The Black Swan: The Impact of the Highly Improbable

A Black Swan is an outlier. It is an event outside regular expectation. It has extreme impact. We cannot anticipate them though we are tempted to find explanation in retrospect. The term references the belief that, until the discovery of Australia, people believed that all swans were white. One observation, however improbable, can refute a statement long held and accepted as fact. Some notable Black Swans are World War I, the invention of penicillin, the creation of the Internet, and the attacks of 9/11.

In The Black Swan Taleb continues with the premise he explored in Fooled By Randomness: The Hidden Role of Chance in Life and the Markets. In many respects it is Part Two of that book. I suspect the success of his first book played a prominent role in the creation of the second. Although entertaining, edgy and confrontational in style, The Black Swan explores little new territory until the end of the book. Chapters 15 -17 are exceptional and contain the essence of his argument. In these he dissects the foundation for most probability theories and offers compelling criticism for why they have little relevance in regular life. Chapter 16, The Aesthetics of Randomness, which focuses on Benoit Mandelbrot, his work in fractal geometry and its impact on probability analysis, is brilliant.

Taleb calls himself an essayist and part time trader. I have no idea if he was a successful trader but he is an accomplished essayist. The book is really a compilation of individual essays linked together by several key tenants. The first is what Taleb calls the "narrative fallacy" which is the human inclination to summarize complex situations in simple stories. In Taleb's words, "The fallacy is associated with our vulnerability to over interpretation and our predilection for compact stories over raw truths. It severely distorts our mental representations of the world; it is particularly acute when it comes to the rare event."

The second key factor is our tendency to "platonicity". (Plato does not fare well in the black swan universe). He says this "is our tendency to mistake the map for the territory, to focus on pure and well defined "forms", whether objects, like triangles, or social notions like utopias." Taleb doesn't claim that platonic forms don't exist only that they often are inaccurate models in specific situations, where "the Platonic mindset enters in contact with messy reality, where the gap between what you know and what you think you know becomes dangerously wide. It is here that the Black Swan is produced."

The third central theme he explores is the" ludic fallacy" (from ludus, Latin for games). Simply, we tend to confuse manageable, known risks such as gambling, with unknown risks. Obviously, we cannot predict or manage unknown risks. "In real life you do not know the odds; you need to discover them and the sources of uncertainty are not defined.' The former Secretary of Defense Donald Rumsfeld, in attempting to explain the dismal failures of the Iraq War gave a lengthy discourse on the "known unknowns" and the "unknown unknowns". I doubt he realized he was demonstrating the ludic fallacy.

Taleb imagines that there are two distinct countries we inhabit, Mediocristan and Extremistan. According to him," the supreme law of Mediocristan is that when your sample is large no single instance will significantly change the aggregate or the total." It is a country whose symbol is the bell curve. Rare events have little impact on the average.

In contrast, in Extremistan, inequalities are such that one single observation can disproportionately impact the aggregate or the total. Taleb continues, "While weight, height, and calorie consumption are from Mediocristan, wealth is not. Almost all social matters are from Extremistan." The danger according to Taleb is in believing you live in Mediocristan when you actually reside in Extremestan.

Each country has different ways of dealing with randomness. In Mediocristan there is great interest in complex theories developed with complicated physics and mathematical models that are elegant yet often precisely wrong. They consider randomness to be a function of ordinary fluctuations; extreme jumps are of small concern.

In contrast, Extremistanians consider Black Swans to be the dominant source of randomness. They reject Platonic abstract models in favor of evidence based empirical skepticism. In this country, with such concern for the impact of extreme events, it is better to be mostly right over a broad range of possibilities rather than perfectly right within a narrow range modeled upon precise assumptions that often do not fit into how the world works.

Financial planers are intimately aware of the Black Swan. We inhabit Extremistan every time we encounter an extreme event. We are the ones who sit with our clients in the aftermath while the theorists retire to their ivory towers to develop retrospective theories as to why the previous theory didn't work.

An excellent example of this was the collapse of the hedge fund Long Term Capital during the currency crisis of 1998. Two of the founders of the fund were Robert Merton Jr. and Myron Scholes, noted academicians who had developed a complex trading theory designed to manage the risks to the hedge fund. Unfortunately they ignored the possibility of a Black Swan and the hedge fund went bust nearly bringing down the world economy with it.

Even though portfolio theory demonstrates serious flaws, graduate schools continue to teach it and investors continue to use it as the basis for constructing investment portfolios. While financial planners have been as stubborn as any to think outside of the MPT box we have been better than most in adapting our plans to the realities of Extremistan. We have been early adapters of Monte Carlo analysis in analyzing possible outcomes of our client's plans. We also have readily accepted the findings of the behavioral finance proponents such as Daniel Kahneman, which demonstrates that investors seldom act as rationally as is expected in Modern Portfolio Theory.

We know how inefficient markets can be. We see and feel the physical, emotional, and mental impact of Black Swans on the lives of our clients and ourselves. Yet we continue to hold to finance theories that can be precisely wrong. Taleb does not offer alternatives. He certainly does not claim to any predictive ability of future Black Swans. It is enough that he has presented a thoughtful, entertaining book. It is a book that challenges those of us who plan for the future to take our theories less seriously, the consequences of our actions more seriously and the impact of the highly improbable most seriously.

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