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Nassim Nicholas Taleb now popular “The Black Swan: The Impact of the Highly Unlikely“ is a book about epistemology, probability, risk and psychological biases. As such, it is more of a book about how NOT to invest than how to invest.
the term black swan itself has entered common financial vernacular and is used to describe an atypical event entirely outside the realm of predictable expectations, which has a disproportionate impact on future developments. Furthermore, it is only rationalized as predictable in retrospect, after the fact. Or, more precisely, for an event to be qualified as a black swan, it must meet the following criteria:
- It’s an exception. Nothing that has happened before (no historical information) can point to the possibility of this happening;
- It has an extreme and disproportionate impact (events with low predictability and high consequences);
- It becomes explainable only after the fact (prospectively unpredictable, retrospectively predictable).
A black swan, in other words, represents unknown unknown (a gray swan is referred to as a known unknown). Prof. David Snowdenin Cynefin Structure It helps you gain some guidance about the type of environment you are operating in and how to approach decision making under different levels of uncertainty.
For example, simple and following established best practices, complicated and requiring specialized knowledge, complex and heuristic, chaotic requiring new practices.
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In our usual way of thinking, we tend to accept forward-looking models and repeatable patterns that assume normal distributions of simple inertia bell curves. However, most things in the world tend to be complex and the simplistic sense of linearity of how the world works is what makes us blind to the hidden black swans.
Examples of black swan events are the outbreak of World War I, the invention of the computer, the rise of Google, and perhaps the example that best illustrates this, the Thanksgiving turkey, which Taleb explains:
Consider a turkey fed every day. Each feeding will reinforce the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race “who have its best interests at heart,” as a politician would say. On the Wednesday afternoon before Thanksgiving, something unexpected will happen with the turkey. This will incur a review of belief.
It is worth mentioning that Taleb himself has extensive experience as an options trader.
How to deal with black swans
It took 5 volumes to get to the main point: “The main point is that although there is excessive uncertainty about what is happening, there is great certainty about what should be done about it.” – Nassim Nicholas Taleb.
Taleb (not unlike the Cynefin framework mentioned above) categorizes events into two metaphorical realms to differentiate between domains that we can predict (collectively referred to as Mediocristan) and domains that resist prediction (called Extremistan). Everything social, including economic life, comes from Extremistan and the metrics we tend to use are not adapted to that.
What Taleb suggests as an investment strategy is to avoid putting your money in medium risk investments (because how do you know they are medium risk?) and instead put most of your eggs (say 85%) in extremely safe baskets. it’s safe. They can be assets like treasury bills, for example, because if they fail, your investment portfolio will be the least of your problems. And the rest in things that are extremely speculative (like startups or options) and that expose you to the possibility of achieving positive black swans (a rare event that represents a large slice of the pie).
Conclusion
Taleb’s Black Swan is a sequel to his “Fooled by randomness” And it’s also full of delightful anecdotes and useful practical advice (like, for example, never take advice from someone who wears a suit and tie).
It is highly relevant to the dismal science of economics, as it illustrates how, in theory, there is rarely much difference between theory and practice, but in practice, there tends to be a considerable gap between the two.
Taleb himself worked eighteen years as an options trader and has a considerable amount of academic publications in addition to Black Swan and those that follow (“Antifragile: Things that Gain from Disorder”, etc.). Which are more fun and philosophical to help someone avoid being stupid (our most innate human quality) while figuring out how to turn a lack of knowledge and understanding into action (i.e., how not to be a turkey).
Another conclusion is that probability is not something you can measure in the same way that temperature is measured and you cannot take the lottery winner as an example to follow to guarantee that this will be a recipe for replicating your success.
The wise approach is to ensure reasonable exposure to luck (positive black swans) while being hyper-conservative to ensure survival.