what exactly many investors felt last week when they reacted to the possible repercussions of the current Covid-19 virus outbreak. Investors reacted adversely as the World Health Organization (WHO) has upgraded the threat to a possible pandemic sending the world markets into tizzy.

In absolute numbers, the infection and mortality are turning into unprecedented for any virus attack in recent history. While the infection rate is very high compared to the recent outbreaks of SARS, MERS, H1N1 flu, etc., the fatality rate has remained relatively low. As investors began to price the risks the world markets bled not just in the riskier assets like equities but even crude and gold have tumbled.

This has suddenly transformed into a Black Swan event which was coined by Nassim Taleb, which is a metaphor to describe an event that comes as a surprise having a major effect and is often inappropriately rationalized after the fact with the benefit of hindsight. The term is based on an ancient saying that presumed black swans didn't exist. Some are considering this outbreak as a Black Swan event, though unlike the 9/11 event is not a one-off incident.

The problem with the current outbreak is that there's no way to know the exact extent of the possibilities that it could lead, both primary and secondary in nature. To assess what it could trigger in the future - be it near and/or medium - is difficult. It's because there was little information available about the outbreak in the initial days as it originated from Mainland China and one has to depend upon the version of the officials which's less transparent. As the virus spread to other parts of the world, created new epicenters and still are early days to clearly assess the outcomes.

There are numerous studies already floating at the various possibilities about the effect it is having and could've in the coming months due to the disruption of trade. The quarantine and restricted cities in China have resulted in disturbance of supply chains across the world. As the ships/containers have piled up at the ports, trade trickled down and any prolonging in the situation could snuff away the little green shoots of the world economy which is limping its way around the trade wars.

The most notable comparisons being drawn are of the equity market reactions to the previous such virus outbreaks. Data suggests recovery over a year or so period from the beginning of those crises and how normalcy has regained in the subsequent months. It's true that these events like those of the others (dot com burst, Great Financial Crisis, Ebola/SARS, etc.) would turn into mere blips in the history of long-term charts but to assume that a particular percentage of correction is sufficient or overdone comparing past is incorrect.

Also, when such events happened in the past, the stock market & economic conditions prior to the outbreak is completely different from that of now. For instance, prior to the 2002-03 SARS epidemic, the world was recovering from the dotcom burst and was on a robust growth for the next 4-5 years which saw was busted by the financial crisis. Moreover, China's share of global exports was at about 8.3 per cent in '02 and is now at about 16.5 per cent while the share of global GDP has risen to about 16 per cent from that of around 4 per cent. Currently it contributes about 37 per cent of the world's growth, so certainly the recent crisis will have higher secondary effects that can destabilize the world economy.

The greater integration of China in the world trade and also the world's dependency since the last such event has greatly increased. China contributes over 15 per cent of the share in exports of global intermediate goods has risen from 6.7 per cent in '02. With infection spreading to Japan and South Korea, 3 out of the 5 export hubs of intermediate goods are significantly impacted by Covid-19 outbreak, asserts a BCG study. With this backdrop it's difficult to predict the outcome of impact from the present crisis, so should one move out of equities?

While long-term returns in the equities is well documented, one needs to survive the short-term hiccups it poses, thus asset allocation turns critical. One can't be too heavy equity or otherwise when planning for investments. The current situation is no different and one has to strictly adhere to basics of investing in-line with their risk appetite and goal timelines.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)