Friday, 29 January 2010

'The Black Swan', by Nassim Taleb


This is an important book. All intellectual people should read it. It should be a set text – certainly for all business school students. The trouble is that business schools would have trouble accepting much of what he has to say. Furthermore, Mr Taleb is unrestrainedly outspoken, so that he almost seems offensive. In the first half of the book, I wondered what kind of egomaniac was keeping me company. BUT his erudition and his arguments (and his rough charm) gradually and firmly win through. By the end of the book, I simply have to admit that he is correct.

To admit that he is correct is intellectually like an earthquake, since it shakes down the towers of many things taught in our conventional education, not least business school itself. If you accept he is correct and then go on with your life as normal, then you have not fully accepted that he is correct. I personally realise that I have not internalised his messages and changed my way of thinking and my way of life. I am somewhat confused about the far-reaching implications of his arguments. I will have to read it again and contemplate, and then implement some changes. This almost sounds like a religious book!

So what is it about? A ‘Black Swan’ is his label for a highly improbable, but high impact event. It is an outlier; something beyond our regular expectations. So we do not think about a ‘black swan’ event much. We may not even know it exists. Our experience gives us no clue that it exists. We take a thousand balls out of a bag and find they are all white. Why would we expect a black ball? Our statistics, whether Pascalian or Bayesian, will not alert us to the possibility of a black ball. Then one day we draw out a black ball. All our previous experience is vitiated. Mr Taleb’s metaphor comes from Europeans seeing only white swans, and being astonished to discover black swans in Australia.

The metaphors of swans or balls in a bag do not capture well his other key point here. The ‘black swans’ have a high impact. Think of history. 9/11 was unexpected and had high impact. The First World War has unexpected and had high impact – to put it mildly.

Or think of your own life, and the unforeseen key events that changed your life for ever. They were not planned, but once they happened, everything changed. The person you met and married. The job you applied for and got, and the job you suddenly lost. Specifically I think of going to work in Japan, something not remotely contemplated 12 months before I arrived there. I also think of the thunderbolt of being diagnosed with Polycythaemia in 1994; or the stroke that might suddenly floor me as a result.

If you think in personal terms, the significance of ‘black swans’ comes home. Mr Taleb says forecasting is impossible in many circumstances. Planning often turns our to be futile. I would have been astounded to be told in 1978, as an English student at Oxford, that I would turn out to be a financial markets trainer in 2008 (having the effrontery to teach physics graduates financial maths!).

Mr Taleb seems to wander over all kinds of ground in this book, and you wonder sometimes what the relevance and point is. But it all comes together by the end of the book. For instance, he discusses fame at several stages of the book. We tend to idolise the famous. But how did they become famous? Are they really worthy of our adulation? Maybe they were just lucky. Maybe they just happened to be a touch ahead in talent, but then were swept up in the many ‘winner takes all’ processes of modern life. Are the footballers earning £10 million really 500 times better than a lowly footballer earning £20,000? Is the man on TV being heard by millions of people more worthy to be listened to than a mere teacher in a classroom? Was Admiral Nelson truly the greatest leader in the Royal Navy? And what about those who achieved great things, and have never been heard of? A stunning poem written in a book that is lost forever. A talented composer who never gets published? A man who prevents a terrorist outrage, whose name is never known to the public.

What has this to do with infrequent, high impact events? Everything. Many of the fortunate are the products of positive black swan events. Furthermore the luck element, or some self-reinforcing effect like academic peer review, leads to the domination of ideas which are simply weak or misleading – or should be more critically challenged, were they not coming from the mouths of such ‘famous’ people. When he is scathing of Nobel prize winners – especially those who won the Economics Prize – you at first think that Mr Taleb is being very disrespectful. Well he is. And when the scales fall from your eyes, and you see the unfair process by which Nobel prize winners are selected, you realise that Nobel prize are possibly not so worthy of our exaggerated respect. This is well explained by his description of social contagion.

Contagion and feedback loops are a large part of social phenomena that set them apart from pure science. He discusses the financial markets in several chapters, and firmly regards them as social phenomena, affected by human emotions and crazes. He rips apart the ideas of efficient markets and portfolio diversification and risk management techniques (all Nobel prize winning topics).

He talks a lot about ‘Mediocristan’ and ‘Extremistan’. He says we have to know which country we are in, and it is fatal to the search for truth and assessing risk to mix them up. He stores up positive venom for those who misuse the Gaussian normal distribution curve. It is a tool of Mediocristan. It can be rightly applied in the physical sciences and mechanical / chemical engineering fields. But he rages against it being used in the social ‘sciences’. Banks who assess their ‘Value at Risk’ with the normal distribution curve are telling us about the 99.9% confidence interval, which is actually unimportant. By their methods and actions they ignore the 0.1%, which is the Black Swan that changes everything. So they are not truly measuring risk, let alone thinking about it.

Finance is rich with black swans that come out of the 0.1% zone: the 1929 and 1987 stock market crashes; the Latin American Debt crisis of 1981; the collapse of LTCM in 1998; the collapse of Bear Stearns in 2008. Oh, they are all explained after the event. But we really did not forecast them and we really did not know the ultimate cause, any more than we know the cause of the First World War.

So we are urged to get away from the toxicity of Gaussian Curve thinking and to face the fact that many important distributions are highly skewed. Take wealth ownership for instance. Independently of this book, I have found statistics saying that 20% people own 83% of the world’s wealth. Furthermore an eye-popping 1% of people own 40% of the world’s wealth. The winner takes all – or so near to all that it hardly matters. We are talking about Extremistan here.

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